Keeping it in the family

Since the changes to the taxation of trusts introduced in March 2006 there has been much discussion about the use of family partnerships as an alternative structure to a trust. Passing comments have been made about the use of a company but nothing that extols its virtues as a trust alternative, even though a family investment company ('FIC') is a viable alternative that deserves greater attention.

Before we get to the detail it is worth recapping why we need an alternative to a trust. Lifetime gifts into a trust above the available nil rate band '“ currently £325,000 '“ are subject to an immediate 20 per cent inheritance tax charge. This tax charge can be avoided if the property put into trust attracts either business property relief or agricultural property relief or is made out of surplus income. Annual exemptions can also be used. But if a couple wanted to establish a family fund with, say, £1m, a trust structure would not be possible without incurring a significant and immediate tax charge of about £70,000 (£1m less two nil rate bands x 20 per cent). Alternatives to a trust are now needed to avoid these tax charges.

At this stage it is worthwhile to recall why we use a trust. The reasons include:

• to pass assets down the generations;
• to pool family investments;
• to retain control of investments;
• to retain control of distributions;
• to protect assets on divorce; and
• to keep tax to an acceptable level.

Reminding ourselves why we use a trust helps to put into context the key issue that stops people considering companies as a trust alternative. That issue is, of course, the double tax charge.

The double tax charge '“ a fatal flaw?

Companies pay corporation tax on their profits (income or gains) and shareholders pay tax to extract that profit. Overall this can result in a 46 per cent effective tax rate which is not attractive if the proposal is to have a structure that distributes all its income annually. But most trusts are used to accumulate income. In that scenario the tax rate is only 28 per cent which compares very favourably to a 40 per cent trust rate on income and even more favourably to the 50 per cent rate that will apply from 6 April 2010. This means a company has a further 12 per cent of its income available to be reinvested and from 6 April 2010 a further 22 per cent.

Capital gains are also taxed at 28 per cent in a company, which at first sight does not compare well to the 18 per cent available to a trust. But companies can still get indexation allowance which means tax is only paid on real gains not just gains arising as a result of inflation. For assets that make reasonable gains over the medium to long term indexation can reduce the effective tax rate to below 18 per cent.

It is also worth remembering that the double tax charge only arises if the shareholder is a higher rate taxpayer. Lower rate taxpayers do not have to pay additional tax on their dividends. This makes giving shares to minors (using a nominee) particularly attractive.

Companies have also been made more attractive by the recent Budget, as from 1 July 2009 most UK and foreign dividends received by a company will be exempt from corporation tax. Previously only UK dividends were exempt. The result is that for dividend income there is no double tax charge for any shareholder.

So the double tax charge is not a fatal flaw of a FIC and can be managed by making suitable investments. But the important point is that a FIC is a long term vehicle designed to accumulate and protect wealth for future generations, it is not intended to be a short term tax saving vehicle.

Structuring a FIC

The structure of a FIC is very flexible and can be altered to adapt to changing circumstances. A typical FIC may start with a couple making an initial cash subscription for shares followed by gifts of some or all of those shares to family members.

For example, James and Ruth have cash funds of £4m and wish to undertake some estate planning. They have two children, Michael and Chloe '“ both still minors. James and Ruth subscribe for 10,000 ordinary shares of £1 each. As minors, Michael and Chloe cannot hold shares directly so James and Ruth establish bare trusts for them and transfer to each of those trusts 3,700 ordinary shares giving Michael and Chloe a 37 per cent interest each in the FIC. The gift of the shares to the bare trusts soon after subscription results in no capital gain and will be a potentially exempt transfer for inheritance tax purposes.

James and Ruth also decide to give 600 shares to a discretionary trust. No capital gain arises again and for inheritance tax purposes the gift to the trust is within available exemptions. The advantage of using a trust to hold some shares is that the voting rights of those shares can be exercised by the trustees.

This assists with the control issues referred to below. In addition and at the same time James and Ruth subscribe for 1,990,000 redeemable preference shares of £1 each.

The advantage of these shares is that they can be redeemed at the discretion of the board of directors returning the initial subscription price tax free to the shareholders.

James and Ruth give some of the redeemable preference shares to the two bare trusts and the discretionary trust in the same proportions as the gifts of ordinary shares. Care needs to be taken to ensure that the rights and restrictions attaching to these redeemable preference shares does not result in their value being less than the subscription price as this will reduce the base cost of the shares for Michael, Chloe and the discretionary trust.

In addition to the share subscriptions James decides to make an interest free loan repayable on demand of £2m to the FIC. This has no tax consequences but is a useful way of gifting a proportion of the growth on these funds while being able to return the capital tax free by repaying the debt.

James and Ruth will each have 1,000 ordinary shares and 199,000 redeemable preference shares. The two bare trusts will each have 3,700 ordinary shares and 736,300 redeemable preference shares. The family trust will have 600 ordinary shares and 119,400 redeemable preference shares.

As a result of this planning, James and Ruth have made gifts of £1.6m without incurring any immediate tax liability and potentially saving £640,000 in inheritance tax. But importantly they have added those funds to a structure that is protective and gives them the ability to retain full control. They have also retained a personal interest in the FIC to enable them to manage the families investments together, take some income now and facilitate future estate planning by further gifts of shares.

Delivering income

A discretionary trust provides flexibility on when and how income is passed to a beneficiary. A FIC can mirror this flexibility by allocating to each shareholder a separate class of shares. To continue our example, James, Ruth, the family trust, Michael and Chloe would hold A, B, C, D and E ordinary shares respectively. The board of directors can then declare dividends at different times and on different amounts for each class of shares.

Care needs to be taken that James and Ruth have not reserved a benefit in the shares gifted by having the ability to pay themselves dividends at the expense of the other shareholders. This problem can be avoided if the distributable reserves of the FIC are specifically divided between each class of shares in the Articles of Association. This would prevent James and Ruth stripping out all the FIC's profits.

Exercising control

Control is an important aspect of a FIC. For a trust control rests with the trustees and for a FIC control rests with the board of directors. In our example, James and Ruth would act as directors. As directors they would have sole discretion to determine the payment of dividends and to decide on the investments of the FIC. The constitution of the board of directors can be protected through a combination of the Articles of Association of the FIC and a shareholders agreement. A shareholders agreement is a useful way to ensure the FIC is operated as the founders intend. Certain key decisions can require a 100 per cent shareholder approval which in effect gives a minority shareholder, such as the family trust in our example, a right to block decisions by future generations if appropriate.

Further long term protection can also be achieved by giving the family trust or a founding shareholder a right to appoint directors for as long as they are a shareholder.

To control the identity of shareholders the Articles of Association would limit transfers to family members and family trusts. The board of directors would also retain the right to refuse to register a transfer.

Asset protection

Protecting assets, particularly on divorce, is a major concern for clients and it is perhaps in this area that FICs are particularly useful. The recent case of Hashem v Shayif & Another [2008] EWHC2380 (Fam) is an unusual but significant case dealing with corporate structures in family proceedings.

A family-owned company was central to the litigation and the family court was asked to pierce the corporate veil and make orders against the company. Several different arguments were put forward but the judge refused to pierce the corporate veil and instead made clear that a court can only do so if there has been some impropriety linked to the company. The judge did not believe that legitimately taking advantage of a corporate structure involved any impropriety. Accordingly no order was made against the company even though to do so may have appeared in the interests of justice.

This is good news for FICs and puts them on the same footing as non-nuptial trusts even when formed during the marriage by a party to the marriage. It does not mean however that the value of the shares will not be seen as a resource, but the key is that the assets are protected and in practice the courts allow time and flexibility on how any settlement is reached.

A viable alternative

If we revisit the reason why trusts are used as noted at the beginning of this article we can see why FICs offer a very viable alternative to a trust:

• assets can be easily passed down the generations by the gift of shares;
• investments are pooled within the FIC;
• control is retained by the board of directors;
• the board of directors determine when and to who distributions are made;
• assets within the FIC are protected on divorce; and
• tax liabilities of a FIC are favourable if income and gains are accumulated.

This article only touches on some of the possibilities that a FIC can offer clients as it is such a flexible vehicle. It is that flexibility that enables a FIC to largely mirror a trust structure and yet importantly it is a structure that for many clients is familiar. As a result, a FIC is something that clients may feel more comfortable with than other alternative structures.