There are more than a million more limited companies registered with Companies House in 2017 than there were in 2012. According to Companies House, there were 3,896,755 companies on the total register at March 2017, and the upward trend does not appear to show any signs of slowing. While some of these companies will be under the ownership of listed groups, the number of unquoted companies continues to rise in the UK.
Some of the UK's largest businesses are not listed, and individual investors have been keen to participate in their success, as they look to diversify their investment portfolios away from traditional asset classes such as property and quoted shares. Household names such as Iceland, Dyson and Bet365 are all privately owned, yet are some of the UK's most successful businesses.
With the rise of the 'business angel' and access through crowdfunding and peer-to-peer channels, there are more opportunities than ever before for individual investors to invest in unquoted companies.
This feature covers the personal tax issues for individual investors in unquoted companies. While some of the tax features can appear attractive, it's important to understand the investment considerations, which can be very different from purchasing quoted shares. Our feature in February, 'The lowdown on EIS', covers the personal tax implications of investing in companies qualifying under the Enterprise Investment Scheme ('EIS').
Forms of investment in unquoted companies
The most common way for an individual to invest in an unquoted company is through shares. An investor can purchase shares from another party or subscribe for newly issued shares in the company.
Companies can issue varying forms of shares that can have different rights attached to them - eg, rights to income, capital on a takeover or winding-up and voting at the company's meetings.
The two main types of shares are ordinary shares and preference shares. Ordinary shares are the most common form of shares and, broadly speaking, each ordinary share represents a unit of ownership in the company. Preference shares 'rank' ahead of the ordinary shares as to dividends or capital or both, but generally have limited or no voting rights. The dividends attached to preference shares are normally at a fixed rate. Preference shares do not usually participate in the success of the company - eg, the growth in value of the company upon a sale.
An increasingly popular form of investment in an unquoted company is through a loan note or corporate bond. A loan note is essentially lending to a company usually at a fixed rate for a term. The company will pay interest to the holder of the loan note either at the end of the term or periodically - eg, every six months. The loan note may be secured on the assets of the company (eg, a property or fixed plant and machinery), which theoretically makes the investment less risky, or it may be unsecured. A loan note holder is expected to receive their interest payment before profits are paid to the shareholders. When the term ends, the company will repay the par value of the loan note.
Unlike investing in listed securities, investments in unquoted companies, whether through shares or loan notes, are not particularly liquid as there is no trading exchange. This can be unattractive for some investors who desire the flexibility of having short-term access to their money. For share investments, the investor will generally only receive their return upon a sale of the company; for loan note investments, the money will be returned when the term ends.
Income tax
Individuals receiving dividends from unquoted companies are taxed at the special dividend rates (see table 1). The government introduced a £5,000 dividend allowance with effect from 6 April 2016, which provides for the first £5,000 of dividend income received by an individual not to be taxed. The dividend allowance will be reduced to £2,000 from 6 April 2018, as announced in the 2017 Budget.
Interest received from loan notes is assessed to income tax at the normal rates (see table 2). Since 6 April 2016, a basic-rate taxpayer can benefit from the £1,000 'personal savings allowance', which means the individual does not pay income tax on interest received up to £1,000. If the individual is a higher-rate taxpayer, the personal savings allowance is reduced to £500, and 45 per cent taxpayers are not entitled to the allowance.
Although bank and building societies now pay interest gross on savings accounts, UK companies are still required to deduct 20 per cent withholding tax on interest payments, in the majority of cases. Where an individual is eligible for the £1,000/£500 personal savings allowance, this can mean that too much tax has been deducted by the company and the investor will need to recover this tax through their self-assessment tax return (if they complete one) or by writing to HM Revenue & Customs.
It is important to note that dividends and interest are taxed in the year in which they are received. This can be particularly relevant for loan notes/corporate bonds where the interest is accrued (ie, rolled up) and only physically paid at the end of the term. In this situation, the investor can only benefit from the £1,000/£500 personal savings allowance for that year. In addition, the 'one-off' income received in that year could put the individual into a higher tax bracket, which would mean their personal savings allowance is reduced to £500 or they are not eligible at all because they are now in the 45 per cent tax rate banding.
Unlike shares in listed companies, it is not currently possible to hold investments in unquoted companies through an individual savings account (Isa). However, it may be possible to make 'peer-to-peer' investments in unquoted companies through the Innovative Finance Isa, which became available from 6 April 2016. In order to hold investments through the Innovative Finance Isa, the investments would have to be made through FCA-regulated and approved peer-to-peer lending platforms.
| Table 1: Income tax rates on dividends (2017-18 tax year) | ||
|---|---|---|
| Income | Dividend tax rate | |
| Dividend Allowance 1 | £5,000 | nil |
| Personal Allowance 2 | £11,500 | nil |
| Basic-rate band (dividend income between £11,501 and £45,000) | £33,500 | 7.5% |
| Higher-rate band (dividend income between £45,001 and £150,000) | £105,000 | 32.5% |
| Additional rate band (dividend income above £150,000) | >£150,000 | 38.1% |
Notes: 1. Dividend allowance to be reduced from £5,000 to £2,000 from 6 April 2018; 2. Reduced by £1 for every £2 of income over £100,000
| Table 2: income tax rate on interest (2017-18 tax year) | ||
|---|---|---|
| Income | Income tax rate | |
| Personal savings allowance for basic-rate taxpayer | £1,000 | nil |
| Personal savings allowance for higher-rate taxpayer | £500 | nil |
| Personal allowance 1 | £11,500 | nil |
| Basic-rate band (income between £11,501 - £45,000) | £33,500 | 20% |
| Higher-rate band (income between £45,000 - £150,000) | £105,000 | 40% |
| Additional rate band (income above £150,000) | £150,000 | 45% |
Notes: 1. Reduced by £1 for every £2 of income over £100,000; capital gains tax (CGT) (see table 3 for CGT rates, exemptions and reliefs)
For most individuals that acquire or subscribe for ordinary shares (see above) in unquoted companies, the hope and expectation is that their investment will generate a capital gain. For higher-rate and additional-rate taxpayers, the rate of CGT is 20 per cent (however, capital gains realised on the sale of residential property and carried interest is assessed at 28 per cent).
An individual is entitled to a capital gains annual exemption of £11,300 (for the 2017-18 tax year). Capital gains above the annual exemption are reduced by any unused capital losses brought forward from earlier years, and the excess capital gain is taxed accordingly. It is important to note that for a taxable capital gain to arise, the assets have to be sold (or deemed to be sold). The increase in the value of the unrealised investment is not taxed.
While the current CGT rate of 20 per cent is attractively low, especially when compared with the highest rate of income tax of 45 per cent, there are two key reliefs that can serve to reduce the CGT rate to 10 per cent.
Entrepreneurs' relief applies to the first £10m of qualifying capital gains an individual makes in their lifetime, and those gains are assessed to CGT at 10 per cent rather than 20 per cent. The application of the relief is essentially worth £1m in CGT.
The basic qualifying conditions for entrepreneurs' relief in relation to shares in a company are as follows:
1. The individual owns at least 5 per cent of the ordinary share capital in the company.
2. The individual's shareholding entitles them to exercise at least 5 per cent of the voting rights.
3. The individual is an employee or officer/director of either the company in which they own the shares, or a company within the group (but it's important to have a genuine role that is remunerated at a commercial level).
4. The company qualifies as a 'trading company' (or holding company of a 'trading' group).
These conditions have to be satisfied throughout the 12 months immediately prior to the sale of the shares.
Passive investors in unquoted companies may not qualify for entrepreneurs' relief because they do not satisfy the third (employment/officer) condition.
The government introduced a new investors' relief in 2016, which has the same effect to assess the first £10m of qualifying capital gains an individual makes in their lifetime to a reduced rate of CGT of 10 per cent. The basic qualifying conditions for investors' relief are as follows:
1. The individual subscribed for newly issued ordinary shares in an unquoted 'trading company' on or after 17 March 2016.
2. The shares have been held solely by the individual for a period of at least three years.
3. The individual (or someone connected to him) must not have been an employee or officer/director of the company (or a group company) at any time during the period they held the shares.
Investors' relief is available in addition to entrepreneurs' relief, and therefore an individual investor could achieve a tax saving of £2m during their lifetime.
| Table 3: CGT rates, exemptions and reliefs (2017-18 tax year) | |
|---|---|
| Rate | |
| Basic-rate taxpayers | 10% |
| Higher-rate and additional-rate taxpayers | 20% |
| Capital gains qualifying for entrepreneurs' relief or investors' relief | 10% |
| Exemptions and reliefs | |
| Amount | |
| Annual exemption | £11,300 |
| Entrepreneurs' relief lifetime allowance | £10m |
| Investors' relief lifetime allowance | £10m |
Where an individual loses all or part of their investment in shares in an unquoted company, a capital loss arises that can be offset against capital gains arising in the same tax year, and any excess loss is carried forward indefinitely and is available to use against future capital gains. In certain circumstances, a capital loss arising in relation to the subscription for ordinary shares can be set against the investor's income, but this is generally only available where the investment qualifies under EIS (see 'The lowdown on EIS', 24 February 2017).
Where an individual makes a loan investment to an unquoted 'trading' company, and the company is unable to repay the loan, the individual should, in the majority of cases, be able to claim a capital loss.
Losses that relate to a 'peer-to-peer' loan can be exceptionally offset against any interest received on 'peer-to-peer' loans in the year of loss. If the individual has not received sufficient interest to use the full loss, the unused loss can be carried forward and offset against future P2P interest received in the next four tax years. In order to come within the provision, the 'peer-to-peer' loan must have been made through an 'operator' who is authorised under the Financial Services and Markets Act 2000 to operate an electronic system in relation to lending. If this requirement is not satisfied, the loss on the loan is likely to be treated as a capital loss, as outlined above, provided the relevant conditions to claim the capital loss are satisfied.
Inheritance tax (IHT)
Shares in unquoted companies can attract business property relief (BPR), which may reduce the amount chargeable to IHT by 100 per cent. The effect of BPR is to remove the value that relates to that qualifying asset from the charge to IHT, saving IHT at 40 per cent.
As a general rule, only shares in unquoted 'trading' companies will qualify for BPR. A shareholding will not qualify for BPR if the company's activities mainly relate to making investments - eg, dealing in stocks and shares and owning property. In addition, the shares must have been owned by the individual for two years before they qualify for BPR.
However, once the shares are realised for cash, BPR will no longer apply and the value will be immediately exposed to IHT at 40 per cent. However, if the monies are reinvested within three years in an asset that qualifies for BPR, the relief will immediately apply - ie, it is not necessary to have held that new investment for two years before it qualifies for BPR.
Maximising BPR using trusts
Another option to maximise BPR is to transfer the unquoted 'trading' company shares into a discretionary trust. Normally, a transfer to a trust by an individual in excess of the IHT nil-rate band (currently £325,000) is a 'chargeable lifetime transfer' for IHT purposes, resulting in an immediate IHT charge of 20 per cent of the transfer of value. However, where assets qualifying for BPR are transferred into a discretionary trust, the 20 per cent upfront charge is relieved, allowing greater value to be placed into the trust. The discretionary trust is able to sell the shares and receive cash proceeds, which can be reinvested, or used to make distributions to beneficiaries. The trust is subject to periodic IHT charges of 6 per cent of the value of the trust every 10 years, but this can compare favourably with IHT on death at 40 per cent.
Where an individual transfers an asset to a discretionary trust, they are treated as disposing of that asset at the then market value, which can give rise to a CGT charge. However, where the asset is a 'business asset' (which should include shares in an unquoted 'trading' company), it is possible to 'hold over' the capital gain so no tax charge arises.
Loan notes/corporate bonds
A loan note investment in an unquoted company is unlikely to qualify for any IHT relief, and therefore the full value of the loan will be exposed to IHT at 40 per cent.
