Tax-efficient distributions via family investment companies

Family investment company shareholders will have breathed a sigh of relief last summer when HM Revenue & Customs (HMRC) closed the unit it had set up two years previously to investigate the vehicles’ use among wealthy families for tax purposes. 

As we noted in ‘When should you set up a family investment company?’, IC October 2020, family investment companies are most often used by people with relatively large sums of money as a form of succession planning. They have become increasingly popular since regulations introduced in 2006 made trusts less attractive.

While the creation of the unit sparked speculation family investment companies would be the latest target in a broader government crackdown on ultra-high-net-worth individuals, HMRC minutes published in August found “no evidence” of a correlation between those who set up a family investment company and tax avoidance.

'HMRC's research concluded that people use family investment companies as a “planning strategy, often with the primary objective of generational wealth transfer and mitigation of inheritance tax (IHT)”.

Sharon Wood, tax specialist and partner at accounting firm Gilliland & Co, says she has seen a surge in popularity for the vehicles since the pandemic struck, with people deciding to sell their businesses and move the proceeds into a family investment company. 

Because family companies are complicated vehicles for anyone unfamiliar with company structures, they are popular with those who have owned businesses and are familiar with the process of running one. 

In October 2020 we covered who family investment companies are suitable for, how they are taxed and how to set one up. On top of this, there are also nuances to watch for when it comes to making tax-efficient distributions. If you are considering setting up such a company, it is worth seeking professional advice to make sure you have arranged the structure in the best way possible to meet your needs.

Dividend payments

The way in which family company distributions are made depends on how the vehicle has been set up. Typically, however, distributions are made to shareholders via dividend payments. Many family investment companies have multiple share classes, allowing for situations where the parents control what the company invests in and when dividends are paid, while the children have non-voting share classes which receive dividend payments.

Shareholders pay tax on dividends they receive at their marginal income tax rate. From April 2022, dividend tax rates are increasing by 1.25 percentage points, setting the tax at 8.75 per cent for basic-rate taxpayers, 33.75 per cent for higher-rate taxpayers, and 39.35 per cent for those paying additional rates. Shareholders that don’t have another income benefit from the income tax personal allowance of up to £12,570 per year. If they already earn an income over that amount, there is the dividend tax allowance of £2,000. 

For parents who have set up a family investment company and are paying dividends to their children, it is important to note that those dividends will be taxed at the parents' income tax rate until the children reach the age of 18. Julia Rosenbloom, tax partner at Tilney Smith & Williamson, says this is a particularly important point for family investment companies that have been set up to help pay private school fees. 

Dividends paid out from the company must be from distributable reserves. This includes any dividend income received from assets within the company – or rental income if the company owns a property portfolio. It also includes any gains made from sales of assets within the company.

But Wood says she tends to find that family investment companies are used as vehicles to accumulate capital and help with IHT planning, rather than pay out chunky dividends. That is despite the fact that family companies usually pay corporation tax on any profits annually, rather than dividend tax or capital gains tax on investments held. This can make it more tax efficient to hold high-yielding assets rather than high-growth assets within the company. Corporation tax is currently 19 per cent, due to rise to 25 per cent in April 2023.  

Those who want to pay dividends of different amounts to different children can do so by setting up ‘Alphabet shares’. This provides a different share class for each child, and every year directors can decide what type of dividend they pay to each share class. “Some parents like the idea of the flexibility, others wouldn’t dream of having it,” Wood says. 

Loan arrangements

Another key way of extracting money from a family investment company is setting it up using a loan arrangement. This means lending money to the company and then drawing down from the loan instrument over time free of tax. However, any children or grandchildren who are shareholders in the company would not be able to draw from the loan. Another potential disadvantage of using a loan account is that it will fall within your estate for IHT purposes. Nonetheless, Wood says that most of the family investment companies she comes across include a loan arrangement as it tends to be tax efficient for the person setting up the company.

Wood has one client who has placed £10m in a family investment company and has been drawing about £150,000 per year. His plan is to gift some of the remainder of the loan account balance to his children, so that part of the loan will move out of his estate for IHT purposes. As the company grows, the loan will become a smaller proportion of it, meaning that the IHT advantages grow over time.  

Instead of, or possibly as well as, a loan, there is also the option of creating preference shares which are redeemable when the company is set up. These shares do not require distributable returns and are generally treated as a capital gains tax position for the shareholder, which can be quite small. Rosenbloom says redeemable preference shares achieve a similar result as a loan but are harder to understand and tend to be less popular. She adds they can be expensive to set up.

Paying a salary

You might also choose to pay a child a salary out of the family investment company. This can help them when they apply for a mortgage, for example. But those going down this route must be careful and involve the child in the management of the company. In short: if you pay anything more than the commercial salary of the job being carried out you risk the whole company falling into your estate for IHT purposes. “On a practical level, I’d veer people away from taking a salary," Rosenbloom says. Salaries also increase the administrative costs as they require the creation of a payroll and National Insurance payments.

Redeeming shares/company wind up

If one of the shareholders wants to extract their money from the company, this could be done via a company buyback of their shares. If you do this, approach HMRC for clearance to make sure that the buyback value will be treated as capital value rather than an income distribution to lower your tax liability. You also have to do this if the whole company is wound up. 

There are some targeted anti-avoidance rules to consider, too. If you extract money from a family company and immediately set up your own separate family company, HMRC may say the proceeds should have been treated as an income distribution rather than capital. However, if you buy a house with the proceeds, that's likely be acceptable, according to Wood.