FICs offer asset protection; a means to pass on wealth down the generations, an ability to retain control over family investments and tax savings.
Trusts have been traditionally used to pass on assets down the generations whilst retaining control and providing asset or wealth protection for the family. Trusts were also a tax efficient structure which of course added to their popularity. However following the Finance Act 2006, the ability to put funds into a trust without incurring an immediate 20% inheritance tax charge was significantly curtailed. As a result alternative structures are now needed and the FIC is emerging as the simplest and most flexible option.
Recent changes to taxation have also made a FIC increasingly tax efficient when used as a vehicle to accumulate wealth. Most significantly a FIC will only pay corporation tax at 28% (reducing to 24% by 1 April 2014) on its income. This looks very attractive when compared to a trust which will suffer a 50% tax rate on its income and means a FIC has an extra 22% (increasing to 26%) of income to reinvest.
FICs are even more efficient structures for investments in other companies as dividend income from UK companies and most offshore companies are free of tax resulting in a tax free roll up.
The income tax savings offered by a company is attracting many individuals to using such a structure. However, simply using an off-the-shelf company is in our view missing an opportunity to create a structure that can offer much more than just an income tax saving.
The key to a FIC is that it includes features which facilitate estate planning, create greater flexibility to deliver income and offer increased asset protection.
An initial subscription for shares in cash should trigger no tax charges. A transfer of assets to a FIC is more problematic and will normally trigger a capital gain and for property transfers a stamp duty land tax charge. Using cash to establish a FIC is therefore generally preferable.
FICs make estate planning easier as shares can be gifted to family members or trusts rather than passing on a share of the underlying assets. Such gifts may give rise to a capital gain (although this gain can often be deferred if the shares are gifted to a trust). A gift soon after subscription and before the shares have increased in value will also avoid a capital gain. For inheritance tax purposes a gift to an individual of a share will not trigger any immediate inheritance tax.
Holding shares in a FIC on death will attract inheritance tax but immediate savings are available. This is achieved as the value of a shareholding will normally reflect a discount to the value of the underlying assets based on the size of holding.
A FIC is likely to pay corporation tax on its profits at the full rate which is currently 28% but from 1 April 2011 will reduce to 27% and reduces at the rate of 1% over the next three years resulting in a 24% rate from 1 April 2014. Capital gains are taxed as part of the profits and therefore at the current 28% rate. This is now of course the same as trusts and higher rate taxpayers but it is worth noting that companies still receive the benefit of indexation allowance which for long term investments reduces the effective tax rate to below 28%.
A particular advantage of a FIC is that UK companies do not pay corporation tax on dividends received from other UK companies and most offshore companies.
Shareholders will pay income tax on dividends they receive, although the 10% tax credit covers the tax payable by basic rate taxpayers. A 40% taxpayer pays additional tax at an effective rate of 25% and trusts and 50% taxpayers pay at an effective rate of 36.11%.
The combination of the tax paid by the company and the tax paid by the shareholder results in an overall effective tax rate of 46% for a 40% taxpayer and 54% for a 50% taxpayer. However when the corporation tax rate reduces to 24% the effective combined tax rate will reduce to 43% for a 40% taxpayer and to 51% for a 50% taxpayer. In view of this double tax charge it is recommended that a FIC is only used where the expectation is that profits will be accumulated over the long term. In this scenario the benefit gained by reinvestment at low tax rates offsets the double tax charge.
Structure of a FIC
A FIC offers an almost infinite choice of possible structures as there are few limitations on what rights can attach to shares or the number of classes of shares that can be issued.
A FIC structure may have the following features:
- ordinary shares which carry voting rights but no right to income or capital on a winding-up;
- separate classes of non-voting ordinary shares which carry the right to income and capital on a winding up but have no general voting rights; and
- redeemable preference shares that have a right to income which may be rolled up and payable only on redemption.
The advantages of these features are that:
- control (in the form of the ordinary shares) is separated from value (in the form of the non-voting ordinary shares) which enables value to be passed on, whilst retaining voting control of the company;
- the ability to pay different dividends to different shareholders by the use of the separate classes of non-voting ordinary shares; and
- the redeemable preference shares give the flexibility to return capital easily and with a low tax cost as only income tax will be payable on the interest received.
Where control and value are separated it is recognised that inheritance tax anti-avoidance provisions can cause some difficulties. To address these issues the Articles can provide that each class of non-voting ordinary shares has a fixed entitlement to the available distributable reserves. To the extent any distribution falls short of this entitlement, the unused proportion shall be carried forward and taken into account when assessing future distributions. These provisions ensure that (as far as possible) all classes of non-voting ordinary shares remain entitled to an equal share of distributable reserves, albeit these may be paid out at different times or accumulated within the company.
The Articles of the FIC should include a clause prohibiting the transfer of shares to anyone outside a defined class and this would generally exclude spouses. Where the Articles include such a restriction, the Courts in divorce proceedings are very reluctant to order a transfer of shares that is not permitted by the Articles.
A shareholder in a FIC will not have a direct right to the assets owned by the FIC. The underlying assets are therefore protected.
The board of the FIC has control over the dividends payable to shareholders and a Court cannot demand that dividends are paid.
A market valuation of a shareholding in a FIC is likely to reflect a discount to the true asset value of the FIC. It is possible to argue that only the discounted value should be taken into account in divorce proceedings.
Further protection can be obtained if shares in the company are owned through a bare trust as such trusts are not automatically regarded as matrimonial property of the beneficiary in the event of a marriage breakdown.
(A bare trust is the only form of trust where no immediate inheritance tax charge arises when assets are added to the trust. This is because the beneficiary has an absolute right to the trust fund.)
It is envisaged that the FIC would be an unlimited company. The primary reason for this is that unlimited companies are not required to file accounts at Companies House therefore the accounts will not be publicly available. An unlimited company would not be recommended if it is envisaged that the FIC will undertake any trading activity.
Shareholders of an unlimited company are not directly liable to creditors of the company. If an unlimited company fails to discharge its debts, creditors can petition for the company to be wound up and the shareholders, both past and present, will be liable to fund any shortfall of funds needed to pay the company’s debts, liabilities and the expenses of the winding up. The only risk to shareholders of an unlimited company therefore arises if the company is insolvent or undertakes an activity which carries a risk in excess of its assets.
The founder can retain the majority of the voting shares to retain overall control of the company if required but this is not necessary.
Day-to-day control and investment decisions would be taken by the board of directors. It is expected that the founder of the FIC would appoint individual members of the board, in the same way a settlor of a trust would appoint the first trustees. It would be recommended that at least two directors would be appointed, one of which would normally be the founder.
Once established, the appointment of directors is ultimately in the hands of the shareholders. However, through a shareholders’ agreement established at the outset the constitution of the board may be fixed and any changes may require unanimous shareholder approval to provide additional protection. By this mechanism the founder can ensure he/she retains control by holding only a nominal number of shares which gives him/her the right to block any undesired changes.
Further control can also be retained if shares in the company are held in either a formal trust or a bare trust as the trustee retains control of the asset whilst in the trust.
Investment in a FIC
In its simplest form a FIC is a straight forward investment company and the costs of establishing such a company can be very low. A more complex structure will be more expensive to establish and therefore to justify the cost a larger investment would be recommended. Given however that trusts are still available and remain a very effective vehicle and bearing in mind that a married couple can generally add at least £650,000 (double their current nil rate band) into a trust, it is suggested that a FIC investment would be an addition to the use of trusts and would therefore probably start with an investment of £1 million or more.