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Tax implications for business owners

From time to time companies will find themselves with more capital than they need in the short term. If the company decides not to distribute the funds or utilise them within the business then it could invest rather than leaving them on deposit.

In addition to the tax on the investments themselves there may also be tax implications for the business owners.

Impact on IHT relief

Individuals who own a share of an unquoted trading business will normally qualify for IHT business property relief (BPR) after two years of ownership. But cash built up in the company bank account or investments held within the company could be regarded as an ‘excepted asset' and not qualify for BPR.

Cash and investments within the business will generally be excepted assets unless they have been used within the business in the previous two years and are held at the time of the transfer for a future business purpose, such as a specific project or acquisition.  A business holding excepted assets could still qualify for BPR but the relief would not extend to the value of those excepted assets.

There is an added danger if the company has excessive levels of cash or investments. BPR would be lost entirely if the primary purpose of the business is deemed to be investing rather than trading. If in doubt, the business should speak to their tax advisers.

Impact on CGT relief

Business owners may benefit from entrepreneurs’ relief (also known as business asset disposal relief) on disposals of business interests. The relief is provided by a special rate of CGT of 10% on disposals up to a cumulative lifetime limit of £1 million for disposals made on or after 11 March 2020. From 6 April 2025 the rate of CGT will increase to 14% and from 6 April 2026 to 18%, on disposals up to £1 million. Like BPR, this relief is restricted to trading and not investment businesses. Holding substantial cash and other investments could contribute to a company losing its ‘trading' status. The test for entrepreneurs’ relief is all or nothing. If cash and investments trigger a loss in relief it affects the full value of the business disposed of; not just the non-trading assets.

The legislation defines a “trading company” as a company which carries on trading activities and does not carry on other activities to a substantial extent. HMRC’s view is that substantial means more than 20%. But this isn’t simply based on the value of investments on the company’s balance sheet. It is tested across a number of factors such as time spent managing investments and revenues from non-trading activities etc.  Determining whether this 20% test could be breached requires specialist tax advice.

Taxation of investments

Companies are subject to corporation tax on the income and gains they receive from the investments they make.

How company held investments are taxed will depend upon the accounting basis the company uses and the type of investment they hold.

The size and nature of a company determines the accounting standards they can use, and this should be checked with the company's accountant. 

If a trading company qualifies as a micro-entity, they can use the historic cost basis of accounting for ALL their investments (cash, investment bonds and OEICs). Historic cost accounting effectively means that tax is only payable where a withdrawal is taken in the accounting period. Companies regarded as 'investment companies' will not qualify as a micro-entity.

Micro-entity status means that tax deferment is possible and the company may be able to plan the timing of withdrawals to its advantage. For example, a withdrawal could be taken in a year where there are losses available to offset against the investment gains.

To be eligible for the Micro-entity regime, the company must meet two of the following criteria:

• Turnover of £632,000 or less
• Balance sheet assets of up to £316,000
• Average of 10 employees or less

For all other companies the type of investment will determine how they are accounted for and subsequently how they are taxed.

Investment bonds

A company owned investment bond or capital redemption bond is assessed for corporation tax under the loan relationship rules and not the chargeable event legislation.

Generally companies which are not micro-entities will need to use the fair value accounting basis for their bond investments. Under this basis, the investment bond is valued at its market value - i.e. the surrender value at the end of each accounting period. Any growth (or loss) over the value from the previous accounting period (the carrying value) will be included in the loan relationship account and be subject to corporation tax. There is no tax deferment as gains are taxed each year even if no withdrawals are taken.

The example illustrates how, under the fair value basis, gains and losses are assessed annually, whereas with historic cost accounting they're deferred until proceeds are actually withdrawn from the bond.

The non-trading credits will be subject to corporation tax at the company's applicable rate in the accounting period in which they arise.  Any non-trading debits can be offset against profits in the same accounting period. If there are insufficient profits in the current year to offset the debit those losses may be carried forward and set against future profits of any kind.   

Partial surrenders

When a company makes a part surrender of an investment bond, the amount withdrawn is deemed to be part of their original capital and part investment growth. As a company is not subject to the chargeable events rules, the 5% tax deferred allowance cannot be used. Neither does it make any difference if part surrenders are taken by encashment of individual segments or across the bond. The growth element of the proportion withdrawn is subject to corporation tax.

Company owned investment bonds were subject to the chargeable event legislation prior to 1 April 2008. There was a deemed surrender of such bonds but with taxation of the gain deferred until a withdrawal is taken. There's an exemption from the loan relationship regime for investment bonds taken out by companies before 13 March 1989 that haven't been enhanced.

Grossing up for onshore bonds

Companies are given a credit for the corporation tax deemed to have been paid within an onshore bond. The credit is not given on a year by year basis - it's only provided when money is withdrawn from the policy.

The profit from the contract is grossed up by the 20% tax paid within the fund.  For fair value the profit from the contract is the sum of all of all the non-trading credits and debits over the investment term.  Any subsequent corporation tax payable by the company on its loan relationships will receive a deduction for the deemed tax paid within the fund.

Historic cost

The non-trading credit on surrender is simply grossed up by 20% to reflect the tax paid within the fund which then acts as a deduction against the corporation tax payable.

*This assumes the full rate of corporation tax is payable. Companies with annual profits below £250,000 will pay a reduced rate of corporation tax and just 19% if profits are under £50,000.

Fair value

It is profit over the term of the contract which is grossed up to determine the tax treated as paid. This is to reflect that the company has paid corporation tax each year without any credit given for the tax deducted from the fund.

Losses

Companies can offset any losses on their investment bonds against corporation tax. Losses can arise on an annual basis if the value of the bond investments has fallen over the accounting period where the fair value basis is used. Where there's a loss, a debit will appear in the loan relationship account and is offset against any non-trading credits in the loan relationship account in the same accounting period.

If there are insufficient credits in the loan relationship account to fully offset any losses, the resulting deficit can be either:

• offset against any profits of the company in the current accounting period, or
• carried forward to the next accounting period and set against
  
  • any company profits (losses arising from 1 April 2017 onwards), or
  • non-trading profits (carried forward losses that arose before 1 April 2017)
• carried back and offset against previous loan relationship gains.

Unit trusts/OEICs

The taxation of the income and gains on OEICs or unit trusts, for corporate investors is determined by the mix of the underlying assets within the fund.

• Where the fund manager invests greater than 60% of the fund in cash or fixed interest (such as gilts and corporate bonds), the fund will be classed as a non-equity fund and income will be treated as an interest distribution
• Where the fund contains less than 60% in cash or fixed interest, the fund will be classed as an equity fund and income will be treated as a dividend distribution

Non-equity funds

Income
Interest distributions are paid gross and will be subject to corporation tax under the loan relationship rules.

Capital gains
Gains are subject to corporation tax under the loan relationship rules. Companies are taxed on realised and unrealised gains on an annual basis. Investment gains will be a non-trading credit in the loan relationship account and losses will result in a non-trading debit.

Micro-entities will be able to benefit from tax deferment until disposals are made as they will be able to use the historic cost basis on non-equity unit trusts and OEICs.

Equity funds

Income
Dividend distributions received by UK resident corporate bodies have to be split into that part which relates to dividend income and that part which relates to other income. This is known as ‘streaming'. The part relating to dividend income (known as ‘franked' income) of a fund is not liable to tax in the hands of the corporate investor.

The part relating to other income of a fund (known as ‘unfranked' income) is taxable as if it were an annual payment in the hands of the investor and is subject to corporation tax.

Capital gains
The capital gains of equity funds are not subject to the loan relationship rules. All companies are only taxed on capital gains when there is a disposal, including fund switches. Unrealised gains are not taxable so there is the potential for tax deferment on growth. Realised gains are subject to corporation tax. Indexation allowance is still available to reduce the gain but for disposals from 1 January 2018 is frozen at the December 2017 factor.

Unlike an individual investor, a company does not have an annual exemption. Any losses that arise can be offset against the company's corporation tax liability.

Other investments

As well as investment bonds and non-equity mutual funds, the loan relationship rules cover most other corporate investment vehicles such as:

• bank or building society deposits
• gilts
• corporate bonds
• capital redemption policies
• certain life assurance policies

Life assurance policies (both onshore and offshore) which have a surrender value, purchased life annuities and capital redemption policies are all included within the loan relationship account. There's an exemption for pre 14 March 1989 policies. This exemption doesn't apply to purchased life annuities or capital redemption policies.

Term assurance and critical illness contracts used for business protection purposes generally won't be included as they typically don't include a surrender value. Such policies remain subject to the chargeable events legislation.

Corporation tax rate

Companies will pay corporation tax on any profits arising from income, capital gains or loan relationships which arise in the accounting period.

From April 2023 there was  no longer be a single  flat rate of corporation tax.  Companies with small profits less than £50,000 will pay 19%.

There will also be a return of the marginal relief for companies with profits between £50,000 -  £250,000. Corporation tax is calculated on the full profits using the main rate of 25% and then marginal relief is applied to provide a gradual increase in the effective rate of tax payable.

HMRC provide an online marginal relief calculator.

However, a simple way to calculate the corporation tax where marginal relief applies is to calculate tax in bands in a similar way to calculating income tax , using the rate of 26.5% on profits between £50,000 and £250,000.

Companies with profits over £250,000 will pay a full flat rate of 25% on ALL their profits. 

Profit extraction

A company may decide to transfer a corporate investment to an employee or shareholder. But this will typically have tax implications.

Transfer to employee/director

The transfer of an investment bond or non-equity mutual fund will trigger a potential charge to corporation tax on any untaxed gain under loan relationships. In the case of an equity type mutual fund there will be a disposal with any capital gain being subject to corporation tax.

The employee receives a benefit that is subject to both income tax and Class 1 national insurance. The employer will also be subject to national insurance but should be able to offset the transfer value as a trading expense in its accounts.

Transfer to shareholders

Again, the transfer will be subject to corporation tax under loan relationships or the disposal of an equity type mutual fund as appropriate.

The transfer will be taxed in the shareholder’s hands as a distribution of dividend income. The company cannot offset dividend distributions against their taxable profits.