When businesses start out there never seems to be enough cash flowing through to allow the business to do what it might want. Owners spend large periods of time ensuring they conserve this scarce resource, paying bills just on time, working extra hours themselves and hunting for the cheapest insurances, suppliers and utility costs.
As the business grows over the months and years, for some a strange problem occurs, something they never thought of in those early days starts to happen, they accumulate too much money which they don’t need (or don’t need today). They never thought that they would be in this position. It’s then that they find there are often as many problems with too much money as there was with not enough.
They turn over in their minds what to do;
They could draw it out…. but what about the tax, they hate paying it, it’s HMRC taking away the fruits of their toil, then they think again how much tax will it be, will they end up in a higher band and lose 20%, 40%, 45% or even 60%? * Then, what happens if they pay the tax and need it again within the business in the near future, and will the cash create a tax problem of its own once it is outside the company, if something happens to them?
So, they keep it, usually in a business bank account with one of the big banks, paying nearly nothing in interest, so they can access it if they need it and don’t pay tax on it, but it is eroded by inflation. Sometimes it mounts higher and higher, year by year and they are nagged by the accountant that they have too much and might end up paying taxes if they sell the business or die.
*if personal income is above £100,000 the tax-free personal allowance of £12,500 is reduced on a 2 for 1 basis until it is removed completely at income of more than £125,000. This is an effective taxation rate of 60%
How could you put your surplus cash to work?
There are alternatives to this position, depending on your situation. For some business owners keeping it in the business in an easy access account is best, giving access as and when they need it. In these circumstances, the company bank account is likely to be the most sensible place to keep it. But for some they need this surplus cash to work hard for them whilst it awaits its next destiny.
It is sometimes surprising for directors to learn that they can actually invest company money into similar investments to those they might undertake personally i.e., unit trusts and bonds, however there are pitfalls for the unwary so taking good advice from the company accountant and a qualified Financial Adviser is critical.
Normally companies holding surplus cash would expect to pay this out to the owners through dividends, as shareholders are the best placed to make investment decisions. Alternatively, reinvesting cash in the company’s business will usually generate the best return for shareholders.
However, there are situations in which a company has surplus funds that it doesn’t want to pay out and which simply can’t be reinvested in the business.
When this arises, the company could consider investing those surplus funds to generate a better return than that which can be achieved from a bank account. This could mean for example, investments into stocks and shares.
Although past performance is not a reliable indicator of future results, over the last 20 years investment returns have generally (in most years) been good, albeit with some periods of underperformance in crises such as the Dot Com Boom and Bust, the 2008 Credit Crunch, Brexit, the Eurozone debt crisis and more recently the Coronavirus issue. For many, making an appropriate investment may be very sensible and lead to reasonable returns for a previously moribund asset.
Surely this means business owners can generally just start investing. Ideally, the first step should be to have a discussion with a financial adviser to determine how to invest the money and what level of risk should be taken, it is also just as important to understand what investment vehicle it is placed in and the effects of this.
These can be held in various ways and a common method is a company-owned life assurance contract which holds investments, or a company owned capital redemption investment. A capital redemption contract is one which, in return for one or more fixed payments, a sum or series of sums of a specified amount (based on actuarial calculations) become(s) payable at a specified time.
Although this type of investment is common there are of course other methods of investing for limited companies, and it is widely accepted that investment decisions should not be based solely on tax factors so individual advice is crucial.
However, assuming a life assurance investment or capital redemption investment is appropriate there are things to think on.
TAXES, TAXES AND MORE TAXES.
Firstly, taxes. Companies pay taxes like everyone else. If the business is based in the UK it pays corporation tax on all its profits wherever those profits come from (whether they are paid in or sent to the UK).
The business’s corporation tax bill is paid on profits (income or capital gains) which occur in each company’s financial year. The current rate is 19% from 1 April 2021.
The other issue is that certain investments are treated differently depending on the size of the business and even the type of accounting applied to the business. For example, since 2008 corporate investments using “Life Insurance Contracts” to invest have been treated differently depending on which accounting practice they use.
- Companies using “Historic Cost Accounting” are taxed on profits made when they happen through encashment of part or all the investment due to the director’s own wishes, transfers to others (assignments) or death of the last life assured.**
- Companies using “Fair Value Accounting” will be taxable in the same way on any realised profits as above but also in addition on any increase in value of the Life Policy investment each year. **
**This is for information purposes only, taxes and rates of tax change regularly without warning. You should seek individual advice from a suitably qualified adviser to understand how the details outlined in this article could apply in your circumstances.
In truth over the life of a Life Insurance Investment the business will pay tax on the actual profit it has made regardless of the accounting basis used but the timings and amounts of when taxes need to be paid will of course vary particularly when the rules above are applied.
Generally, what are known as micro entities will be able to use historic cost accounting; other companies must use fair value accounting.
At least two of the following.
- Turnover not more than £632,000
- The balance sheet is not more than £316,000
- The average number of employees must not be more than 10
This difference in treatment means for many businesses operating on a fair value accounting basis they may need to pay taxes each year on any uplift in the value of the investments although these have not yet been realised.
Secondly, taxes, again.
Business owners in most cases benefit from what is known as Business relief, or business property relief (BPR).
Exempts certain business assets (either 50% or 100% of the asset value) from inheritance taxes on death for those who are business owners.
However, this exemption is only allowed on those assets which are needed for the business. In addition, it won’t be allowed if the business carried on by the company, consists wholly or mainly of:
- Dealing in stocks and shares
- Dealing in land or buildings (e.g. buy to lets, investment properties)
- The making or holding of investments.
The above ‘wholly or mainly’ exclusion from BPR in respect of investment businesses etc. is an ‘all or nothing’ test and the wholly or mainly is considered by HMRC to be 50%.
This means that companies which are investing in say rental properties with no other services, will not receive this exemption so will pay more tax if an individual owner passes away. It also means that if there are assets held, which aren’t immediately needed for the business (such as cash holdings), they don’t qualify. These are known as ‘excepted assets’ so are excluded from the exemption.
Excepted assets =
Those not used wholly or mainly for the purposes of the business throughout the last two years immediately before the business is transferred.
Those not required at the time of the business transfer which were required for the future use for the purposes of the business in question.
If the business has excepted assets these will not be exempt so will get taxed as part of your estate.
This means you cannot hold cash “just in case”. It is expected that “required” implies that the money will be used upon a given project or for some tangible business purpose.
Worryingly cash can be as much an ‘excepted asset’ as any other investment. The exemption is only ‘checked’ on a transfer including a transfer on death, this means that many businesses have a problem but might not realise its severity unless something happens and keeping the business capital in cash rather than choosing to invest doesn’t solve the problem.
HMRC has stated that their rules apply even if you are holding more cash to potentially weather more difficult times: “Our guidance remains the same, and unless there is evidence which directs us to the fact that the cash is held for an identifiable future purpose, then it is likely it will be treated as an excepted asset”.
This can lead to large issues with businesses retaining much more cash than needed in order to operate, leading to a large tax bill on the death of a shareholder.
Lastly, taxes once again.
Could investing in a life assurance or capital redemption investment affect the position if some or all the business is sold?
You know, it could.
Business Asset Disposal Relief is allowed, subject to meeting certain conditions, in respect of capital gains realised on sales of business assets. This is a 10% tax rate on the first £1m of gains (since March 2020)
These ‘business assets’ could be a sale of shares in a company which is a trading company, or a holding company of a trading group. However, this is only offered if the sale satisfies certain conditions. Most importantly is it a trading company?
A ‘trading company’ =
A company which carries on trading activities and does not carry on other activities to a substantial extent. Whilst most companies and groups will have some activities that are not trading activities, legislation outlines that companies and groups still count as trading, if their activities, “… do not include, to a substantial extent activities other than trading activities”.
In the opinion of HMRC ‘substantial’ in this context means more than 20%.
The activities test is very wide and includes: income from non-trading activities, the company’s asset base, the company expenses incurred, and time spent by officers / employees of the company in undertaking its activities. The “tests” above are not individual tests to which a 20% ‘limit’ applies but should be applied ‘in the round’ of the overall business position.
For example, holding an investment that is below 20% of the asset base may seem conclusive in terms of passing the “tests”. However, the associated relief may still be lost if the other criteria and activities of the business do not also meet the test limits.
If you believe any of the above affects you and would like to hear more about how we can add value for you and your business, please do not hesitate to contact me or a member of the team who will be happy to discuss how we can help.
This article is for general information purposes only and is not intended to address your requirements. This shall not be deemed to be, or constitute, advice.
The value of investments can down as well as up and you may get back less than you invested. Past performance is not a reliable indicator of future results.