Swimming Against the Tide

There are times when conventional wisdom seems so obvious, but is actually the complete reverse of true wisdom. Maybe the best example of this in the tax planning sphere is the idea that you should pass businesses down to the younger generations.

What we’re talking about here is trading businesses, and the same basic principles apply whether you’re looking at a partnership, LLP, or limited company structure.

Let’s take a typical scenario of grandfather, father, and son. Father is the entrepreneur, and has, let’s say, a thriving limited company manufacturing front door bells. As he gets older, should he, as conventional wisdom dictates, think about passing the business down to his son, perhaps in tranches?

Not so, but far otherwise! Both inheritance tax and capital gains tax planning, if thought through properly, suggest doing the exact reverse, and passing the company shares up to grandfather.

CGT Rebasing

You might think there’s very little you can do about capital gains tax (CGT) on an ultimate sale of the company. The situation most frequently found in practice is that the company shares were acquired for a nominal amount when the company was first set up, say £100, being the initial subscription for share capital. The company may now be worth several £ millions, and therefore the whole of its value would be liable to capital gains tax if you sold out.

But it’s quite wrong to assume that there is nothing you can do about it.

Let’s think about the scenario we’ve discussed, where father gives the shares to grandfather. In the nature of things, grandfather is likely to die before father. If he does, what happens to the capital gains tax base cost? Let’s assume that his Will leaves the shares back to father.

The answer is, that father is treated for CGT purposes as if he had acquired the shares at their value on the date of grandfather’s death. That is, there is a CGT “rebasing” of the value to its current, probably much higher, value. So in principle, if father then went on to sell the shares to a purchaser shortly afterwards, there would be no gain. Swimming against the tide has, in fact, washed out a large inherent tax liability. Neat, or what? This is an example of the very useful principle that there is no capital gains tax on death, in normal circumstances. But what about inheritance tax?

Inheritance Tax

Continuing with our example, when grandfather’s estate comes to be totted up, the shares that he now has in the trading company, providing he has owned them for two years by the date of death, will be eligible for 100% business property relief – so they won’t give rise to any tax at all. But there’s an even more interesting tax planning situation, potentially, if grandmother is still alive.

Try this one. Father, who we’ve assumed is the legatee receiving the shares in the trading company, agrees with his mother that he will sell the shares to her for their probate value. We will assume that grandmother has cash resources, either of her own, or left to her, by way of an IHT exempt legacy, by her late husband.

So she pays cash for the shares, and once again they move up a generation.

Assuming no change to the business status of the shares, or indeed the business property relief rules, when grandmother is eventually reunited with grandfather, the shares pass back down to father’s generation, again tax free. This, in itself, might seem unremarkable, because trading businesses are tax free. But you’ll notice what’s happened. As a result of the purchase transaction which she undertook during her life, a lot of cash which would have been fully chargeable to inheritance tax in her estate has passed down tax free to father’s generation. And, being an arm’s length transaction, there’s no need for grandmother to have lived a further seven years after (although we are sure we would all want her to).

We come to the surprising conclusion, then, that movement of trading business interests should always be upwards, from the younger to the older generation: that is, if we want to plan optimally for capital gains tax and inheritance tax. Of course, you are in problems if Son gets so fed up with ownership and control of the company constantly receding from his grasp that he goes off to live in the South Seas!