SUCCESSION PLANNING FOR FAMILY BUSINESSES AND PLANNING FOR DEATH

I am now to talk about the most fascinating thing in the world. How you interweave the succession planning for family businesses and planning for death with the multitude of taxes which flesh is heir to.

I like the title of this seminar. You are all look young enough to find the process of planning for death a pleasantly remote one, but as we progress through our professional careers we reflect more and more on the well known saying that only two things are inevitable: death and taxes. But, as I shall hope to show you over the next few minutes, it is only death that is inevitable.

Who here has made a will? Good-ish. What about an enduring power of attorney? Who here has not settled the order of their funeral service? Oh improvident ones!

The point I am trying to make is that the tax planner should, like the boy scout, be prepared: indeed, be very prepared. The time for tax planning is before you begin in business. You must look far, far ahead. How will you extract profits? How will you provide for a future trade sale? For succession by the next generation, or the one(s) after that? How will you use losses, in the start-up scenario? In the case of a temporary set-back? And in the case of insolvency? In my experience, 90% of businessmen consider these matters too late. They are busy manufacturing, selling, contracting, expanding and so on. They let the business tail wag the tax dog.

The taxes I am going to look at today: income tax, capital gains tax, inheritance tax. But look at the totality:

Think about it. Tax may take 40% or more – think National Insurance contributions, irrecoverable VAT, – of profits. There was a time in living memory – at least in my memory – when the top rate of income tax was 98%. The mitigation of tax is not a bolt-on to business: it is fundamentally necessary to achieve what is sometimes called shareholder value. How many other factors can affect the bottom line by 40% or so?

And tax strikes not only once but again and again. The individual entrepreneur is taxed at 40% on the income he derives from his business. The remaining 60% he may, perhaps, invest in property which he lets. He is taxed on the rental income at 40%. He may sell at a gain, and will be taxed on that at 40%. Eventually, and inevitably, he dies. 40% again, please, in inheritance tax on his estate. And HM Revenue and Customs call this “fair”.

Well, diatribe over. You now know my motivation for being a tax lawyer. Let us get down to my main subject: the Taxation of Discretionary Trusts. The first thing I have to say is that it is changing – fast, and on the whole not for the better. Details are contained in two articles which I wrote recently for “Tax Adviser” and which give more detail than I shall be able to cover today. Copies are in your folders.

I will begin with income tax. In the (fairly) good old days, before 6 April 2004, discretionary trusts were taxed at a ‘rate applicable for trusts’, endearingly known as the RAT, of 34%. In the words of the consultation document on Modernising the Taxation of Trusts: “a compromise designed to reflect the fact that some trust beneficiaries will be basic or lower rate taxpayers, whilst some others will be taxable at the higher rate”. The RAT still exists, but now at 40%: no more compromise, at least for 2004/05. From 6 April 2005 there is a lower rate band of £500, within which income tax is charged at the rate applicable to the nature of the income. 22% generally, but 20% for ‘savings type income’ and 10% for ‘dividend type income’. How does this work in practice? A basic tax rule is that the taxpayer can select the most advantageous of alternative tax treatments which may be available. Say trustees have £200 general income (for example rents), £200 savings income and £200 dividend income. Can they opt to have £200 taxed at 10%, £200 taxed at 20%, £100 at 22% and the remaining £100 at 40%. Total tax £20 + 40 + 22 + 40 = £122? Any guesses? No, they cannot. The prescribed treatment is: £200 at 22%, £200 at 20%, £100 at 10% and £100 at 32.5%. Total tax: £44 + 40 + 10 + 32.50 = £127.50.

This 32.5%? This is the ‘dividend trust rate’. It reflects that fact that dividends carry a non-repayable tax credit of 10%. The gross dividend (say £100) is taxed at 32.5% but the trustees have already borne 10% represented by the tax credit and they receive credit for this amount. The additional tax payable by the trustees is £32.5 - £10 = £22.5, so out of £100, the trustees are left with £100 – 32.5 = £67.5. This seems rather better than the £100 x 100-40)% = £60 which they are left with after paying tax on non-dividend income at the RAT.

But there is a sting in the tail when it comes to distributing income from the trust to beneficiaries. Beneficiaries generally get a tax credit for income paid out to them representing the tax paid by the trustees. So if little Johnny, aged 10, is paid £100 gross (£60 net) by the trustees and has no other income he is entitled to reclaim the £40 tax which the trustees have paid on their £100 income, since he has unused personal allowances to cover this. But if the trustees try to pay him £100 gross out of income on which the they have paid tax at the dividend trust rate, he does not get back the whole amount of the tax paid by the trustees. They cannot pay him £67.50 net on which he can claim a repayment of £32.50. It works like this: Net income after tax £67.50 Tax paid by trustees 22.50 Gross income 90.00 Tax credit (£90 x 40%) 36.00 36.00 Less tax already paid by trustees 22.50 Additional tax payable by trustees 13.50 Net payment to Johnny 54.00 On which he recovers the tax credit of £36.

So, routing dividends through a discretionary trust is not tax- efficient. What can one do about it? One answer is to arrange for the trust to have fixed rate preference shares, in which case the fixed rate income is taxed as interest and there is no non-repayable tax credit to mess things up. A chief advantage of the discretionary trust is that the income which beneficiaries receive may be varied from year to year to take their needs into account. For example, a series of brothers and sisters may be funded successively through their university courses and professional training, and when they have lucrative jobs as accountants funds can be directed elsewhere. This can be achieved in other ways, where the problems caused by the trust dividend rate do not bite. They can be given interests in possession in parts of the trust fund for the four or five years it takes for them to qualify. Income subject to such trusts is taxed directly on the beneficiary and there is no trust rate to worry about. When they have qualified, their interests in possession can be terminated by the use of an overriding power of appointment, and the income can revert to being held on discretionary trusts, or on fixed interest trusts for other up and coming family members. You have to take care, because you do not want to trigger a charge to capital gains tax by engineering a deemed disposal of their share in the trust fund, nor an inheritance tax charge on the deemed transfer of value when a fixed interest comes to a end. But with appropriate care it can be done.

Capital Gains Tax As a leading law lord said in an avoidance case: capital gains tax is a tax on gains not on arithmetical differences. Gains are now treated as the highest slice of income, and a trust has an annual exempt amount of, usually, half the individual rate: £4,250 for this year. Where there is more than one trust established by the same settlor, this exemption is divided by the number of associated trusts, so if you have two each gets £2,125 and so on. You can beat the system, since where you have more than 10 trusts a minimum allowance of £425 applies to each. However, by the time you have set up 20 trusts you will probably have spent almost as much on the paper as you save in capital gains tax.

For business property there is a useful relief in that gifts of business property benefit from hold-over relief on the gift under section 165 of the Taxation of Chargeable Gains Act 1992. You must claim the relief and it operates by reducing the transferor’s chargeable gain and the transferee’s acquisition value by the amount of the gain held over. There are some problems with this, for example, of the transferee emigrates within 6 years of the gift he is deemed to make a chargeable disposal immediately before becoming non-resident and a charge arises. An non-residence is another way of avoiding capital gains tax, since of course only UK residents are within the charge, although the Revenue have attacked the utility of this by moving the goal posts and taxing any gains made by a taxpayer who becomes non- resident but then returns to the UK within 5 years. For trusts, timely emigration by appointment of offshore trustees was once an extremely useful ploy, but this was attacked first in 1991 and harder more recently. Where the settlor retains an interest in the trust he remains taxable on any capital gains made by the trustees. A settlor retains such an interest not only if he is a beneficiary, but also if, originally, his children were beneficiaries, and now even if his grandchildren are beneficiaries. However, no gains can be taxed on a settlor who is dead and where ancient family members are looking a little peaky there are possibilities. And the will trust in particular comes into its own here.

Where there is no charge on the settlor, however, there may be a charge on the beneficiaries. A UK-resident beneficiary who receives a capital payment from the trust will be taxable on the amount of any gains made by the trust before the capital payment is made. But he will also be taxable where, after he has received a capital payment, the trust then makes capital gains. So it is difficult to use non-residence as a complete avoidance strategy, although it is a useful deferral – except that a 10% surcharge is imposed for each year between the trust making a gain and a beneficiary receiving a capital payment, for up to 6 years. This is where non-resident beneficiaries can have a part to play because, of course, capital payments made to non-residents cannot be taxed on them under the ordinary rules which do not extend the charge to non-residents.

Inheritance Tax The first consideration in looking at the inheritance tax position is the generous reliefs for business and agricultural property, which can be, and in most cases are, 100% and so equivalent to exemptions. The rules are similar, but I shall concentrate on those relating to business property as they relate to shareholdings in companies.

The 100% relief now applies to all shareholdings in unquoted companies, providing that they have been held for at least two years. The company must be carrying on a business, which is a broader term than ‘trade’ so the relief is not limited to shares in trading companies. However, business has a restricted definition and excludes dealing in securities or land and making or holding investments. There have been a number of recent cases where the company was carrying on a mix of activities and you have to identify the predominant activity. A number of cases have decided that caravan parks are likely to be investment activities. It all depends on the facts, and if the business of the owner of the caravan park is mainly buying and selling caravans and only incidentally letting pitches he may be able to meet the test. The test is an all or nothing one: you cannot have partial business property relief, so planning may involve hiving off non-business activities into another entity.

However, even where the predominant activity qualifies as business, the relief only applies to assets used mainly for business purposes, assets which are not so used being called ‘excepted assets’. To avoid falling into this category, assets must have been used in the business in the two years prior to the transfer, unless it can be shown that the asset is required for future use in the business. Excepted assets typically include let property, substantial cash balances and investments.

The necessary two-year period of ownership provides a limitation which may sometimes present problems. Where shares are held following the death of a spouse the period for which the deceased spouse held the shares counts towards the two year period. Note that this extension does not apply on a transfer by a living spouse. So you cannot arrange it so that a wife whose husband is looking increasingly peaky gives a shareholding which she has held for two years to the husband who promptly dies. What you may be able to arrange is that the husband leaves any qualifying shares which he has held for less than two years to his wife, so that the spouse exemption applies instead of business property relief, and hope that she lives long enough for business property relief to apply before she transfers the shares into, say, a discretionary settlement for succeeding generations, on death or otherwise. The relief applies by reducing the value transferred by the transfer.

Where business property relief does not apply, the inheritance tax rules for discretionary trusts are a matter of Byzantine complexity, so a brief historical introduction is not inappropriate. In the days of estate duty the discretionary trust was the supreme vehicle. Estate duty was levied only on death, so the creation of a trust inter vivos was not an occasion of charge and, because no beneficiary had a right to benefit, there was no duty payable when a beneficiary died. Equally, the termination of the trust at the end of the perpetuity period or on an earlier advancement or appointment did not trigger a charge. Eventually, in the 1960s, a rule was brought in that on the death of a beneficiary a share of the trust fund was taxable in proportion to the income which he had received from the settlement for a number of years before death, so duty could still be mitigated by making other provision for ancient beneficiaries and paying them nothing from the settlement during their last few years.

Capital transfer tax (introduced 1975) was, however, a tax on lifetime transfers as well as those on death, and so discretionary trusts were caught. When inheritance tax replaced capital transfer tax in 1986 most lifetime transfers became potentially exempt, but the creation of a discretionary trust remained a chargeable transfer. This contrasts with the position of an accumulation and maintenance (A&M) settlement, where the transfer is property into trust is a potentially exempt transfer, and I shall have more to say about these marvellous animals later.

So far, so simple. When you put property into a discretionary trust you pay inheritance tax on the amount by which your estate is diminished. You have the nil rate band available (£275,000 this year), and to the extent that this is exceeded tax is charged at the lifetime rate, 20%, being half the death rate. And you can go on using the nil rate band time and again by setting up separate discretionary settlements, so long as 7 years elapse between the establishment of settlements by any particular settlor. If the settlor dies within 7 years of setting up a discretionary settlement additional tax at the death rate of 40% will be payable, but, as in the case of the death of the transferor within 7 years of a potentially exempt transfer, a tape relief applies after the settlor has survived for the first three years.

Because death does not happen to discretionary trusts, the Revenue have found a way of imposing tax through a periodic charge levied every ten years. The rate of charge is 30% of the lifetime rate, so that the maximum tax is 6% of the capital in the trust on each 10- year anniversary. If the value of the trust fund is within the nil rate band (or if 100% business property relief is available) there is no tax.

In addition to the periodic charge, there is an exit charge, when property leaves the settlement or, more accurately, where it ceases to be ‘relevant property’. It may remain in the same trust, as would be the case if part of the capital was appointed on fixed interest trusts in favour of a particular beneficiary. The charge is essentially a topping-up charge and replaces proportionately the charge which would have occurred on the next ten-year anniversary, had the property not left the settlement. You have 40 quarters in 10 years, so if property leaves the settlement after four years you have a charge at the rate of 16/40ths of what the ten-year charge would be. The maths can get complicated, and there is some difference between exits before the first ten-year anniversary and after it. Obviously, not all the property needs leave the trust to trigger the provisions and there can be a number of proportional exist charges between ten-year anniversaries.

Earlier I mentioned A&M Settlements. These have two great advantages over the traditional discretionary trust. First, transfers into them are PETs; and secondly they are not subject to the charge on ten-year anniversaries. They are available only in limited circumstances. The trust must not be an interest in possession trust; the income must be accumulated insofar as it is not applied to the education, maintenance or benefit of beneficiaries; and they have to provide that beneficiaries become entitled to the capital or an interest in possession in it at or before the age of 25.

There are also a second set of statutory requirements. The most usual one in practice is that the persons who are or have been beneficiaries must be grandchildren of a common grandparent, or children, widows or widowers of one who has died. Thus there is a ‘single generation’ class of beneficiaries, although illegitimate, adopted and step children are included. The grandparent need not be alive, but the beneficiaries must be at least first cousins. The second possible test is that not more than 25 years have elapsed since the commencement of the settlement, or such later date as it became an A&M settlement.

A further wrinkle is that, once a beneficiary has attained 25 (or other specified age) and taken an interest in possession, that interest can be appointed away from him to other beneficiaries, although this should not be done for at least a year after the interest in possession has arisen, so that the Revenue cannot argue that the interest was so ephemeral as to be a sham. It is useful where a beneficiary has developed a taste for expensive Ferraris.

What has not been covered: