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Invest via a company: beware tax traps

Beware if you invest in a company via a company.  You pay corporation tax on the gain & tax on dividends. Individuals who invest obtain entrepreneur’s relief. 

This warning results from a meeting with one unfortunate entrepreneur. He invested in a start up, acquiring shares, via his wholly owned company (Holdco).  Beware: The tax consequences are disastrous, if you hold investments via a company. Tax efficient choices include:

  • EMI options;
  • EIS, SEIS;
  • Structures that maximise entrepreneurs relief.

Investment company’s activities

The start-up company, called Start-up, developed some compelling software.  The company succeeded.  Holdco, besides holding Start-up shares, also received modest streams of consultancy income.

Holdco will sell it’s Start-up shares during the next investment round. Probably Holdco will receive a seven figure sum, an amount that significantly exceeds Holdco’s current trading assets.

Applause all round. BUT….. how to transfer Start-up’s sale proceeds into our entrepreneur’s hands tax efficiently. It is complicated. There are two stages to consider:

  1. What tax is payable when Holdco gets paid;
  2. How to transfer the cash from Holdco to the entrepreneur.

1 Tax payable when Holdco is paid

In the UK, companies can make capital gains free of corporation tax, if they satisfy the substantial shareholding exemption. The legislation is complex. There are tricky time limits. Broadly, the company realising the gain must be either:

  1. A “trading company”: holds over 10% of the investee company’s shares; or
  2. Holds shares in a “joint venture company”.

Unfortunately Holdco had to pay corporation tax on the share sale proceeds. Holdco failed to satisfy both exemption:s

Trading company exemption

Generally, HMRC says to qualify as a “trading company”, no more than approximately 20% of the company’s assets can arise from non-trading sources. But HMRC has not published:

  • A precise definition of “trading company”;
  • A helpful, precise method of calculating the “20%”.

HMRC is prepared to consider goodwill as part of the assets,  even although goodwill is not on the balance sheet.  The value attributed to goodwill depends on the facts, trading history, and nature of the business.

Holdco passed the 10% holding test, but failed the “trading company” requirement.  Holdco’s trading income was not 80% greater than its Start-up’s share sale proceeds.  If Holdco managed a portfolio of routinely traded companies, then it may have passed.

Joint venture exemption

Unfortunately, Holdco also failed the “joint venture company” requirements.  75% of Start-up’s shares were not controlled by five, or fewer, shareholders.  This is common after multiple investment rounds, in which high net worth investors subscribed for shares via angel networks.

2. Transfer cash to entrepreneur

After Holdco pays corporation tax, the question is how to transfer cash to the entrepreneur.  The most tax efficient means would be a dividend payment. However,  it’s best to avoid large dividend payments in one tax year, as it spikes the rate of tax.  It is more tax-efficient to spread dividend payments over multiple years.

Alternatively, we could wind up Holdco. However, this constitutes a deemed distribution for capital gains tax purposes.  At the time, for a higher rate tax payer:

  • The rate of capital gains tax is higher than the effective tax payable on dividends, given:
    • Careful planning on the timing of dividend payments,
    • However, check the prevailing tax rates before any transaction.

The entrepreneur could transfer shares to a spouse or civil partner. This would reduce the tax burden for both the dividend and distribution options. However, there may be family related complications.

How the entrepreneur should have invested

Our entrepreneurs day to day involvement in Start-up qualified him for Entrepreneur’s Relief, if he had directly held the shares. Entrepreneur’s Relief allows a CGT rate of 10% for qualifying gains. So on a  £1 million gain, our entrepreneur would pay £100,000 tax, instead of five times that amount.

Moral

The current start-up tax regime,  utilising EMI Option Schemes, EIS, SEIS and Entrepreneur’s Relief, works.  These schemes are not tax avoidance schemes, but when properly used, provide incentives.  All these schemes require individuals to invest, rather than companies.

Sometimes, there are good reasons to invest via a company e.g. traditionally investors wanted to keep their name off the register of subscribers or shareholders. However, note this benefit is changed.

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