Property investment companies, inheritance tax and freezing value

You may have clients who have built up substantial portfolios of investment properties which have been transferred into a limited company. The shares in the company may be a valuable asset and your clients might wish to try to mitigate the inheritance tax liability on their estates without diminishing their current flow of dividend income deriving from the shares. We look at a possible solution.

Business Property Relief (BPR)

BPR provides up to 100% relief from inheritance tax (IHT) on business property including company shares. To qualify for BPR the shares must fall within the definition of “relevant business property” laid down by the Inheritance Tax Act 1984. If the business carried on by your client’s company is wholly or mainly dealing in land or buildings or making and holding investments the Act provides that it will not be relevant business property and will not qualify for BPR.

This has proved to be a stumbling block for a number of BPR claims where property has been involved. A long line of cases has established that for property and property holding companies to qualify as relevant business property there must be a number of additional services offered to the customer over and above that which would be provided in the normal course of letting property. Those services must predominate over the investment activity of holding the property.

Where a company’s main activity is the receipt of rents it is therefore highly unlikely to qualify for BPR and the company shares belonging to your client will be fully liable to IHT.

Reducing the taxable value in your client’s estate

Given the unavailability of BPR your client may be keen to mitigate the IHT liability attaching to their shares, but at the same time they may be reluctant to pass too much of the company’s current value over to the next generation, and may wish to retain the current dividend flow. In these circumstances it may be worth your client considering a form of planning using so called “freezer” shares.

The intention is to freeze the value of the shares belonging to your client so that future growth in value accrues to their intended beneficiary, typically the next generation. This is achieved by altering the company’s Articles of Association to divide the company’s shares into two classes, A and B shares. The A shares carry an entitlement on winding up equivalent to the current value of the company and are retained by your client; all future growth in the value of the company will accrue to the B shares which will be owned by your clients’ children or perhaps by a trust which benefits succeeding generations.

At this point there should be no IHT implications inherent in this planning. The new B class of shares will have only a nominal value as initially they have no voting rights, no dividend rights and no capital value above their face value. S98 Inheritance Tax Act 1984 imposes an IHT charge on the alteration or extinction of share rights, but the argument against a potential s98 charge is that the value of the existing shares is not substantially reduced. Capital gains tax implications will have to be considered.

If the planning is successful, on their death your client will be taxed only on the value of the company at the date the two share classes were created.

Example: Marcus

For example, Marcus is the founder of MLW & Co which owns ten properties in Brighton which are let. The current value of the company shares (net of lending secured against each property) is £2 million. New B shares are issued to Marcus and the original ordinary shares are re-designated as A shares. The company’s Articles of Association are amended to provide that the B shares are entitled to dividends and capital on winding up only to the extent that the A shares have already received £2 million. Marcus gives the B shares to a discretionary trust for his children and grandchildren. When Marcus dies five years later, the total value of the company has increased to £3.5 million. £1.25 million (£2 million less dividends paid of £750,000) is within Marcus’s estate and subject to inheritance tax but the remaining £2.25 million belongs to his family trust leading to a substantial IHT saving.