Matt Taylor, Managing Partner of Rockpool Investments, explains an alternative IHT mitigation strategy which uses lending for BPR qualification.
Launched in 1995, the Alternative Investment Market (AIM) market helps smaller companies raise the capital they need to scale up.
From small beginnings, the AIM market has seen significant growth over the last 22 years with over 1,000 companies now listed. There is no doubt that this success has partly been due to the tax reliefs offered. Shares held by investors in most companies listed will qualify for Business Property Relief (BPR) and can therefore be passed onto the next generation free of inheritance tax (IHT) if held at death and for at least two years. Many providers offer AIM IHT planning services.
While investing in companies on the AIM market can be an important part of an IHT offering for clients, it is not the only choice and advisers should look beyond AIM when planning an IHT mitigation portfolio to help spread risk. Like the stock market, the AIM market can experience sudden dives.
Relying solely on AIM investments subjects the whole portfolio to the volatility of this market.
Using an approach which is uncorrelated to the market
Adding an uncorrelated investment is a real option to ensure a more balanced portfolio. Private companies are uncorrelated to the market and offer a simple and flexible alternative, specifically where lending is the qualifying trade for BPR purposes. While loans themselves do not qualify for BPR and are therefore not suitable for IHT mitigation planning, investment in a company whose established trade is lending does qualify.
Lending offers a uniquely risk-controlled trade and there are many established and profitable unquoted companies in the UK which need funding for growth. The risks are controlled as lenders are more protected if the company hits problems than equity holders because any outstanding debts must be paid back before any returns to shareholders. In addition, risk can be mitigated by ensuring that each borrower is subject to stringent due diligence, and can demonstrate annual profits of at least two times their interest outgoings with a strong capital base.
How it works
To qualify for BPR but benefit from the advantages of lending, an investor must hold shares in an unquoted company whose trade is to make loans to other companies. The benefit of this, is that it offers flexibility for the investor and an IHT solution which can be tailored to suit individual situations and needs.
For company owners
For investors who own their own company, then BPR qualification can start immediately – they just need to set up a lending programme. A diverse book of loans within a BPR qualifying lending company can deliver annual returns of 5% or more after tax with very low charges. The 40% IHT saving is still a key part of the planning, but the higher returns make this approach attractive over a longer term. A flow of high quality loans can be sourced through a private company specialist.
For large estates
For investors who don’t own their own company but have a significant amount to shelter from IHT then it is still worth going down this route. It’s actually very easy to set a company up and be ready to start a programme of lending. Lending companies don’t need staff or overheads and can be very simple to run. There are service providers ready to take over this task if the investor prefers not to. The BPR qualifying period starts as soon as the shares in the company are issued. Cash can then be loaned to borrowers over time, with interest receipts and loan repayments replenishing the company’s cash and funding new loans in a continuous cycle. This cycle doesn’t affect BPR qualification.
For investors who have money to shelter but don’t want to own their own company, there are managed alternatives. The investor still invests in shares in an unquoted company whose trade is lending but the company can have many shareholders. The company’s lending programme will be managed by the investment manager.
IHT planning for a younger investor
It’s easy for investors to dismiss estate planning because they feel too young for it. But using a BPR qualifying lending company changes the picture, because it isn’t a tax saving product with low returns. For investors aged 55 or over, then mitigating IHT when the underlying returns justify investment on their own makes sense.
Some common situations that can benefit from this approach
Jane’s wealth is mostly in a portfolio of traditional assets – shares, bonds and funds. She wishes less of her wealth would be lost to IHT, but it’s too early to pass on to the children. If Jane reallocates a third of the portfolio to a BPR solution based on lending, the potential IHT bill on Jane’s estate is much lower, but she still has full control over her wealth.
Rachel and Robert are selling their holiday home, which is worth far more than they paid. They want this wealth to work for them, but don’t like the idea of paying capital gains tax (CGT). By combining BPR lending with an EIS portfolio, the gain on the house sale is invested in EIS shares, so the CGT liability stays locked away. The original cost of the house is invested in their own company set up for lending, starting the two-year clock to IHT exemption. And of course the EIS shares are also IHT exempt.
Roger set up a family investment company a few years ago as a vehicle for generational planning. He wants a simpler way to mitigate IHT. Roger rebalances the company’s activities towards the trade of lending and away from investment. That way the whole value of the shares falls outside the IHT net. Roger now has more flexibility to decide when he passes wealth to the next generation.
Stephen built up a successful business in his company and recently sold it, leaving cash in the company. He always relied on BPR to save IHT, but the company is no longer qualifying. BPR qualification can be re-established immediately. The company approves a strategy designed to deploy at least half of the cash to a programme of lending, with loans to be made over time. Stephen didn’t incur the income tax bill that would have been due if he had withdrawn cash to put into traditional IHT mitigation solutions.
Lending for BPR adds diversity to estate planning. Advisers should consider an inheritance service which uses lending for BPR qualification as part of the investment strategy. The ability to tailor the solution to the individual client circumstances is also a key benefit.