Business property relief (or BPR) is a well-known form of inheritance tax (IHT) relief. It’s probably well-known for two main reasons; first, due to its generosity, as BPR offers relief of 100% or 50% on a transfer of value which is attributable to ‘relevant business property’; and secondly, because BPR is available in respect of a fairly wide range of business assets. The type of business property considered in this article is unquoted company shares, which potentially qualify for 100% BPR.
Not all unquoted company shares qualify for BPR. Certain company activities make the shares ineligible for relief, such as dealing in stocks or shares, land or buildings, or making or holding investments (s 105(3)). These exclusions are subject to certain exceptions (in s 105(4), (4A)), including where the company’s business consists wholly or mainly in being a holding company of a group of companies whose business does not consist of excluded activities. However, for the purposes of this article, let us take the example of a single unquoted trading company which is not carrying on an excluded activity.
Why are the anti-avoidance rules necessary?
The anti-avoidance rules mentioned above are concerned with what the IHT legislation calls ‘excepted assets’. These rules are contained in IHTA 1984, s 112. There is a definition of ‘excepted asset’ which applies to most categories of relevant business property in s 112(2). This legislation broadly states that an asset is an excepted asset if either of two alternative tests is met. The first test is that the asset was not used wholly or mainly for the purposes of the business throughout the whole or the last two years of the relevant period. The second test is that the asset was not required for future use in the business. There is a relaxation of the excepted asset rules in respect of group companies, but this article concentrates on a single trading company.
Before looking at how the excepted assets rules work, it may be helpful to briefly consider their purpose. In broad terms, it would be relatively easy to ensure that BPR became available on a non-business asset by placing it into a business wrapper. For example, without the excepted asset rules:
- A wealthy individual who owned all the shares in an unquoted trading company might be tempted to transfer (say) an expensive yacht into his company, in the hope that the yacht became sheltered from IHT, on the basis that he would be eligible for 100% BPR on the value of his company shares;
- The same individual might try to secure BPR on his private cash funds by using the cash to subscribe for additional shares in the company. That cash may then be sitting in the company without it being needed or used in any business being carried on by the company. Effectively, the individual would be treating the company as his personal ‘money box’, on the basis that the funds are sheltered from IHT (assuming that 100% BPR is available on the company’s shares).
The excepted assets rules are aimed at preventing BPR being exploited in these types of situation. If ‘caught’ by the legislation, the effect is broadly that a transfer of value for BPR purposes is restricted by the value attributable to the excepted asset. In other words, only that part of a transfer of value which relates to relevant business property is reduced by BPR; the other part relating to the excepted asset is not reduced by BPR, and is therefore chargeable to IHT in the normal way.
Excepted assets can take various forms, such as holiday homes, sports cars, or luxury yachts. However, this article focuses on perhaps the most common form of excepted asset held by an unquoted trading company, which is surplus cash.
The ‘past use’ test
As mentioned earlier, there are two alternative tests which determine whether an asset is an excepted asset. The first of these is that the asset was not wholly or mainly used for business purposes throughout the whole or the last two years of the relevant period. The ‘relevant period’ in the case of a single company is broadly the period immediately before the transfer of value during which the asset was owned by that company (s 112(5)). In HMRC’s view, this test is not satisfied if the asset was used for the purposes of a previous business during the period (IHTM25351).
Note that this ‘past use’ test looks back at a period of up to two years. However, the test period may be less than two years if the company has owned the asset for that shorter period. This can be quite helpful in certain circumstances, because it means that an asset may not be an excepted asset even though it has only have been bought shortly before a transfer of shares in the company, provided of course that the asset was used wholly or mainly for the purposes of the company’s business throughout its period of ownership.
For example, a trading company with surplus cash could use some of that cash to purchase plant and machinery for use in its trade, shortly before it becomes necessary to consider the availability of BPR, such as on the death of the shareholder, or a gift of the company’s shares into trust.
The ‘future use’ test
The second of the two excepted assets tests is that the asset was not required at the time of the transfer for future use in the business. HMRC’s view is that future use must clearly be contemplated, and that there should be evidence of some positive decision or firm intention. HMRC will also look at the nature and previous history of the company’s business. The ‘future use’ test can be difficult in practice, but case law may provide some guidance.
In Brown’s Executors v IRC [1996] STC (SCD) 277, Mr Brown died in November 1986. He was the majority shareholder in a company (‘Gaslight’) which had operated a nightclub business. The nightclub was sold in January 1985, and the proceeds were paid into a short-term deposit account of Gaslight, earning some interest. Prior to his death, Mr Brown had looked at premises with a view to Gaslight opening another nightclub, and he had also explored the possibility of the company opening a nightclub in Los Angeles. Unfortunately, Mr Brown died suddenly of a heart attack, and without the company having opened another nightclub. The executors claimed BPR on Mr Brown’s shares in Gaslight. However, the Revenue refused the BPR claim, not on the basis that the company’s proceeds from the nightclub sale was surplus cash and an excepted asset, but that Gaslight had become an investment company due to the deposit account interest received. The Special Commissioner allowed the executors’ appeal. The Special Commissioner held that it was necessary to look at Gaslight’s operations in the two years prior to Mr Brown’s death. He also said that the intentions of the company’s directors should not be looked at in isolation, and that it was necessary to look at the activities of Gaslight as well as the directors’ intentions. Whilst this case did not specifically address the excepted assets rules, HMRC considers that the Special Commissioners’ comments are relevant to them (SVM11230).
A case which was directly relevant to the excepted assets rules and the ‘future use’ test was Barclays Bank Trust Co Ltd v IRC [1998] STC (SCD) 125. In that case, the deceased held 50% of the shares in a company which had an old established business of selling bathroom and kitchen fittings. The company’s turnover fluctuated above or below £600,000, and it had a strong cash position. At the time of the deceased’s death, the company’s cash at bank was approximately £450,000. It was argued for the company that the cash held on the deceased’s death was required at that date for its future business use. The Revenue accepted that the company needed cash of around £150,000, but argued that the other £300,000 was an excepted asset. The Special Commissioner held on the evidence that the cash of £300,000 was not required for future use by the company in its business. The Special Commissioner also made the following comments, which are worth bearing in mind:
“I do not accept that ‘future’ means at any time in the future nor that ‘was required’ includes the possibility that the money might be required should an opportunity arise to make use of the money in two, three or seven years’ time for the purposes of the business. In my opinion and I so hold that ‘required’ implies some imperative that the money will fall to be used upon a given project or for some palpable business purpose.”
Is it ‘surplus’?
So what can be done to demonstrate or argue that cash held by a company is not ‘surplus’ for excepted asset purposes? It is a question of fact whether the excepted asset tests in IHTA 1984, s 112(2) are satisfied, based on the evidence in each particular case. For example, when considering the ‘past use’ test it may be necessary to look at the company’s accounts for at least the previous two years. Some questions that HMRC might ask are listed in its Shares and Assets Valuation manual (at SVM111220):
- Was the cash used for the business?
- Was the cash used to finance the business carried on by the company?
- How much cash did the company use regularly?
- What were its short-term cash requirements?
- Does the amount of cash fluctuate?
Of course, every trading company needs working capital. How much working capital it needs will depend on the type of trade. For example, in the Barclays Bank Trust Co case mentioned earlier, HMRC accepted that the company needed cash of around £150,000, which represented about 25% of the company’s turnover. However, some trades may, for example, be subject to seasonal fluctuations, which could perhaps mean that a larger proportion of cash is required.
HMRC’s own guidance (at SVM111230) also acknowledges that some companies, such as travel agents and insurance brokers, hold potentially large amounts of cash for months at a time before passing the cash onto the respective travel operators or insurance companies. So a distinction may need to be made between cash which does, and does not, belong to the company. HMRC also accepts that in difficult trading conditions such as a recession, the company may retain a higher proportion of funds, for example where the company is currently making losses and the cash is needed to support its main trading activity. However, HMRC considers that the holding of funds as an ‘excess buffer’ to weather the economic climate is not a sufficient reason for it not to be classed as an excepted asset (ICAEW Technical Release 1/14, January 2014).
When considering the ‘future use’ test, there should be clear evidence to indicate how the funds are going to be used in the company’s business in the future. For example, in one case I was involved with, HMRC required documentary evidence to substantiate the company’s claim that it intended using significant amounts of cash to expand its retail premises. Fortunately, the company had already obtained planning permission to extend the property, and was also able to send HMRC copies of an architect’s drawings of the extension. That was enough to persuade HMRC that the company had a clear intention to use the cash for business purposes, and a BPR claim on the company shares was therefore accepted by HMRC without any excepted asset restriction for surplus cash.
Other helpful evidence of future use for the cash might include directors’ reports accompanying annual accounts, and company board minutes demonstrating a positive decision or a firm intention to use the cash, although as indicated in the Barclays Bank Trust Co case, this is unlikely to be sufficient evidence in itself to satisfy HMRC; it will probably be necessary to consider the company’s business history as well.
What can be done?
If a trading company does have a large cash balance which appears to be surplus, what can be done to potentially improve the IHT position? There are some things which might be considered, including the following:
- If cash is sitting in the company’s bank account, consideration could be given to using some of that cash for a business purpose, for example to pay trade creditors earlier, or to discharge other business creditors such as where the company has bought plant and machinery under a hire purchase agreement, and has an outstanding liability which could be repaid early without incurring a penalty.
- The company could invest the surplus cash in such a way that its investment activities amount to a separate business, for example by acquiring a portfolio of quoted shares and securities, or perhaps buying and managing some investment properties. The excepted assets rules do not apply to an investment business, so there should be no BPR restriction in respect of the company’s shares on that basis (SVM111220). However, it is vitally important that the company’s investment activities remain secondary to its trading activities. If the investment business predominates, so that the company is wholly or mainly an investment company, BPR entitlement on the company’s shares will be lost in its entirety (IHTA 1984, s 105(3)).