18. Fourthly, if a person with control of a close company, exercises his control so that value passes out of his shares or out of shares of a person with whom he is "connected"," and passes into other shares or rights over the company, there is a deemed disposal of the shares or rights.18 19. There are also further provisions in paras. 15, 16 and 17, Finance Act 1965, Sched. 7, which may affect other transactions between the parties concerned, which should be referred to. 20. The above provisions would seem to cover everything, except possibly the sale by a member to the company of an asset at an over-value. However it is highly likely (and it is understood that the Revenue take the view) that this counts as a distribution19 and therefore the difference between the price paid and the market value is taxed accordingly under Schedule F and is also subject to surtax in the hands of the recipient, if applicable. This is however a moot point but is probably not worth-while testing. 21. Subject to the above, any receipt by a shareholder in respect of his shares, which is not taxed as income, constitutes a disposal or part disposal of his shares for capital gains tax purposes, whether on a capital repayment or reduction, or on a winding up.20 The only real exception to this is where the shareholder takes up a rights issue, or receives a bonus issue, or receives new shares in exchange for his old shares on a take-over or amalgamation, in which event his liability is deferred until such time as he disposes of his shares in one way or another.1 Estate Duty Aspects 2 22. Brief mention only can be made of the estate duty position in relation to shares in a company. For estate duty (as well as for capital gains tax) purposes, all the assets held by the deceased are deemed to have been disposed of at market value. In general the value is the same for both purposes except where an "assets valuation" applies for Estate Duty purposes only. Broadly speaking this applies where the deceased himself at any time in the previous seven years, had control, or, had powers equivalent to control for at least two continuous years out of the seven years before death3 and if the statutory provisions apply, the relevant shares are valued as an appropriate proportion of the total open market value of the company if sold as a going concern. 23. In addition, if the deceased at any time made a transfer to a company (and subscribing for shares is a transfer) then, if the company was or becomes a controlled company (which to all intents covers a close company), and the deceased received benefits from the company in the seven years before death, other than reasonable remuneration, then, in certain circumstances, a share of the assets of the company can be 17 Finance Act 1965, Sched. 7, para. 21. 18 Ibid., Sched. 7, para. 15 (2). 19 Ibid., Sched. 11, para. 1 (2) (in that the Interpretation Act 1889, s. 1 (b) provides that the singular shall include the plural and vice versa) and possibly Sched. 11, para. 9 (2) will also apply. 20 Ibid., Sched. 7, para. 3. 1 Ibid., Sched. 7, paras. 4, 5 and 6 (as amended) but even these do not give a full "Carte Blanche" and should be studied. * Finance Act 1940, s. 55, etc., and Finance Act 1954, s. 29, etc. The period was previously 5 years but is now extended to 7 years by Finance Act 1968. Previously 5 years but amended to 7 by Finance Act 1968. included as part of his estate, with the duty payable thereon chargeable primarily to the company itself. The statutory provisions are extremely complicated and widely drawn, but, as the Revenue apply them in a reasonable manner, they tend to be invoked only in obvious tax avoidance cases. 24. If the above provisions do not apply however, then, so far as the estate duty and capital gains tax valuation of the shares is concerned, the company entity offers considerable estate duty mitigation opportunities. Not only can the shares be settled in an appropriate estate duty saving settlement, but the shares can be spread over the family with much lower market values attributable to the shares than a valuation based on a proportion of the company's assets or full open market value. Except in occasional cases, few minority holdings with a low dividend yield will attract a high market value. It can be argued therefore, for example, that 100 shares out of 1,000 issued, which yield 8-10 per cent per share, are only worth about £100 if held in a continuing company, despite the fact that if the company were sold as a whole on a takeover, or were liquidated, the shares might produce say £5-6 each. Thus, whilst the company is in existence and continuing, the value of the shares is kept down and it is only when the company is sold or liquidated (when presumably the money will be available) that the full value is achieved and full death duty or capital gains is payable. This somewhat artificially low valuation, however, does have the eventual defect that the shares, or their equivalent, attracts full tax in the long run, but it does help to preserve the family fortunes, often tied up in the business, in the meantime. Loans 25. The problem of loans from shareholders, who are directors or associated with an appropriate director, have already been referred to (Chapter 2, A, para. 11) and apart from this, the "distribution" provisions, particularly the extension relating to a close company, practically prevent any shareholder from getting any income or assets from the company except on a liquidation, without a charge to income tax and surtax. 26. Where a company is bound to distribute its shortfall, however (or suffer the shortfall directions) and, where the director or appropriate associates are liable to surtax, it may very often pay the appropriate person to borrow from outside and then lend money, at the same rate, to the company, where a loan is required, rather than for the loan to be made direct. This may seem strange, but, because the loan interest paid constitutes a distribution, it will count towards the shortfall, yet will be ignored in the recipient's tax position because of the equivalent loan interest he pays out. Thus the company will be able to retain more of its profits after corporation tax and will have to distribute less after the loan interest distribution has been deducted. It is true that the benefit is in the hands of the company and not of the shareholders, but the retention could eventually be taken out at 30 per cent tax only on a liquidation compared with the alternative rate of income tax and surtax. CHAPTER 4 Alternatives to the Limited Company Structure Apart from the limited company structure, which is the most familiar and accepted body, there are of course alternative media through which either an individual or a group of individuals can trade. Having considered the taxation implications of the limited company, it is now necessary to consider the alternative media since one of these, or a suitable combination, may afford the solution to the problems confronting the directors and shareholders of the family company. A. PARTNERSHIP 1. The partnership is the trading medium which is first considered as the real alternative to the family company and allied with this is the position of the sole trader. Whilst a partnership does confer certain advantages and benefits vis-à-vis the limited company, there are many instances where trading alone or in partnership is in fact more disadvantageous. 2. Under a partnership, a group of individuals carry on "business in common with a view of profit". The partnership is, however, no more than a convenient composition of the individuals linked together and is not a separate legal entity like a company. A partnership is not liable to corporation tax and the profits of the partnership in fact constitute the earned income of the partners, divided up amongst them according to the agreed profit sharing ratio. An assessment is made in the partnership name3 and the profits, whether in fact retained or distributed, are assessed according to the profit sharing ratio but after taking into account the individual personal reliefs of each partner. The total assessment is a joint liability of the partners. The position of the sole trader is therefore the same except that the whole of the profits of the trade are assessed on him alone. 3. Unlike the corporation tax liability of a company, however (where the tax is assessed on the actual income of the company for the financial year in question), the partners (and the sole trader) are in general assessed on the trading profits of the partnership year ended in the previous year of assessment (6 April-5 April each 1 Partnership Act 1890, s. 1 (1). 2 Finance Act 1965, s. 46 (5) (a). year) but divided up according to the profit sharing ratio of the current year of assessment. Thus the profits for the partnership year to 30 April 1967 for example, form the basis of assessment for the year of assessment 1968/69 and the partners are assessed on these profits according to the ratio in which they actually divide up the profits in the year ended 5 April 1969. The tax is payable in two equal instalments on 1 January in the year of assessment and the following 1 July. 4. The above represents the general rule, but there are special provisions relating to opening and closing years. Obviously a partnership cannot have a “previous year" in the first year, so that it is assessed on its actual profits for that year of assessment (usually therefore for a part of the year). For the second year the assessment is based on the profits for the first year of the partnership and, then, the assessment for the third year and thereafter is based on the profits of the previous year (the usual basis). Apportionments are made where the partnership year does not correspond with the appropriate period for assessment purposes. The taxpayer, however, can elect to be assessed on the actual profits for each year of assessment for the second and third years of assessment." 5. When the partnership is discontinued, another set of rules apply and the partnership is normally assessed on the actual profits of the period from 6 April up to the cessation and, at the option of the Revenue, where the actual profits exceed the profits based on the previous year assessment for the two previous years of assessment, on the actual profits (appropriately apportioned) for the two penultimate years of assessment also. There is no similar option for the taxpayer where the actual profits are in fact less. 6. The discontinuance or "cessation" provisions apply on any change in the partnership, e.g. by a retirement of one of the partners or entry of a new partner, but so long as one partner continues throughout, the old, new and continuing partners can jointly elect to be treated as continuing. This latter provision offers scope for considerable flexibility in a partnership by suitable changes in the partnership, particularly bearing in mind the normal basis of assessment and the cessation and recommencement provisions outlined above. The cessation provisions normally leave a year out of account and the recommencement provisions enable, in particular, a firm to be taxed on the profits of its "first" year for three years of assessment. No such flexibility is now possible with a company. 7. Whilst a company is a separate legal entity, however, and liable only to the extent of its assets for its liabilities (in the absence of fraud), a partnership is not, since it is no more than a convenient combination of the partners, who are liable, jointly and severally, for the partnership debts as if each had incurred them individually. The only partial exception to this provision is the limited partnership which is discussed later. Advantages of a Partnership-Taxation 8. Ignoring surtax, the partnership set up is undoubtedly preferential from the taxation point of view, since corporation tax at 42·5 per cent is at a higher rate than " Income Tax Act 1952, s. 223. Ibid., ss. 127 and 128. 7 Ibid., s. 129. 8 Ibid., s. 130 and Finance Act 1963, s. 46. income tax at 8/3d. in £1 (41·25 per cent) and, in addition (up to the statutory limits), earned income relief is granted on the partners' income, so that the effective rate is (approx.) 32 per cent (at 2/9ths relief) and 36 per cent (at 1/9th relief). The close company director can also receive income at these rates, but the company first has to bear corporation tax on such of the fees as exceed the prescribed limits. 9. Surtax, however, is often a large factor and it is because of this that the company is not always on the losing side, since its retentions are only liable at 42·5 per cent in the absence of a shortfall direction, so that at least 40 per cent (and often more) of its estate and trading income can be kept surtax free. All retentions in a partnership, on the other hand, are fully taxed. Capital Gains 10. Because of the inherent double charge to tax on capital gains made by a company (i.e. corporation tax in the company and either income tax or surtax, if distributed, or 30 per cent, if taken out by means of a winding up or sale of shares), the partnership is the best medium for holding non-trading assets with gain prospects. Long term gains on any assets held by a partnership, or an individual trader, are liable only at the 30 per cent rate and sometimes at the lower rate of charge.10 On the other hand, a company, unlike an individual, is liable to corporation tax on its gains, although with short term gains this may be less than income tax and surtax. The "roll over" provisions apply equally on replacement of assets11 within a partnership (see Chapter 2, A, para. 16) as also do the “transfer of business on retirement” provisions, where an individual sole trader or partner aged over 60 disposes by way of sale or gift of the whole or part of a business which he has owned throughout the previous ten year period. In this latter case, the same provisions and restrictions on relief apply in a similar way to those on a sale of shares in a family company but, assuming the provisions apply to a partnership, 12 the relief is not limited to a minimum specified share in the partnership, as it is, in the case of shares in the family company (see Chapter 3, para. 9). Loans 11. There are no real problems concerning payment of interest on loans by non partners, even if made by "relatives" of "associates" of partners. The interest paid will be allowed as a deduction from the profits of the partnership. So far as loan capital provided by the partner himself is concerned, however, this is ignored as such and is adjusted in the profit sharing ratio. The partner will get earned income relief on such interest as part of his profits. It would not be advantageous in any way to treat such loan interest as a deduction from the profits, as it would then have constituted unearned income of the partner and be fully liable to income tax and possibly surtax. On the other side of the coin, there are no difficulties or tax problems in the case of a loan to a partner-he is either borrowing his own money back or is borrowing effectively from an individual partner or partners. 10 Finance Act 1965, s. 21. 11 Ibid., s. 33. 12 Ibid., s. 34 strictly this applies to an individual owner but it is considered that the words |