News and Articles

The taxation of corporate investments

Corporate investment involves consideration of the investment of corporate funds, mainly by private companies, UK resident companies which, as a consequence, are subject to UK corporation tax.

1. The need for corporate investment

Successful private companies sometimes have funds on deposit that:

  • are not required as working capital
  • have not been set aside for a specific purpose.

Quite often these funds will accrue as a result of excess after-tax profits being retained inside the company. With Corporation Tax rates currently much lower than the Income Tax rates that apply to Director bonuses or dividends, this is a common situation.

Many owners of private businesses are as "lazy" (perhaps risk averse) with their business funds as they are with their personally-owned funds. This means that substantial funds can be held on deposit.
There are sometimes financial planning opportunities to consider in the investment of corporate funds.

There are important potential taxation issues connected with investing corporate funds that must be taken into account before an investment is made.

2. The choice of investment

This will be dictated by a number of factors, such as:

  1. The need for access to cash. If the cash could be needed at any time for, say, business purposes, then there is no other option really than to leave the cash on deposit or in a deposit fund inside a wrapper. Should cash not be required in the foreseeable future, longer term equity-based and asset-backed investments, such as collectives and single premium bonds, could be considered.
  2. The risk profile and investment objectives of the company's directors. If the directors are risk averse then cash/deposit accounts would suit. If the directors are seeking capital growth only (i.e. no income) capital growth oriented investments (or single premium bonds) could be suitable. For an investment that generates income as well as potential capital growth, then equity income or balanced fund investments inside the wrapper of a collective could fit the bill.
  3. The tax position of the company
  4. The tax treatment of the proposed investment
  5. Charges
  6.  Simplicity
  7. The future aspirations of the directors e.g. are they planning to sell the company?

The tax implications of a company investing in different types of investment are considered here in considering the investment wrapper but not the underlying investment strategy that the company should be adopting.

Regardless of the investments chosen, it is likely that one or more of the investments owned by a company will be taxed under the loan relationship rules.

3. The loan relationship rules

In many cases, investments held by a company will be taxed under the loan relationship rules.

Loan relationships are broadly money debts arising from a transaction for the lending of money, but there are also investments which are deemed to be loan relationships - see below. Broadly speaking, the fundamental rules taxing loan relationships provide that income, gains and losses of a company arising from loan relationships are subject to corporation tax.

The loan relationship rules can have a potentially wide application to many of the investments available to, and suitable for, a company. These include:-

  1. Deposit accounts.
  2. Authorised investment funds (AIFs) which pay interest distributions are treated as deemed loan relationships. An AIF is an authorised unit trust or open-ended investment company (OEIC) and interest distributions would usually be paid out of the income of an investment fund which is invested, broadly, as to more than 60% in interest-bearing investments. Typical examples of such an investment would be a cash or corporate bond unit trust.
  3. Offshore collectives which pay interest distributions are treated as deemed loan relationships.
  4. Investment life insurance contracts, whether UK or offshore. "Investment life insurance contracts", as defined in the legislation which treats certain insurance products as deemed loan relationships, are life assurance policies capable of acquiring a surrender value (the prime example of this type of policy is the single premium investment bond), purchased life annuities and capital redemption policies.

I will look at the tax treatment of each of these types of investment in more detail in the subsequent articles.

Meaning of loan relationship

A company has a loan relationship if:

  1. It is either a creditor or debtor for a money debt and
  2. That debt arises from the lending of money
  3. It owns an asset which is taxed as a deemed loan relationship

Examples of actual loan relationships are overdrafts, bank loans, building society loans, bank deposits, building society deposits and mortgages. As stated above, AIFs which make interest distributions and, since 1 April 2008, certain investment life insurance contracts, are also taxed under the loan relationship rules as deemed loan relationships.

Income and gains are treated as trading income where the company holds the loan relationship for the purpose of its trade, and non-trading income otherwise. Relief is available for expenses or losses whether or not a loan relationship is held for the purpose of its trade.

Where a company is investing funds surplus to its immediate trading requirements then income and gains would be treated as non-trading income which gives rise to a non-trading credit. A loss would rank as a non-trading debit. Credits and debits on non-trading loan relationships are aggregated to arrive at an overall profit or loss on non-trading loan relationships in an accounting period.

Net profits from non-trading loan relationships are within the charge to corporation tax as income. Net losses, known as non-trading deficits, can be relieved as follows:

  1. By offset against the company's profits (which includes capital gains) chargeable to corporation tax in the same accounting period or
  2. By carry back against non-trading credits arising in the immediately preceding accounting year or
  3. By carry forward against non-trading profits (ie profits exclusive of trading income) of subsequent accounting periods.

Basis of Accounting

Loan relationship debits and credits are based on the profits shown in company accounts prepared in accordance with UK generally accepted accounting practice or international accounting standards. Subject to what is said below in relation to small companies and the historic cost basis of accounting (see 4 below), for accounting periods which begin on or after 1 January 2005, two methods of accounting are relevant, the amortised cost basis and the fair value basis:

  1. The amortised cost basis - this basis is used in the loan relationship legislation and is the basis of accounting in which the loan asset (or liability) is shown in the balance sheet at its original cost, adjusted for amortisation (depreciation) of any discount or premium, fees incurred for borrowing (or received for lending) and similar amounts, and any impairment (similar to a bad debt provision), repayment or release
  2. The fair value basis of accounting.

This basis is also used in the loan relationship legislation and is the basis of accounting under which assets or liabilities are shown in the company's balance sheet at "fair value". "Fair value", in relation to a loan relationship, is the amount that an independent third party would pay for a debt asset, or the amount the company would have to pay an independent person for release of a debt liability. If this method of accounting was in place and the company owned an investment life insurance contract, the fair value would be its surrender value as quoted by the life company. However, see 4 below for the special provisions applicable to small companies.

For certain types of loan relationship use of one or other of the above accounting methods is stipulated in the legislation - the fair value basis for AIFs. Otherwise a company can choose which method to adopt for a particular asset taxed under the loan relationship rules.

Small companies

A small company, as defined in the Companies Act 2006, can elect to prepare its accounts on a basis which means that it avoids having to use the generally accepted accounting standard rules described above. Such a small company will generally adopt a historic cost basis of accounting. This means that the loan relationship is treated as a fixed asset and carried in the accounts at cost. It is thought that most small companies would use this method of accounting.

A company is a small company for this purpose if it satisfies 2 of the following 3 requirements:

  1. Turnover is £6.5 million or less
  2. Balance sheet total is £3.26 million or less
  3. The average number of employees is 50 or less.

So if a small company owned an Investment Bond and that company elected for the historic cost basis, the purchase price of the bond would be included in the company's accounts each year. This would mean that no non-trading credits/debits would arise until the bond is encashed.

It should be noted that regardless of the basis of accounting valuation adopted for an asset, it would seem that HMRC has the power to disregard this if it considers that the basis adopted does not follow generally accepted accounting principles.

In Summary

Private limited companies will generally adopt one of two bases of accounting for investments - the historic cost basis (for a small company) or the fair value basis (for any size company). Depending on which basis is being adopted there could be a different tax result.

Where the fair value basis of accounting is used in connection with loan relationships, at the end of each accounting period of the company, the value of the investment will be determined and compared to its value at the beginning of its accounting period. That will give the non-trading credit or debit to be included in the company's accounts for that year.

Where the company is operating on a historic cost basis of accounting this means that, with regard to loan relationships, it is the original cost of the asset that is included in the accounts of the company each year until such time as the asset is encashed or otherwise disposed of. This means that there will be no gain/loss to be brought into account each year as a non-trading credit or non-trading debit. However, when the asset is finally encashed the full encashment value is then used and so the whole non-trading credit/debit is brought into charge to Corporation Tax at that time offering considerable scope for tax deferral.

Team Pioneer

Nulli Secundus