COULD YOUR COMPANY DO MORE TO BEAT INFLATION? Every three months, the Bank of England publishes its Inflation Report and sets out the detailed economic data taken into account by the Monetary Policy Committee when making interest-rate decisions. The report also sets out the prospects for UK inflation over the following two years. The most recent Inflation Report, published in May, makes clear the Bank’s views that inflation still remains a risk in the medium term, despite interest-rate increases and a drop in energy costs. We all know that inflation has recently been very high on the political agenda because of the widespread reporting of Mervyn King’s recent letter to the Chancellor explaining why inflation had veered so far off the Treasury’s target. Since that time, the rate of inflation has fallen back slightly, with April’s headline rate showing a year-on-year reduction of 0.3% to 4.5%. (At these rates, your assets will halve in value in just 15.5 years.) As we know, a fall in the rate of inflation does not mean that overall prices are lower this year than last; it’s just the rate of increase that is slowing down. Helpful though the inflation numbers are for individuals, they are less useful for business owners trying to work out the rise in annual costs and the effects on business profits. Maintaining profits can be a difficult juggling act, especially where the option to raise ‘factory prices’ for items produced or services provided is restricted due to strong competition from other suppliers. Cost-cutting exercises undoubtedly play a part in helping to maintain profitability but can be costly in the short term, especially where staff reductions are being considered. Perhaps the average small- to medium-sized company might do better by ensuring its existing assets are deployed better in producing income for the business. Throughout my time advising such companies, I have noticed that many have cash reserves which are just left sitting on deposit, normally with the company’s clearing bank. I accept it is easy to deposit money with the company’s bank, and of course it does help to build good relationships with local bank managers. However, the rates of interest offered to businesses customers are normally nowhere near as generous as those available to personal customers. It is quite common for companies to hold more money on deposit than could be reasonably required for their normal trading requirements. As a result, any excess money, which might be used more efficiently, is left sitting in rather unattractive deposit accounts generating relatively low levels of interest. We must not forget that any interest received is subject to corporation tax as part of the company’s taxable profits; this further reduces the scope for cash reserves to help businesses fight back against their rising costs. Although bank deposits may not be the ideal solution, many companies are reluctant to distribute excess reserves to their shareholders, or to use these monies to provide benefits for staff, in case their trading position should change and the business require access to some or all of the money. Perhaps these businesses are seeking an alternative approach that allows cash reserves to achieve better returns in relation to both investment gains and tax efficiency, while still maintaining access to the money should it be required at short notice. With the Bank of England’s base rate currently standing at 5.5% (at the time of writing this article), it should be possible with careful planning to achieve interest rates close to or in excess of this figure. By utilising the investment opportunities available from an offshore capital investment bond, it might be possible to control the timing of taxation on any investment gains made or perhaps reduce the tax due on any gains. Regular readers of Schmidt Tax Report may remember that I made mention of offshore capital investment bonds back in October 2005 as a means of avoiding difficulties with the EU Savings Tax Directive. That article was aimed at personal investments by individuals. Now I would like to show how companies could use the same products as part of their investment strategies. For convenience, throughout the remainder of this article I shall simply refer to the product as an offshore bond. Why might a company wish to consider holding some of its cash reserves through an offshore bond? Obviously, one reason is the potential for greater investment returns than might be available from the simple deposit accounts offered by the clearing banks. However, probably more important to longer-term investments are the controls that offshore bonds offer investors, including companies, over investment choice and any taxation of investment gains. Many of the UK’s best-known banks and building societies are currently offering deposit accounts with very attractive interest rates, well in excess of the Bank of England base rate. Although these accounts are not always available to corporate investors, they can be accessed by investors holding offshore bonds. Therefore, in order for a company to access such accounts, it would need to hold an investment bond product from one of the many ‘offshore’ providers. The key to the success of offshore bonds is that investments grow virtually free of taxes, with only small amounts of irrecoverable withholding tax being levied on income from certain share-based investments. Any interest generated from bank accounts held within the offshore bond would normally be available to the investor without any deduction of tax. Offshore bonds are non-income-producing assets; this means that unless the investor (which in this case is a company) elects to withdraw some or all of the investment gains made then any such gains are accumulated inside the offshore bond. Taxation of the gains is deferred until the investor chooses to access money from the bond. Even then it may be possible to defer taxation on a particular withdrawal by utilising the ‘5% tax deferred withdrawal’ facility that is a feature of all capital investment bonds held by UK investors. This facility allows the investor to withdraw, each policy year, up to 5% of the original investment without any immediate liability to taxation. In the case of company investors, that could mean they access 5% of the original investment each year without any immediate liability to corporation tax. Withdrawals could continue each year until the offshore bond is eventually surrendered. Only at that time would taxation of any investment gains be necessary. Since offshore bonds do not carry a fixed investment term and can be surrendered at any time, it is possible to arrange surrender to occur during an accounting period when the company’s profits might be expected to fall, either as a result of difficult trading conditions or, as is becoming far more common, artificially suppressed by payment of a substantial pension contribution on behalf of a shareholding director. Imagine a company that generates taxable profits for 2007/08 of between £300,000 and £1.5 million. That element of the profits above £300,000 will be effectively taxed at 32.5%. Were some of those profits generated from a bank deposit offering interest at 4.5% gross, the net return to the account holder would be just 3.03%. This is substantially less than the current headline rate of UK inflation. As an alternative, the company could hold part of its cash reserves in an offshore bond, with the money invested in a bank account offering higher rates of interest. If required, the company could elect to draw 5% of its original investment each year without an immediate tax liability. Interestingly, this ‘5% withdrawal facility’ allows unused withdrawals to be accumulated and accessed at a later point. For example, were no withdrawals taken during the first two years of the offshore bond’s life, the investor (which includes companies) could withdraw 15% of the amount originally invested in year 3 without any immediate liability to tax. Final encashment of the offshore bond in our example could be arranged to occur during an accounting period when the company’s profits might be expected to be less than £300,000. Please note that any investment gains made within the offshore bond would be added to trading profits to establish the actual level of taxable profits. If the taxable profits, including any investment gains, were less than £300,000 then taxation on the investment gains would be significantly lower (20% in 2007/08 rising to 22% in 2009/10) than would have been the case had the money remained on bank deposit throughout and been taxed on a year-by-year basis. There has been a significant increase in the number of companies electing to hold bank accounts that are accessed through offshore bonds. All the major providers of offshore bonds are reporting major increases in the amounts invested through their products. The taxation advantages of these products alongside the higher interest rates available are proving to be a very popular mix. If you want further details of how these products might be of use to your business, please feel free to contact me. Robert Wemyss Dip PFS| Courtney Havers LLP 24 London Road, Southborough Tunbridge Wells, Kent, TN4 0QB Telephone: 01892 544 233 Authorised and regulated by the Financial Services Authority. Email: robert.wemyss@courtneyhavers.co.uk