A friend has asked you to back her new business. She has the expertise and you have the money. She wants you to buy a share of her company or lend it money. Each type of investment has different tax consequences, but which is better?
Investing in a company
The two most important factors when deciding how to finance are probably risk to your capital and return on your investment. Tax is important too, but only as a consequence of the type of investment you choose, either a share of the company ownership or a loan.
Shares v loans
Whether you buy shares in or make a loan to a company, you could lose some or all of your money if it fails. In that event, subject to conditions, you’ll be entitled to capital gains tax (CGT) relief for the loss. The trouble is that capital losses aren’t worth anything unless you make subsequent taxable capital gains from which they can be deducted. This is where the tax treatment of shares can have an edge over loans.
Special rules for shares
If your investment is in shares that lose value and you sell them, or their value becomes negligible and you don’t sell them, you can claim tax relief for a capital loss. The difference is the loss can, where conditions are met, be converted to an income loss which you can use to reduce the income tax on your earnings and other income instead of CGT.
Tip. Investing in shares rather than making a loan can reduce your net financial loss in the event the company fails.
Example. Harry buys 25% of Sally’s company by subscribing for ordinary shares for £50,000. After three years the company is going nowhere and Sally agrees to buy Harry’s shares for £20,000. Harry has made a capital loss of £30,000. He can convert the capital loss to an income loss. Because Harry is a higher rate taxpayer this can save him £12,000 (30,000 x 40%) which reduces his financial loss from £30,000 to £18,000.
Tip. Harry can choose to use the loss to reduce his income tax bill for the year in which he sells his shares to Sally or the previous tax year.
Trap. One drawback with shares is that they can only generate income (dividends) when the company makes a profit. If Harry had lent the £50,000 instead he could have charged interest and received some income from his investment. However, in our example the chances are that the tax loss relief would be worth more than interest.
Tip. To get the advantage of income tax loss relief in the event a company fails but the advantages of a loan, i.e. the right to charge interest, negotiate with the other shareholders to be issued with convertible ordinary shares, i.e. they can be converted into a loan, or have an option that requires the other shareholders to buy you out after an agreed period and at an agreed price. That way in the early years of the company, when risk is high, you can claim income tax loss relief if the company fails, and after the shares are converted you can charge the company interest on the loan.
There’s no obvious best option but one advantage of shares is that if the company fails you can claim income tax relief which will reduce your overall financial loss. Consider convertible shares, which can be turned into a loan after the initial risky start-up period has passed. That will allow you to charge the company interest.
This article has been reproduced by kind permission of Indicator – FL Memo Ltd. For details of their tax-saving products please visit www.indicator-flm.co.uk or call 01233 653500.