When is 20% not 20%? The real impact of the proposed changes to business property relief on trading companies

The impact of the Budget's proposed reforms to business and agricultural property relief (BPR and APR) has garnered a lot of attention insofar as it will affect farmers - as evidenced by the increasingly popular use of the term “family farm tax”.  However, it will also have a huge impact on the owners of trading businesses and - as explained in this post - an even greater impact on trading companies.

Many explanations of the reforms have focused on the “effective” rate of tax which will apply to APR and BPR assets from 6 April 2026.  The figure of 20% is often cited which is a shorthand method of explaining that agricultural or business property value which only attracts 50% relief, and is then subject to 40% tax on death, will be subject to a marginal rate of 20%.  For example, ignoring the £1m allowance and nil rate band, a £10m business attracting 50% relief and subject to 40% tax on death will result in an inheritance tax (IHT) liability of £2m (ie an effective rate of 20%). However, for businesses operating as companies, this 20% is an oversimplification and the real cost will be much higher.

Take Alan.  His family trust (in which he has an old-style life interest) owns 100% of the shares in a trading business, of which he is CEO, worth £10m.  Historically, he has been relieved to know that the company will receive 100% BPR on his death and therefore no IHT will be payable by the trustees in respect of his shares.  From 6 April 2026, he understands that on his death, the shares will have a chargeable IHT value of £4.5m ((£10m - £1m of 100% relief) x 50% relief).  He has multiplied this by the rate of IHT which applies on death (40%) and expects that £1.8m of IHT will be payable on his death in respect of the shares.  Alan has therefore been working closely with his CFO to work out how that £1.8m might be funded from the business whilst preserving it as a viable commercial enterprise.  

However, Alan may be in for a shock.  Although his IHT calculation is correct, he has not considered how to get the £1.8m out of the company and into the hands of the trustees in order to pay the IHT.

If the company pays the tax directly, this will be treated as a deemed distribution from company. Likewise, if a dividend is declared (which is the normal mechanism of extracting money from a company), income tax will be due at the dividend rate of tax.  

Alan and his trustees therefore need to take advice on the funding of the IHT liability and, in particular, how money extracted from the company to meet this liability may be subject to separate taxes.  The top rate of dividend tax is 39.35%. If this rate applies, then in order for his trustees to receive the £1.8m that they need to pay the IHT, they would need to receive a dividend of almost £3m.  They would then pay almost £1.2m in income tax and £1.8m in IHT. Suddenly, the effective rate of tax on Alan's business is closer to 30% than 20%.  There may also be other taxes to consider (such as corporation tax) if Alan's company has decided, say, to save a proportion of its profits each year and invest them in an “IHT pot”.  Any gains realised on turning that portfolio into cash following a death may attract corporation tax.  

In addition, has Alan factored in that if he has a £1.8m “IHT pot” in his company, this may be an excepted asset for BPR purposes and therefore get no relief?  An excepted asset is one which is not needed, or used, in the business.  This will also shift the IHT calculation upwards.

There may be ways to mitigate the tax position.  However, the key point at this stage is for the trustees and Alan to identify the problem and seek professional advice on managing it.  This may involve looking at different methods of extraction, considering different funding options (eg meeting the liability from outside the company, or from life assurance) and considering the role that the interest-free instalment option may hold in meeting the liability.

The news may also not be quite so bad depending on the ownership of the shares, and the plans for paying the IHT.  For example, executors pay income tax at the basic rate (8.75% on dividends) which reduces the tax leakage. However, this lower rate may not be available throughout the 10 year period if the executors/family elect to pay the IHT by interest-free instalments in order to manage cashflow; in this case, the beneficiary of the shares (such as the deceased’s children) may well be subject to higher rates of tax on extractions to pay the later annual instalments.

For smaller business owners weighing up the various models of ownership (sole trader, partnership, company) the cost of extracting funds from a company to pay IHT should also be brought into account when reaching their decision as to the best structure for their business. Likewise, a “dry run” plan for funding the IHT should be made before business owners undertake succession planning, in light of the proposed reforms, such as settling shares into trust or making gifts to the next generation.  

If the company is held by a relevant property trust, similar issues will apply, although overlaid by the further complexities of trust taxation and fiduciary considerations.  Where a trust is subject to 10 year charges, the effective 3% IHT rate on a 10 year charge may be increased to more like a 5% rate if the IHT is funded by way of dividend which is subject to income tax at 39.35%.  In addition, before a dividend is declared, the trustees would need to consider the terms of the trust to ensure that they have the power to use the dividend income to meet the capital expense of IHT.  

The reforms are complex and it will be vital for business owners to understand the full-picture implications for their trading companies when devising their strategies on how to meet this increased tax burden.