Tony Mudd: The investment bonds and small firms tax puzzle

Tony Mudd

Prior to April 2008, investment bonds (both onshore and offshore) held by companies were taxable under the chargeable events regime – precisely the same regime that applies for individual investors today. In other words, a tax charge would arise where there is a chargeable event and any resulting gain would have been subject to corporation tax for the company in the year in which it arose.

New rules came into effect from 1 April 2008 which meant investment bonds held by companies were no longer taxable under the chargeable event regime. Instead, they were taxed under the loan relationship rules, contained in Part 5 of the Corporation Tax Act 2009, which provide that credits or debits (gains or losses) are taxed or relieved as they arise in the company’s accounts.

The company’s accounts would be prepared under the Financial Reporting Standard for Smaller Entities, with the tax treatment of any debits or credits dependent upon the underlying accounting policy applicable to the company, which will be either on the historic cost basis or fair value basis.

At a high level, the historic cost basis of accounting permitted gains from life assurance policies to come into account, and ultimately to be subject to corporation tax on any gains only in the case of a chargeable event arising. In other words, the historic cost basis provides tax deferment.

The fair value basis of accounting, however, resulted in an annual assessment of any gains or losses: it does not provide tax deferment with corporation tax arising each year on any gains, without the need for a chargeable event to arise.

FRSSE has now been withdrawn and replaced by the Financial Reporting Standard 102. FRS 102 applies for companies preparing their annual financial statements for accounting periods commencing on or after 1 January 2016 and will have a significant impact on all businesses, particularly those that previously used the historic cost basis.

The adoption of accounting principles will be based upon a variety of factors. In practice, I would suggest most companies holding investment bonds will be small companies as defined in the Companies Act 2006.

These companies will generally have adopted the historic cost basis of accounting. This means the loan relationship (investment) is treated as a fixed asset, carried on the balance sheet and retained at cost, thus providing tax deferment.

A company is a “small company” if it satisfies two of the following three requirements:

  • Turnover is £6.5m or less
  • The balance sheet total is £3.26m or less
  • The average number of employees is 50 or fewer

In practice, therefore, until the introduction of FRS 102, most small companies holding investment bonds would have had the benefit of being able to defer any liability to corporation tax on gains until they were recognised on disposal or part disposal of the investment.

What is FRS 102?

FRS 102 not only replaces FRSSE as a new standard accounting practice for the UK, it also replaces all of the current financial reporting standards and statement of standard accounting practices. Under FRS 102 “basic financial instruments” such as bank loans, trade debtors and creditors, cash at the bank and other corporate debt will continue to be valued using the historic cost basis of accounting.

However, investment bonds do not fall within the definition of a “basic financial instrument” and, as a result, will, with the exception of micro entities, now be accounted for under the fair value basis of accounting.

Application and transitional rules

As a result, while the vast majority of companies holding investment bonds would have previously accounted for these at cost (i.e. used the historical cost basis) they should now expect to book a taxable gain or loss simply as a consequence of their adoption of FRS 102 based on gains/loss to date.

Helpfully, under new transitional rules, the gain or loss would be brought into account for tax purposes over a period of 10 years on a straight line basis, starting with the first accounting period commencing after 1 January 2016.

That said, tax credits available from onshore bonds will only be available on encashment and, therefore, likely to produce negative cash flow issues for the company.

Companies affected by FRS 102

As mentioned, the adoption of FRS 102 applies to most companies from the first day of its own accounting period after 1 January 2016. For example, if a company’s accounting period runs from 1 April to 31 March then it will adopt FRS 102 for the first time for its year 1 April 2016 to 31 March 2017.

As a result, the company will have to settle the corporation tax arising due to FRS 102 “gains” for the first time not later than nine months and one day after the end of the accounting period (i.e. by 1 January 2018) unless the company is “large”, and must pay corporation tax via quarterly instalment payments. This is a significant change and companies impacted will need advice.

Tony Mudd is divisional director of tax and technical support at St James’s Place