Previously, smaller companies could invest surplus cash into investment bonds and, if the historic cost method of accounting was adopted, they could benefit from tax deferral and therefore have no corporation tax to pay on the bond gains until they were realised. However, following a new EU directive, this benefit is unlikely to be available.
New EU Accounting Directive
The UK GAAP (Generally Accepted Accounting Practice) is the body of accounting standards and other guidance published by the UK’s Financial Reporting Council (FRC). The FRC issued a suite of changes that updated and, in some cases, simplified UK and Ireland accounting standards.
The changes were largely in response to the implementation of the new EU Accounting Directive and this meant, in effect, that the UK Financial Reporting Standards for Smaller Entities (FRSSE) was being withdrawn.
In this note, we only consider the investment options available for smaller companies who were previously able to use the FRSSE.
The changes were effective for accounting periods beginning on or after 1 January 2016 – but early application was permitted for accounting periods beginning on or after 1 January 2015 so some companies may have already been using the new FRS102 (The Financial Reporting Standard applicable in the UK and Republic of Ireland).
The FRC produced FRS105, which is the Financial Reporting Standard applicable to the micro-entities regime. This began on 1 January 2016.
The FRS105 had further simplification over the FRS102 and this meant that there are now four categories for company accounting: micro-entities, small entities, medium-sized and large.
The definition of a micro-entity is contained in sections 384A and 384B of the Companies Act 2006. The company will qualify as a micro-entity in a year in which it satisfies two or more of the following conditions:
- Turnover of £632,000 or less
- Balance Sheet total of £316,000 or less
- Average employees during the financial year of 10 or less
Micro-entities are not permitted to use fair value or revalue any assets or liabilities – so these must all be held at cost – whereas the FRSSE permitted certain assets to be revalued.
Limited liability partnerships cannot currently apply the micro-entity regime as they are not companies.
Smaller companies criteria
From 1 January 2016, smaller companies criteria apply in a year in which a company satisfies two or more of the following conditions for two consecutive years:
- Turnover of £10.2m or less
- Balance Sheet total of £5.1m or less
- Average employees during the financial year of 50 or less
Therefore some companies may be able to adopt FRS102 whereas they couldn’t qualify for the FRSSE.
The main differences between existing UK GAAP and FRS102 are that the accounting treatment is substantially different for financial instruments, investment properties, deferred tax and defined benefit pension schemes.
The area we will concentrate on is ‘financial instruments’, as that is where any investment bonds held by the company would sit. This heading is split into two: basic financial instruments and complex financial instruments.
Complex financial instruments
All complex financial instruments will need to be accounted for under fair value – so the increase (or decrease) in the value of the bond will be reported each year in the accounts and any corporation tax liability settled each year – irrespective of whether or not a withdrawal or encashment has been made.
Basic financial instruments
Basic financial instruments can still be accounted for under the historic cost accounting basis – therefore the tax deferral option will still be available. But do check with the company accountants that this is possible for your particular clients.
The crucial issue is whether investment bonds (UK or international) are classed as basic or complex financial instruments.
And the answer predominantly depends on the underlying fund links.
Fixed income assets
Fixed income assets can still be accounted for at book value. This treatment can also be extended to some variable income assets if the variable element is tied to a single known and observable index.
So if this is the only type of asset held under the policy, it could fall under the ‘basic financial instrument’ category.
If any equities are held inside the fund links, then it falls under the ‘complex financial instrument’ category and would need to be accounted for under fair value.
There are also other conditions, all of which need to be met in order for the bond to be classed as a basic financial instrument. Here is the full list:
Condition 1 – Returns to the holder
The holder’s return must be:
- a fixed amount; OR
- a fixed rate of return over the life of the instrument; OR
- a variable rate of return – that, throughout the life of the instrument, is equal to a single referenced quoted or observable interest rate; OR
- some combination of fixed and variable rates (as above), provided they are both positive.
Condition 2 – Absence of potentially detrimental contractual provisions
There must be no contractual provision that could result in the holder losing their principal or any interest relating to the current or a previous period.
Condition 3 – Contractual provisions
Any contractual terms that enable the borrower (i.e. the issuer) to pre-pay a debt instrument or enable the holder (the lender) to put it back to the issuer before maturity must not be contingent on future events (other than to protect the holder against future tax changes or a downgrade in the issuer’s credit).
Condition 4 – Extension of debt instrument
If the contract permits the term of the debt instrument to be extended, any return to the lender and any other contractual provisions which apply during the extended term must satisfy the conditions 1 to 3 above.
For existing corporate clients holding investment bond policies, you will need to establish with them, or their accountant, what their options are for accounting methods. Do they fall under FRS102 or FRS105?
Then it will be necessary to ascertain what funds they are currently holding inside their bond wrapper to determine whether or not they can benefit from tax deferral. And if not, would they be able (and would it be appropriate) to switch into an investment that would classify their bond as a ‘basic financial instrument’?
Many corporate clients will hold investment bonds which fall into the category of complex financial instruments, as they will be invested in a variety of funds whose return is based on the variable yields from the underlying assets.
One final aspect which needs consideration is where a company is benefiting from tax deferral to date under historic cost accounting, but will fall under fair value accounting once the company adopts FRS102.
It appears that, since this adjustment arises from a valid change in accounting basis, it falls under the Loan Relationship and Derivative Contracts (Change of Accounting Practice) Regulations 2004 (the COAP regulations).
This was originally introduced to deal with similar issues when large companies first adopted the International Financial Reporting Standards. Under Paragraph 3A of the COAP provisions, in the majority of these cases the company can spread the tax payable on the accumulated deferred gains over ten years – taking one tenth into account each year from the year the new accounting basis (FRS102) applies.
Of course, aside from the (very important) tax aspects, directors considering any investment of corporate funds will need to give careful thought to the business’ near and medium term needs for working capital, business investment (for example, capital equipment / infrastructure), debt repayment and the possible impact of investment on entrepreneurs’ relief.
For smaller companies who were previously able to use the FRSSE, as long as they are now ‘micro-entities’, they will still benefit from tax deferral on investment bond gains.
For all other companies, the tax position for corporate investment in investment bonds is:
- Cash deposit and fixed income funds: tax deferral available.
- All other funds: taxed year-on-year
It should also be borne in mind that UK bond cash deposit and fixed income life assurance funds are taxed on an ongoing basis, so no tax deferral is effectively achieved.
This document is based on Canada Life’s understanding of applicable UK tax legislation and current HM Revenue & Custom’s practice, as at January 2019 and could be subject to change in the future. It is provided for professional advisers only. Any recommendations are the adviser’s sole responsibility.