Business borrowing was one of the biggest casualties of the credit crunch and access to external funding is still being squeezed.
Recent surveys suggest many smaller companies and start-ups in particular are still feeling discouraged from asking for a loan or overdraft, partly due to continuing economic uncertainty but also the time and effort involved.
With economic recovery heavily dependent on the ability of companies to borrow and invest, there has been huge scrutiny of the banks behaviour over the last couple of years. Interestingly, more than half of the 5,000 businesses polled by BDRC Continental in its quarterly SME Finance Monitor are not using external financing and just under a half never do so.
One alternative source of funding is the pension schemes of directors or owners of businesses. The markets for Small Self Administered Schemes (Ssass) and Self Invested Personal Pensions (Sipps) were built on the need to use pension assets to support business objectives.
Although recent strong growth in new Sipp sales has been in low-cost and platform-based options, there remains healthy demand from entrepreneurs and directors for pensions that tie in the assets of the scheme with the running of the business. Our experience shows there are many interesting opportunities for Financial Planners who understand what is possible and how to avoid the pitfalls.
Most important is to get the right scheme for the job – Sipps might be the big sellers but in many cases a Ssas could give extra flexibility.
Probably the key point with this more complex business is to choose a provider that sees this kind of business on a regular basis and has the expertise and experience to support you and your clients through the process.
There are four main areas in which pensions can support a business and provide funding. By far the most well known is for the pension to buy commercial property from which the business operates. In addition there is scope for a pension to make loans to the company, buy shares in the company, and to purchase intellectual property rights. It is important to know what is and isn’t allowed in order not to fall foul of HM Revenue & Customs rules that could lead to tax charges.
The fact that a Sipp or Ssas can buy commercial property won’t come as a surprise. What might be of interest is the flexibility around this, in terms of the type of property and how it can be purchased although it should be remembered some providers won’t deal with what they consider ‘non standard’.
The scope goes beyond offices, shops and industrial units into nursing homes, surgeries, restaurants and pubs, schools, hotels, car parks, sport facilities and land for development or forestry.
In addition, there is scope for either part or joint purchase of the property, in specie contribution of property or even part in specie contribution and part purchase. The pension can also borrow, for example to help fund property purchase.
An example might be of a trio of directors of a business who are looking for funding for new equipment. The business owns the property valued at £250,000 with a £150,000 mortgage and the directors’ have pension savings of £150,000.
By transferring the pensions to a Ssas, the scheme can borrow a further £75,000 – the maximum borrowing is 50 per cent of the net value of the fund. The scheme can then buy 84 per cent of the property for £210,000 with £15,000 to cover costs and leave some cash in the fund.
The property is owned by the Ssas and the business on a tenants in common basis. Instead of paying interest on the mortgage, rent is paid as a tax deductible business expense to the pension, helping to boost its value. The clear advantage in the above scenario is that the business has cleared its mortgage and received a further £60,000 to buy new equipment. Points to note are that there could be a Capital Gains Tax liability on the sale of the property to the pension and it must pay a commercial rent to the pension.
Any growth in the value of the property is tax free while it remains a pension asset and when sold there is no CGT liability.
As the pension grows, the directors can use it to buy the remaining share of the property if they wish. At retirement they could either sell the property or use the rent to pay their pension income.
Some firms, particularly family businesses, prefer to use a pooled fund such as a Ssas in this scenario because the rent and contributions from younger members can support pensions in payment for the older generation, while the younger members themselves benefit from the longer-term rise in the value of the property.
The three directors in the example above could equally use Sipps to purchase the property but one of the extra options of a Ssas is the ability for it to make loans back to the sponsoring employer which could provide further funds for business development.
The maximum loan is 50 per cent of the net fund value, the loan must be capital and interest, secured by way of first charge ideally over property or land, and last for a maximum of five years with just one rollover allowed. The minimum interest rate is set by reference to 1 per cent over base rate of six leading high street lenders. This is currently competitive compared to mortgages although it may be in the members’ interests to charge more.
Rather than a company investing £50,000 in new equipment, in some circumstances it could make an employer contribution of the same amount to a director’s pension scheme that would then loan the money to the company to buy the equipment. In this scenario the company could receive a double tax benefit, first from corporation tax relief on the contribution and second on the capital allowance for investing in the equipment.
There are some technicalities to bear in mind. The contribution must meet the “wholly and exclusively for the purposes of the employer’s trade or profession” rule in order to receive corporation tax relief.
Also the size of the contribution must be made with regard to the member’s annual allowance to avoid tax charges although the ability to carry forward unused annual allowance from previous years may give scope for bigger contributions.
Pension schemes are allowed to invest in shares (equities) even if they are not quoted on a recognised stock exchange. For unlisted shares, particular care needs to be taken that no tax charge is created for buying shares that result in the pension having an indirect interest in taxable property.
There are some basic rules that must be met.
First, the shares need to be in a limited company that is a trading concern.
Second, the pension scheme either alone or with associated persons does not have control of the company.
Third, neither the pension scheme member nor a connected person is a controlling director of the company. And fourth, that the pension scheme does not hold the shares for the purpose of enabling the member or any connected person to occupy or use taxable property owned by the company. There are complex rules around who is a connected person – it could be family members, other companies or trusts, or fellow directors.
These rules effectively prevent directors who run their own company from selling personally held shares of that company to their pensions to release cash. But they do give scope for the pensions of some non-controlling employees to accumulate some shares in the business. These could be shares that have been purchased, releasing cash to the business, or which have been given as part of the remuneration package. These may be bought by the pension from the employee or company or received directly by the pension as an in specie contribution.
A Ssas can technically invest up to 5 per cent of net fund value into any one sponsoring employer and up to 20 per cent in multiple employers. In reality, this rarely happens because Ssass are typically set up by controlling directors.
In the case of Sipp, we will allow up to 90 per cent of the fund to be invested in unlisted shares, but the scheme and connected persons must hold less than 20 per cent of the overall shareholding in any one company. This gives a lot of flexibility to invest in the unlisted shares of companies where the pension scheme member has no connection. In recent months we have seen interest in this area increase sharply, mainly from investors who are cherry-picking opportunities from companies that are keen to access funding from private sources.
There is an additional option for the pension scheme to make a third-party loan to a company it is not connected to. The basic rule is that loans are only acceptable if they are genuine investments of pension schemes. “They should be prudent, secure and on a commercial basis.” This means that the loan can’t be made if no other lender is prepared to and the interest rate must be close to market rates. An example we have seen is Sipp investors forming a syndicate to lend to the developer of a new leisure and hotel complex, with the loan secured on the land.
A final possibility is for the pension to buy intellectual property rights from a business which could include brand names, trade marks, logos, patents and copyright. In practice, this can be quite difficult because they need to have sufficient value to make it worthwhile. The pension receives its return by charging a fee to the business for using the intellectual property, similar to how they pay a rent for a physical property.
This article has covered some of the main opportunities for Sipp and Ssas investors to use the scheme assets to provide business funding. It has also probably given a taste of the complexity of some of the arrangements.
The underlying theme is the need for technical expertise in these areas and our best advice is for planners to ensure that their chosen pension administrator has experience of dealing in such transactions and is willing to talk you and your clients through the finer points.
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