Note: The following article was written before the Chancellor’s Autumn Statement 2014 announcement regarding changes to entrepreneurs’ relief upon incorporation in respect of goodwill.
Sole traders and partners incorporate their businesses for a variety of reasons, including potential tax efficiency (e.g. to extract profit from the company by way of dividends).
Transferring an unincorporated business to a limited company often gives rise to a number of tax issues, which need to be handled carefully. There can be both tax planning opportunities and pitfalls. This article looks at some recent tax cases highlighting several important points for taxpayers and their advisers to consider when incorporating a business.
That’s a relief!
Certain assets (e.g. trading premises and goodwill) transferred by sole traders or individual partners upon incorporation are generally treated as disposals at market value for capital gains tax (CGT) purposes, on the basis that the individuals and company are connected (TCGA 1992, s 18(2)). This general rule applies even where the assets are gifted rather than sold (although CGT ‘holdover’ relief may be available in such circumstances (see TCGA 1992, s 165)).
A specific CGT relief is available on the incorporation of a business, if certain conditions are satisfied (TCGA 1992, s 162). The relief broadly applies where an individual transfers to a company a business as a going concern, together with all assets of the business (except possibly cash), wholly or partly in exchange for shares issued by the company to the person transferring the business. Where the relief applies, the effect is broadly that all or part of the gains on the transferred assets are ‘rolled over’ and deducted from the base cost of the shares acquired.
Does it qualify for relief?
It is important to be able to demonstrate that what is being transferred to the company represents a business (i.e. not merely a business asset), and that the business is a going concern. In Roelich v Revenue & Customs  UKFTT 579 (TC), the taxpayer made a transfer to a company (valued at £523,363) in exchange for shares in the company. HM Revenue and Customs (HMRC) raised a discovery assessment charging CGT on the transfer. The taxpayer contended that incorporation relief under TCGA 1992, s 162 was available.
The taxpayer operated a property development consultancy business. He reached an agreement with a contractor (PV), that if PV was successful in obtaining a landfill contract and if planning consent was obtained, PV would pay him a fee of £5 per load of infill. The infill contract was later awarded to PV. The taxpayer transferred the PV contract (which was valued on the basis of likely loads) to the company in exchange for the shares. HMRC did not accept that a business had been transferred to the company, but considered that the transfer was of a single asset (i.e. a stream of income from infill rights). In addition, HMRC argued that the taxpayer’s skills and contacts were personal, and could not be transferred as a separate identifiable business operated by another entity.
However, the First-tier Tribunal found that there was a business. Furthermore, the business was capable of being transferred, as the taxpayer’s knowledge could be passed on to others. The business was transferred with all its assets, and the tribunal held that the transfer was of a going concern. Incorporation relief was available, and the taxpayer’s appeal was allowed.
The incorporation of a business under TCGA 1992, s 162 commonly involves some form of business transfer agreement. Whilst the taxpayer was successful in this case he was perhaps fortunate, as the business transfer was undertaken informally; there was very little documentary evidence of the transfer. If incorporation relief is to be claimed, it will often be worthwhile having the business transfer documented by a legal professional.
It’s all in the timing
Incorporation gives rise to a number of income tax and national insurance contributions (NIC) issues, including cessation and overlap relief, the timing of tax payments, and the treatment of stock and work in progress.
The capital allowances claims of an unincorporated business may also be affected by incorporation. For example, annual investment allowances (AIA) are not available in the chargeable period in which the business is permanently discontinued (CAA 2001, s 38B, General Exclusion 1). The same broadly applies to writing down allowances and first-year allowances (CAA 2001, ss 55(4), 46(2), General Exclusion 1). The timing of incorporation, and of capital expenditure, may therefore be important considerations.
In Keyl v Revenue & Customs  UKFTT 493 (TC), a self-employed air conditioning engineer purchased a new van during his accounting year ended 31 March 2009, and claimed AIA on the cost of the van. He subsequently incorporated his business. The company commenced trading on 1 April 2009. The issue was whether the taxpayer had permanently discontinued his trade in the year ended 31 March 2009, for the purpose of establishing whether he could claim AIA. The taxpayer contended that his trade continued after 31 March 2009, as he carried out maintenance and warranty work for twelve months following installation. He continued to do this work in the period after 31 March 2009 in his own name, and not on the company’s behalf.
However, the First-tier Tribunal held that the taxpayer had transferred his business as a going concern to the company. What he retained (if anything) was a new trade of maintaining systems and dealing with warranty claims. The taxpayer was not seeking new customers, and was not installing air conditioning systems. He was contractually bound to perform maintenance and warranty work in relation to the systems installed for customers prior to incorporation of the business. The tribunal considered that the taxpayer permanently discontinued his trade in the year ended 31 March 2009. On that basis, he was not entitled to AIA.
A potential benefit of incorporation for some business owners is the ability to sell goodwill of the business to the company. The sale proceeds will often be left outstanding as a debt owed by the company to the former sole trader or individual partners, and are repaid as the company’s funds allow. This can be particularly attractive if entrepreneurs’ relief can be claimed by those individuals on the disposal of the business, resulting in a CGT rate of only 10% (on chargeable gains of up to £10 million).
The valuation of transferable goodwill is generally a key consideration. As indicated above, transfers of chargeable assets (e.g. goodwill) between connected persons are generally treated as made at market value for CGT purposes, even if no consideration is given for the assets. The parties to incorporation will often be connected for these purposes (e.g. a sole trader and a company he owns). Establishing the market value of the goodwill (and other chargeable assets) can therefore be important, particularly if it is being sold to the company on incorporation.
In Wildin v Revenue & Customs  UKFTT 459 (TC), an accountant acquired his practice in July 1981, when £100,000 of client business was transferred to him. He ran the accountancy practice successfully, and transferred his share of the practice to a company on 1 April 2003. At that time, the goodwill in the practice was valued at £1,650,000, of which the taxpayer’s share was 84.85% (the other 15.15% related to his business partner). However, HMRC disputed the correct method of valuing the taxpayer’s goodwill in the practice as at 31 March 1982, and also on the disposal in April 2003.
The First-tier Tribunal considered that valuing the goodwill based on a multiple of gross recurring fees was a more accurate valuation method in this case than the formula based approach argued by HMRC. The tribunal held that the base cost for CGT purposes of the taxpayer’s share in the goodwill of the practice at March 1982 should be calculated by applying a multiple of 1.625 to the gross recurring fees of the practice as at June 1983. It was also held that the disposal value of the taxpayer’s share in the goodwill of the practice in 2003 should be valued on the same basis, applying a multiple of 1.5 to the gross recurring fees in 2003, giving a disposal value of £1,584,810. The tribunal considered that it was not correct (as HMRC contended) that the value of a professional firm’s net assets should affect its overall goodwill value. The taxpayer’s appeal was allowed in part.
Some commentators have suggested that HMRC is increasingly challenging the valuation of goodwill in professional practices, including whether there is any ‘free’ goodwill that is capable of being transferred. However, the tribunal in Wildin commented: “the success of the firm was dependent on [the taxpayer’s] own local contacts and work ethic.” There was no suggestion that this gave rise to personal goodwill (which cannot be transferred).
Each of the above cases highlights different practical points. First, ensure that business incorporations are properly documented, particularly if incorporation relief under TCGA 1992, s 162 is sought. Secondly, consider the timing issues of incorporation, including expenditure for capital allowances purposes. Thirdly, if transferring goodwill upon incorporation ensure that it is ‘free’ and not ‘personal’ goodwill, and consider obtaining a business valuation from a specialist.
The above article was first published by Tax Insider (www.taxinsider.co.uk).