Incorporation: The price is right?

By | 23 November 2021

Sole traders or partnerships often incorporate, so that the business operates through a company. This can be done in various ways.

What’s it worth?

For example, the business proprietor(s) might sell the business to a newly-formed company for cash, with the proceeds being left outstanding on a director’s loan account for the proprietor(s) to withdraw from the company as they wish if funds allow.

Disposals of chargeable assets on incorporation are normally transfers between ‘connected persons’ for capital gains tax purposes. This means that the disposal of assets is treated as taking place at market value.

Too much

What if the goodwill is overvalued? HM Revenue and Customs (HMRC) ‘Tax Bulletin’ (Issue 76) indicates that the excess consideration on incorporation could be treated either as employment income or a distribution (i.e. like a dividend) in the capacity of a shareholder. This is based on the premise that the goodwill has been deliberately overvalued. However, HMRC will allow the transaction to be ‘unwound’ in certain circumstances:

  • ‘Reasonable efforts’ must have been made to carry out the transaction at market value using an ‘independent and suitably qualified valuer on an appropriate basis’;
  • There can be no unwinding of intentional overvaluations; and
  • There must be no tax avoidance motive.

If a distribution is unwound, the shareholder must repay the excess value to the company.

Partial repayment

What if the company is terminated before all the sale proceeds for the goodwill can be paid to the shareholder (e.g., if the company trades unsuccessfully)? How much of the excess sale proceeds above the actual goodwill valuation is taxable on the business proprietor?

In Pickles v Revenue and Customs [2020] UKFTT 195 (TC), a husband and wife in partnership incorporated the business and sold all its assets to their company (HFPL). The value attributed to goodwill sold on the incorporation, which was credited to the directors’ loan account, was £1,199,043. However, HFPL was eventually dissolved, leaving a balance owing on the directors’ loan account of £427,180.

Following an HMRC enquiry, the goodwill valuation was agreed at £450,000. HMRC sought to treat the difference (i.e., £749,043) as a distribution to the taxpayers and liable to income tax.

The First-tier Tribunal subsequently determined the market value of the goodwill to be £270,200. The tribunal also noted that following the business sale, the appellants received cash of £771,863 from HFPL for the sale of the goodwill. This exceeded the market value of £270,200 by £501,663. The tribunal held that £501,663 was a benefit received by the taxpayers and a distribution for income tax purposes; however, the balance of the debt which remained outstanding (i.e., £1,199,043 – £771,863 = £427,180) could not also be regarded as a distribution. In a subsequent hearing ([2020] UKFTT 327 (TC)), the tribunal confirmed there was a distribution (under CTA 2010, s 1020(1)(b)) of £501,663.

Practical point

The valuation of assets such as goodwill is a highly specialised area best left to experts. However, even if goodwill has been valued by a professional valuer, it does not necessarily follow that HMRC’s Shares and Assets Valuation division will agree with the professional valuer’s valuation; there could be potentially major differences in valuations of the same asset by HMRC and the valuations expert.

The above article was first published in Business Tax Insider (December 2020) (www.taxinsider.co.uk).