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Draft FB 2015: Capital gains and small business incorporation

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Among the changes announced in the chancellor’s Autumn Statement on 3 December were two little nuggets that came as a complete surprise to most of us, relating to the tax benefits of incorporating a small business. Apparently, we have been advising our clients to avoid tax for many years, without even knowing it! There are two related changes: one restricting the availability of entrepreneurs’ relief on the incorporation of a business; and the other restricting the availability of a tax deduction for the amortisation of any goodwill transferred to the successor company on incorporation.

In the Autumn Statement on 3 December 2014, the chancellor announced two new measures to restrict the tax reliefs available to businesses on incorporation. One was to restrict the availability of entrepreneurs’ relief when transferring goodwill on incorporation. The other will restrict the availability of tax deductions for the amortisation of goodwill transferred to the successor company on incorporation.

Capital gains on incorporation

There are three mechanisms for incorporating a business. If you transfer your business to a company in return for an issue of shares, you could claim incorporation relief under TCGA 1992 s 162 and the gain that would have accrued on the disposal is instead deducted from the base cost of the shares. Alternatively, assets can be gifted to the company, using the business asset gift relief under TCGA 1992 s 165. Neither of these reliefs is affected by the 3 December announcements.

If instead you sell your business to the company and the business is a trade, you would have expected to claim entrepreneurs’ relief and pay 10% capital gains tax (CGT) on the disposal. However, to the extent that you transfer goodwill when you incorporate your business, entrepreneurs’ relief will no longer be available for disposals on or after 3 December 2014, under new TCGA 1992 s 169LA.

Where a qualifying business disposal involves the transfer of a business directly or indirectly to a close company, and the transferor is a related party in relation to the company, then goodwill is not a relevant business asset for the purposes of entrepreneurs’ relief. Therefore, the 10% CGT rate is not available in respect of its disposal. In practice, this means it is unlikely that businesses with substantial goodwill will be incorporated using this method, and people will revert to using the incorporation relief or gift relief.

Whether a person is a related party in relation to a company is defined by the corporation tax rules for intangible fixed assets, in CTA 2009 Part 8. The most relevant rule here is that a participator in a close company is a related party in relation to that company (CTA 2009 s 835(5)). And the definition of close company includes non-UK resident companies that would be close if they were UK resident.

Why is this change being made? The main advantage of selling a business to a company is that this leaves a debt due to the transferor, which allows tax-efficient profit extraction from the company as the debt is repaid. HMRC’s view is that such sums should be extracted from the company by more ‘normal’ means, such as dividends or salaries, so this provision ‘removes an unfair advantage’ (from the tax information and impact note (TIIN)) and ‘supports the government’s objective to have a fair tax system’ (explanatory notes to the draft legislation).

Changes to goodwill amortisation relief

On incorporation (whether you claim incorporation relief or not), the goodwill transferred into the company should appear on the balance sheet at market value, as acquired goodwill on a business acquisition. The amortisation or impairment of that goodwill is generally allowable for tax purposes, under the accounts-based tax rules for corporate intangibles in CTA 2009 Part 8. This advantage is being removed in respect of transfers of intangible assets to connected companies on or after 3 December 2014 – unless a contract for the transfer had become unconditional before that date – by CTA 2009 ss 849B–849D.

Section 849B applies to goodwill or similar assets acquired by a company from an individual that is a related party in relation to the company, or from a partnership where at least one member is a related party in relation to the company. In these rules, a ‘relevant asset’ means goodwill, customer information, customer relationships, unregistered trademarks and other signs and licences in respect of any of the above assets, relating to the business or part of the business that is transferred to the company. So the legislation does not just apply to goodwill (although it will be the most common case), but also to these other assets which are considered, by HMRC at least, to be closely related to goodwill. For example, an unregistered trademark is considered part of the goodwill of a business, as highlighted in Iliffe News & Media Ltd (TC02365).

In the simplest case, s 849D then applies to deny any deductions for amortisation or impairment of the goodwill. Section 849D also treats any debit arising on realisation of goodwill as being a non-trading debit. So if the goodwill is realised at a loss, the debit appears to be allowed for corporation tax purposes; but as a non-trading debit, the availability to set it against other profits of the company, particularly in prior accounting periods, is restricted. It is also unclear whether the debit would be by reference simply to the accounts debit or to the unamortised tax figure.

Section 849B recognises that goodwill transferred on incorporation could have been acquired in previous arm’s length transactions. In such cases, section 849C ensures that some deductions are allowed in the company for amortisation, etc., by applying a factor – the appropriate multiplier (AM) – to the deduction in the P&L account.

AM is a fraction, where the numerator is the ‘notional accounting value’ of the goodwill, as if GAAP compliant accounts had been drawn up by the transferor immediately prior to transfer of the business to the company, on the assumption that the business was a going concern. The denominator is the total goodwill recognised by the company, whether capitalised or recognised in determining profit and loss.

This is not a favourable calculation, as the notional accounting value will usually be the amortised cost of the goodwill arising on previous third-party business acquisitions; whereas the capitalised expenditure in the company’s accounts might well be substantially greater. So any enhancement to previously acquired goodwill prior to incorporation is not recognised by this calculation. On realisation, any debit is again multiplied by AM to determine the proportion that should be treated as a non-trade debit. The rest, relating to goodwill originally acquired from third parties, is treated normally.

In the Autumn Statement document, the change is described (at para 2.146) as being to ‘restrict unfair tax advantages on incorporation’ and is listed under the main heading of ‘Avoidance and Evasion’! The TIIN refers to the removal of an unintended tax benefit and the notes on the draft clause suggest that this increases the fairness of the tax system, putting such incorporated businesses on a par with unincorporated businesses (which cannot claim amortisation of intangible fixed assets) and with businesses that started in a company (which cannot recognise internally generated goodwill).

This last point is fair comment, but my view is that there is a degree of intellectual dishonesty in the references to unintended advantages and to listing this as an anti-avoidance measure. While the effect of incorporation might have been unintended originally, the legislation is unchanged since 1 April 2002 and I do not believe it has taken HMRC 12 years to spot this apparent ‘unfairness’. A more honest approach would be to say openly that we cannot afford this generous tax treatment on incorporation, and the relief is being withdrawn. To refer to it as being somehow accidental, and to list it as avoidance is, in my view, not just dishonest but completely unacceptable behaviour by a democratically elected government or its civil servants.

The practical effect might well be relatively small. While I am aware of a number of cases where people have incorporated their businesses and were conscious of the potential tax advantage in terms of the tax efficiency of amortisation of goodwill, this has not been a main driver for incorporation. In my experience, most, if not all, incorporations are carried out for commercial reasons, and any tax benefit is additional.

Are the changes too wide?

A criticism of both measures is that they also apply even where the company and the unincorporated business are not under the same economic ownership. If I incorporate my business into a company which I wholly own, the rules will apply so that I cannot claim entrepreneurs’ relief on selling my business to the company, at least so far as the goodwill is concerned; nor will I get corporation tax relief on amortisation of goodwill and similar intangible assets. This is the new ‘fair’ result.

But what if I sell my business to a third-party company in return for shares in the company? The entrepreneurs’ relief point may not matter, if I can claim incorporation relief. But is it fair that the corporation tax deductions for amortisation of goodwill should be denied to the purchaser, which is buying a business at arm’s length?

You might argue that this is not a related party transaction, as I am not transferring the goodwill to a company of which I am a participator, as I do not become a participator until the transfer. However, that is not HMRC’s view, or the First-tier Tribunal’s, as demonstrated by HSP Financial Planning Ltd (TC00982), where the incorporation of a business into a company owned by one of the employees, i.e. not owned by the owners of the business, was held to be a related party transaction for these purposes, because there was a commitment for the company to issue controlling shareholdings to the transferors.

The new rules might inhibit commercial transactions; either I will be forced not to take a shareholding in the company or the company will pay less for my business, because they will not get the benefit of the amortisation. With luck, though, we might be able to persuade HMRC to allow some refinement of the new rules.