Daniel - incorporating a consultancy: who actually benefits from the relief?
Daniel, aged 54, has run a software consultancy as a sole trader since 2010. He has no significant assets apart from self-generated goodwill, which a valuer puts at £300,000, and equipment with a tax written-down value of £18,000 and a market value of £30,000. His trading profits are about £210,000 a year, so his basic rate band is fully used every year. His son Aaron, aged 28, is joining the business and Daniel wants him to have a 25% stake. Daniel's accountant has recommended incorporating, transferring the goodwill and equipment to a new company in exchange for shares, and selling the whole company in about five years for an estimated £2,500,000. Daniel has made no other disposals this year and has never claimed business asset disposal relief.
1. Explain how incorporation relief would apply to the transfer of the goodwill and equipment, quantify the gain deferred and the base cost of Daniel's shares, and state what difference it would make if the company paid him £100,000 cash for the goodwill.
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The equipment
Plant is transferred at market value for capital allowances purposes: disposal value £30,000 against a tax written-down value of £18,000 gives a balancing charge of £12,000, taxed as trading income, not as a capital gain. It is not eligible for incorporation relief.
The goodwill
Goodwill with nil cost transferred for £300,000 produces a capital gain of £300,000. Incorporation relief under TCGA 1992 s.162 applies automatically where the whole business is transferred as a going concern, together with all its assets (or all except cash), wholly or partly in exchange for shares.
Consideration for the shares = £300,000 + £30,000 = £330,000. Taking all shares, the whole £300,000 gain is deferred. Base cost of the shares = £330,000 − £300,000 = £30,000. The deferred gain comes back into charge when he sells the shares.
If £100,000 is paid in cash
Relief is restricted: deferred gain = £300,000 × £230,000/£330,000 = £209,091. The balance of £90,909 is chargeable now; after the £3,000 annual exempt amount, £87,909 × 24% = £21,098 due.
Worse, since December 2014 roll-over relief is denied where goodwill is transferred to a close company, so he cannot roll the cash element over either. Taking cash for goodwill is the worst of both worlds - the shares-only route should be used.
2. Advise on the valuation of the goodwill and explain the consequences of the goodwill figure for Daniel and for the company.
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Valuation
The transfer is between connected persons, so market value is deemed to apply and HMRC can substitute its own figure. A professional valuation of the self-generated goodwill, supported by maintainable earnings, should be obtained and disclosed.
Does the figure matter to Daniel's total tax?
Largely not, if he takes only shares. A higher goodwill value increases both the gain transferred and the amount deferred, but it also reduces the base cost of the shares by the same amount. With goodwill at £300,000, base cost is £30,000 and the deferred gain £300,000; with goodwill at £150,000, base cost is still £30,000 and the deferred gain £150,000. On a £2,500,000 sale the total chargeable gain is £2,470,000 either way. The figure matters much more where cash is taken, where the shares are later sold at a loss, or where the company's acquisition cost is relevant.
The company's position
The company acquires the goodwill at £300,000 but s.816A CTA 2009 denies any corporation tax deduction for amortisation of intangible assets acquired from a related party - a participator or a person connected with one. So £300,000 of expenditure earns no relief at 25%; a very high valuation simply locks more dead cost into the company. There is no benefit to inflating it, and a challenge would also undermine credibility on the eventual sale.
Practical point: agree the valuation before completion in a form HMRC will accept, and record it in the incorporation documentation.
3. Advise how Aaron should acquire his 25% stake and compare the capital gains tax outcome of incorporating with remaining a sole trader on the expected £2,500,000 sale.
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Aaron's stake
Aaron should subscribe for newly issued shares rather than buy them from Daniel. The company receives cash as working capital, Daniel makes no disposal and triggers no gain, and Daniel retains 75% and control. If Daniel sold 25% of his shares, he would have a part disposal taxed on the market value, using up part of his £1,000,000 business asset disposal relief limit. Aaron should also be given a service contract and a real commercial role so that, in due course, his own shares qualify for relief.
Incorporation versus staying a sole trader
Incorporate: base cost £30,000; sale for £2,500,000 gives a gain of £2,470,000. Relief on the first £1,000,000 at 10% = £100,000; the remaining £1,470,000 at 24% = £352,800. Total £452,800.
Remain a sole trader: sell the business and goodwill for £2,500,000 with nil base cost. £1,000,000 at 10% = £100,000; £1,500,000 at 24% = £360,000. Total £460,000.
The difference is trivial - around £7,000. Deferral under s.162 is not a saving; it simply moves the same gain into the future, and the relief limit is consumed once.
Conclusion: incorporate for limited liability, for bringing Aaron in, and for salary/pension/dividend planning - not for capital gains tax. Daniel should also note that the lifetime relief limit is shared with any future claim, and that the current BADR rules and rates are subject to political risk over five years.