CAPITAL GAINS TAX - 27.01.2016

Saving tax on incorporation in a hostile environment

Incorporating

Many businesses start off unincorporated or as partnerships. Later, many owners decide that it is time to run their business through a company instead. There can be a number of reasons for this, and historically tax benefits will have been one such reason to one degree or another. There are a number of mechanisms for incorporation.

Sale for cash

Until December 2014 the most popular method was to transfer the trade to a company by way of sale. This might seem counterintuitive, as this would generate a capital gains tax (CGT) charge on the individual or partners selling their trade to a company. But the sale of a trade would only carry CGT at the 10% entrepreneurs’ relief (ER) rate, in most cases, and the tax benefits that followed were worth paying that tax for.

Furthermore, the goodwill would be amortised in the company’s accounts over, say, five years (a likely outcome under FRS102 ), generating a deduction for corporation tax purposes.

All change

This mechanism was closed down by the Chancellor’s Autumn Statement on 3 December 2014. Firstly, the chargeable gain relating to goodwill arising to the individual trader or partners no longer qualifies for ER for transactions on or after 3 December 2014, so the CGT charge will now be at the full 18/28% rate.

Secondly, the tax deduction for acquired goodwill in these circumstances was also abolished, so there is no longer an enhancement of the corporation tax position by amortising the goodwill. In fact, in the Summer Budget 2015, amortisation and impairment deductions for goodwill on all business combinations was abolished from 8 July 2015.

As a result, this method of incorporation is no longer attractive in most cases. It’s important not to discount it completely, however, as good results may be obtained in the now relatively rare cases where the gains arise on assets other than goodwill. The ER rate of 10% may still be available here.

Incorporation relief - sale for shares

The default mechanism for incorporation of a business will probably now be the so-called incorporation relief at s.162 TCGA 1992 . The essence of this relief is that the business is transferred to a company and the company issues shares to the transferors.

Pro advice. This relief applies to the transfer of any business, it does not have to amount to a trade, so it can be used for incorporations of property investment portfolios, for example, as well as of trades.

Example 1. Andy runs a publishing business, worth £500,000 which is all goodwill. He could transfer the £500,000 goodwill to the company and the company might issue Andy with, say, 1,000 £1 shares. Normally these shares would have a market value, and hence a base cost ( s.17 TCGA 1992 ) of £500,000. However, the incorporation relief operates by rolling the £500,000 gain on the goodwill into the market value of the shares. Essentially, this means that no gain arises to Andy on disposal of the goodwill but the shares inherit the goodwill’s base cost, i.e. zero. So the gain will eventually accrue when Andy sells his shares.

Example 2. Let’s now look at Pete, who wants to incorporate his property investment business. Pete has several properties with a total value of £1,000,000 but base cost of £300,000, so the gain is £700,000. If we use incorporation relief, the shares would prima facie have a value of £1,000,000 on issue but the base cost is reduced for capital gains purposes down to £300,000 by rolling over the £700,000 gain.

The downsides

There are a number of points to note with this relief, however, as it does have some drawbacks:

The relief only applies if a business is transferred as a whole, as a going concern and with all of its assets (except cash). For example, a doctor with both NHS and private work wants to incorporate the private practice. HMRC might argue that there is a single profession and that transferring just the private work is only a transfer of part of the business.

The business may have assets that the transferor does not wish to transfer into the company, which will have to be extracted. For example, you might want to transfer cars from the business before incorporation. This may be difficult where the asset is, say, the business premises - can this be extracted from the business before incorporation? These situations need careful consideration.

Pro advice. The relief only applies to chargeable assets within the capital gains regime. There are other rules for assets on which capital allowances can be claimed, stock in trade or work in progress, etc. Each of these needs to be considered separately in the context of the incorporation.

Gift relief

The final mechanism is the gift relief at s.165 TCGA 1992 . The essence of this relief is that assets are gifted to the company and transferor and the company elects that the transfer is treated as being at no gain, no loss. For example, if Andy transferred his publishing business using this relief, the company and Andy would jointly elect for a no gain, no loss transfer of the goodwill. As a result, the company would inherit the nil base cost of the goodwill and Andy would have no chargeable gain.

The downside of this relief is that it only applies to the transfer of assets used by the transferor in a trade, profession or vocation. So it would apply to Andy transferring the goodwill of his publishing business, along with any other chargeable assets, of course, but it would not apply to Pete for the incorporation of his property investment business, as that is not a trade, profession or vocation.

Selective transfer

Where it’s available, this relief can be very powerful. There is no requirement to transfer the whole of the trade or all of its assets, so this relief allows for some cherry picking on the incorporation. So the doctor in the above example could transfer the goodwill of her non-NHS profession to a company by this mechanism. She doesn’t have to worry whether she is transferring the whole of her business.

The other advantage is that it’s possible to manage the level of chargeable gains, as the relief applies to the extent that you elect for it to apply. So it’s possible to manipulate the price paid by the company so that gains might be crystallised up to a level desirable to the transferor, which might be useful if the transferor has unused capital losses, for example. The losses can be used to shelter part of the gains, leaving the company with some base cost in respect of future disposals.

Conclusions

Following the December 2014 changes it’s likely that incorporation relief will take over as the most popular mechanism for managing the tax charge on incorporation of a business. HMRC Helpsheet 276 provides some guidance on the conditions etc. necessary (see Follow up ).

In some cases, particularly where the person carrying on a trade, profession or vocation does not wish to transfer either the whole of that trade etc. or the whole of its assets to the company, gift relief might be more appropriate. In most cases, however, the larger tax benefits of the ability to sell a trade to a company have been eliminated, and so other motives will begin to take a front seat in making the decision.

Helpsheet 276