Stand-out Q – goodwill…
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A client is incorporating his business. How is CGT relief available on the goodwill?
Where an individual or a partnership decides to transfer their business to a company, incorporation relief may be available. The relief will apply automatically unless an election is made to disapply it.
For the relief to be available, the business must transfer as a going concern. All of the assets (with the exception of cash) must transfer into the company, which will issue either shares or shares and cash in return.
The assets include goodwill. Goodwill can be difficult to define, but generally includes the benefit and advantage from the reputation and connection of a business. HMRC discusses the definition in the capital gains tax manual at CG68010.
Incorporation relief works by rolling the gain on the assets, including goodwill, into the base cost of the new shares. This reduces the base cost of the shares, and any tax liability will only arise on the disposal of the shares. This is easiest to understand by looking at an example.
Elsa runs “Frozen”, a small Christmas themed ice hotel, as a sole trader and decides to incorporate. The assets of the business and the chargeable gains are as follows:-
If Elsa receives £1,000,000 of shares, her base cost for the shares will be £700,000 (the value of the assets transferred less the £300,000 gain).
Where, instead of receiving only shares, part of the consideration received on incorporation is cash, capital gains tax will be due on the amount of the gain attributable to the cash received. This commonly happens in practice to allow an individual to use their CGT annual allowance for the year.
If a capital gain is triggered as cash is received, Entrepreneur’s Relief can become important. This is due to the fact that the individual will pay tax at 10%, rather than the potential higher rate of 20% on assets which are not eligible for Entrepreneur’s Relief.
Where Entrepreneur’s Relief is only available on some assets, any available CGT annual allowance can be offset against all assets being disposed of in the most beneficial way.
Instead of receiving £1,000,000 of shares, Elsa receives £850,000 of shares and £150,000 of cash.
£255,000 of the gain which rolls over into the shares is subject to incorporation relief, but £45,000 (the proportion of the gain which relates to the cash consideration as calculated below) will be subject to capital gains tax.
Where all assets which have a chargeable gain qualify for Entrepreneur’s Relief, the gain will be at 10% after the annual allowance has been fully used. However, the goodwill would no longer qualify for Entrepreneur’s Relief for disposals from 3 December 2014 onwards. This means that any goodwill disposed of on or after 4 December 2014 will suffer CGT at 10% or 20%, depending on the individual’s income tax position.
The gains will be apportioned between all assets so that the correct rate of tax can be applied to each gain.
Elsa disposes of her business on 4 December 2018. The gain on the goodwill is not eligible to attract Entrepreneur’s Relief. This means that the gain on the goodwill will be taxed at Elsa’s marginal rate, and the gains on the freehold, which qualifies for Entrepreneur’s Relief, will be taxed at 10%.
The £45,000 chargeable gain is apportioned between the goodwill and the gain on the freehold as follows:-
If we assume that Elsa is a higher rate taxpayer, her CGT liability will be as follows:-
Gain on goodwill – £30,000
Less annual exemption – (£11,700)
Chargeable – £18,300
Taxed at 20% – £3,660
Gain on freehold – £15,000
Chargeable at 10% – £1,500
Where incorporation relief is not available if, for example, some assets do not transfer to the company, business asset hold-over relief may be available against individual assets, but any gain on the goodwill will not qualify for Entrepreneur’s Relief.
It is important to note that the restriction on Entrepreneur’s Relief will only apply where the transfer is made to a connected close company as part of incorporation. Where the disposal is made to an unconnected third party, Entrepreneur’s Relief will still be available on any gain to the goodwill.
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