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Capital Tax Review by Matthew Hutton, MA, CTA (Fellow), AIIT, TEP

Matthew Hutton MA, CTA (fellow), AIIT, TEP author of Capital Tax Review, comments on the approach adopted by HM Revenue & Customs where goodwill is considered to be overvalued upon the incorporation of a business.

Context

With the transfer by a sole trader of his business to a newly incorporated company in which he has a controlling interest, it often happens that the company buys the goodwill of the business. HMRC have found themselves challenging the value attributed to transferred goodwill and the tax consequences in circumstances where it is established that the payment exceeds the market value of the goodwill. While similar considerations apply to the transfer of goodwill from a partnership to a company, an article in the April 2005 Tax Bulletin focuses on transfers by sole traders.

When might the value of goodwill be challenged?

HMRC are concerned about cases where a transfer of goodwill may have taken place at overvalue. In such case the excess value will be wholly or partly sheltered from tax (because of various CGT reliefs), whilst simultaneously inflating a loan account balance against which a proprietor could withdraw sums without any tax liability. There may also be concerns where the goodwill acquired by the company falls within the intangibles regime (FA 2002 Sch 29). Also, cases may arise where the type of goodwill reportedly sold to the company was associated with the personal skills and attributes of the sole trader such as to make it incapable of being transferred to a company.
Under HMRC’s free Post-Transaction Value Check service, CGT valuations can be referred to Tax Offices for checking after the transaction but before submission of the relevant return. Each request for a valuation check should be made on Form CG34, available from HMRC’s website.

Capital gains

The transfer of goodwill to a company in which the transferor and/or persons connected with him have a controlling interest is treated as having taken place other than at arm’s length. Therefore the disposal by the individual and the acquisition by the company are deemed to have taken place at market value (TCGA 1992 s17, s18 and s286).

Excess value may be employment income

Where there has been a deliberate overvaluation of goodwill when sold to the company as an inducement for the individual to take up employment with the company, or in return for future services to be provided by the individual to the company, the excess payment will be taxable as earnings within ITEPA 2003 s62. Where, exceptionally, excess value is paid in respect of the transferor’s employment, but it cannot be described as ‘earnings’, the overvalue may be chargeable as a benefit under ITEPA 2003 s203. S201(3) deems any benefit provided by the employer to be ‘by reason of the employment’.

In such cases the reporting obligation on the employer will depend on whether the excess value is regarded as earnings or a benefit. Earnings should be subjected to PAYE. A benefit should be reported on Form P11D.

There is guidance in the Employment Income Manual (EIM) 21102 and 21120 on the general rule for calculating the value of a benefit for income tax purposes and the concept of ‘making good’.

The excess value is also liable for Class 1 NICs because it derives from the employment and is therefore a payment of ‘earnings’ as defined in SSCBA 1992 s3(1)(a). This treatment applies irrespective of how the payment has been characterised for income tax purposes (and there is no provision for ‘making good’ for NICs).

The charges would be considered to have arisen on the day the goodwill transaction took place.

Where the excess value is treated as employment income, it may give rise to a Case I deduction for the cost borne by the company.

Excess value may be a distribution for tax purposes

In many cases the goodwill will have been transferred from a sole trader to the company before the company has commenced trading. There may be no evidence that any excess value constitutes earnings (or is a benefit). So, in the majority of cases in which goodwill is transferred from sole trader to company, HMRC expect that the transferor will have received any overvalue in his capacity as shareholder, rather than as an employee/director (Company Taxation Manual CT 1529). In such cases the excess value will, for tax purposes, be treated as a distribution by virtue of TA 1988 s209(2)(b) or s209(4).

For NICs, where the transferor receives any overvalue in his capacity as shareholder rather than as an employee/director, that is derived from a shareholding and not employment. The overvalue cannot therefore be classed as earnings under SSCBA 1992 s3(1)(a) and does not attract NICs.

Where the excess value is a distribution, any income tax liability will arise only in the case where he is a higher rate taxpayer and the tax credit does not cover all the Sch F liability [which surely no longer exists]. As for the company, the transfer of goodwill before 1.4.04 will not affect the company’s tax position in terms of characterisation of excess value as a distribution. For transfers on or after that date the distribution will have to be taken into account in computing corporation tax liability at the non-corporate distribution rate.

‘Inadvertent’ distributions may be unwound

Because of the uncertainties in establishing the value of goodwill there will clearly be occasions where a transfer is inadvertently caught by TA 1988 s209(4). If it is clear that there was no intention to transfer the goodwill at excess value, and reasonable efforts were made to carry out the transaction at market value by using a professional valuation, then the distribution may be ‘unwound’. But this will not apply if there is attempted (or actual) avoidance or if the overvaluation was intentional or if no professional valuation was obtained (Company Taxation Manual CT1529a).

Where it is agreed that an inadvertent distribution may be unwound, the individual must repay the excess value to the company. Where the original sale proceeds were credited to a loan account, that credit should be reduced, with effect from the date of the original transaction. If the individual has drawn from the loan account on the strength of the original credit, rewriting the loan account to reflect the unwinding of the distribution may result in the loan account becoming overdrawn. If so, the company may be liable to tax under TA 1988 s419.

From 1.4.02 the new intangibles regime allows companies to claim an income deduction for tax purposes based on the goodwill amortisation shown in their accounts. Where the goodwill was acquired from a related party (such as a sole trader who controls the company) the intangibles regime will apply only if the goodwill was created wholly after 31.3.02 (Corporate Intangibles Research and Development Manual CIRD 11680).

Where goodwill has been acquired from a sole trader and income deductions are made under the intangibles regime, HMRC will be concerned to confirm both that the goodwill was created wholly after 31.3.02 and that for tax purposes the value of goodwill equates to its market value (FA 2002 Sch 29 para 92 and CIRD 45010).

(HMRC Tax Bulletin Issue 76 April 2005)

Comment

The temptation to ‘overvalue’ goodwill on incorporation is obvious. Valuation of goodwill is of course an art rather than a science. But that temptation must be resisted, with clear contemporaneous evidence of market value from, perhaps ideally, a third party adviser. Not many will have found themselves making ‘inadvertent’ distributions as described by HMRC – though, if so, the offer may be worth accepting.

The implications of HMRC’s analysis for compliance purposes are obvious.

August 2005

Matthew Hutton MA, CTA (fellow), AIIT, TEP

More Information

The above article has been taken from Matthew Hutton’s Capital Tax Review, a quarterly update for professional advisers of private clients. For more information, visit http://www.taxationweb.co.uk/books/capital_tax_review.php.

About the Author

Matthew Hutton is a non-practising solicitor (admitted 1979), who has specialised in tax for over 25 years. Having run his own consultancy (latterly through Matthew Hutton Ltd) until 30th September 2000, he now devotes his professional time to writing and lecturing.

Matthew Hutton’s Autumn Series of Estate Planning Conferences resume on 15 September 2005 in Stratford-upon-Avon. The dates and venues are listed below.

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