Tax Doctor:
Mark McLaughlin
CTA (Fellow) ATT TEP

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December 2005

Q:

I operated my electrical retail business as a sole trader for many years until 31 December 2003. The business was then incorporated by transferring it to a new limited company set up by my accountant at that time. He advised me to sell the business goodwill to the company for a substantial sum. He said that I would pay tax at 10% on the sale, but that I would be able to draw the sale proceeds out of the company over a number of years without paying any tax. He also said that the company could claim a deduction for the cost of the goodwill. The tax authorities are now saying that the company paid too much for the goodwill, and that I may have to pay extra tax. Did my ex-accountant give me wrong advice?

A:

He or she may potentially have given you incorrect advice in at least one respect, but it really depends on the precise circumstances. If you started your business from scratch (i.e. you did not buy it from someone else), there will not be a deduction for the company on the purchase of the goodwill from your sole trader business. On the other hand, if you originally bought the business from an unconnected third party and the cost included goodwill, then a deduction should be due. However, the deduction will be limited to the cost of that purchased goodwill. I envisage that this amount will be lower than the value attributed to the goodwill when the business was later sold to your limited company. In any event, a deduction for goodwill is generally allowed gradually over more than one accounting period, by spreading tax relief over its estimated useful life, or by electing for relief over a fixed period of time.

Goodwill valuation

The next issue to consider is the valuation of the goodwill when it was sold to the company upon incorporation. How was the selling price arrived at? Did your accountant prepare a formal valuation of the goodwill? For tax purposes, the disposal is deemed to take place at market value, due to your connection with the company. Problems can arise particularly if the goodwill has not been valued, resulting in an overvaluation. In its publication Tax Bulletin (Issue 76, April 2005), HM Revenue & Customs (HMRC) produced an article explaining the tax consequences where it is established that the payment for goodwill exceeds its market value. HMRC are likely to challenge sales of goodwill upon incorporation if it appears to have been overvalued. This is mainly because of the potentially low tax charge for the business owner, as capital gains tax (CGT) taper relief and the annual CGT exemption will often be available. The selling price can then be left outstanding as a loan from the company to the business owner, and withdrawn as funds allow without any further tax consequences.

Tax consequences

HMRC can treat goodwill overvaluations in alternative ways for tax purposes, depending on the circumstances. For example, the excess payment can be treated as employment income, if the goodwill was excessively valued as an inducement to work for the company, or if in return for future services to the company. However, in your case HMRC will probably treat the excess payment as being received in the capacity as a shareholder rather than an employee. In other words, the excess will be treated as though you had received a dividend from the company for that amount. This is not a problem if you are a not a higher rate taxpayer and the ‘dividend’ does not make you become one (although this seems unlikely). On the other hand, to the extent that you are a higher rate taxpayer, you will effectively be liable to income tax at 25% of the excess payment.

However, there is a possibility that this tax charge can be avoided. HMRC will allow the excess payment for goodwill to be repaid to the company without being treated as a dividend if:

• The goodwill was not overvalued for tax avoidance reasons;
• There was no intention to overvalue the goodwill; and
• A reasonable effort was made to arrive at market value by using a professional valuation.

It would be worth asking your accountant whether the goodwill was properly valued, whether market value has been negotiated and agreed with HMRC, and whether the excess payment can be unwound in the above way. Hopefully, most of the sale proceeds from the goodwill sale will still be owed to you by the company, so that it is simply a case of adjusting the outstanding balance. However, if you have already withdrawn all the funds there will be potential tax implications for the company, in which case ask your accountant for advice.

Failing this, there is another possible escape route. Goodwill is an ‘intangible asset’. There are special rules for transfers of intangible assets between related parties, which treat such transfers as taking place at market value rather than the agreed selling price. This market value rule applies for all tax purposes, subject to certain exceptions. Before Finance Act (No. 2) 2005, this rule arguably prevented goodwill in excess of market value being taxed as a distribution. Further exceptions to the market value rule were added in the above Finance Act, including one which allows HMRC to tax overvaluations as a dividend. However, this change is only effective from 16 March 2005, so your accountant may wish to argue that the excess goodwill payment cannot be taxed.

Clearly, this is a fairly complex and potentially difficult area of tax, and expert professional advice should therefore be sought based on individual circumstances.

Mark McLaughlin

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