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Busy Practitioner by Mark McLaughlin CTA (Fellow) ATT TEP

Mark McLaughlin CTA (Fellow) ATT TEP highlights a Special Commissioner’s decision on the existence of goodwill in a franchise business.

Background

The existence, transferability and valuation of goodwill are important issues when a business is sold or transferred. In Balloon Promotions Limited and Others v Wilson and Another (Insp of Taxes) SpC 524 (two appeals heard together), the taxpayers sold their franchised restaurant businesses to PizzaExpress. The sales agreements ended the franchise and wholesale arrangements between the parties, and the leasehold interests in the restaurant premises were transferred. The agreed price for the businesses included goodwill. The sum of £1 was allocated to the termination of the franchise. The taxpayer in the first appeal claimed rollover relief under TCGA 1992, s 152 in respect of the goodwill. HM Revenue & Customs refused the claim, on the ground that there was no saleable goodwill, and therefore no business asset against which rollover relief could be claimed. The Revenue considered that the goodwill proceeds should be re-allocated to the early termination of the franchise agreement. In the second appeal, the Revenue again attempted to re-allocate goodwill proceeds to the early termination of the PizzaExpress franchise agreement on a ‘just and reasonable’ basis, under TCGA 1992, s 52(4).

The taxpayers’ appeals were upheld. The Special Commissioner found on the facts of the case that PizzaExpress had no direct interest in the profitability of the restaurants, but received a franchise fee represented by a fixed percentage of turnover. The franchise agreement did not give PizzaExpress ownership of the goodwill attached to those businesses. The fact that the parties had entered into restrictive covenants indicated that the taxpayers possessed goodwill in their businesses, which PizzaExpress were seeking to protect.

The Special Commissioner considered that goodwill was a type of property, and that its existence was a question of fact. Therefore the description of goodwill in the sales agreements was not determinative in law as to whether goodwill had actually been sold. The consideration paid by PizzaExpress for the businesses included an amount in excess of the true and fair value of the tangible assets. Based on the legal concept of goodwill, this excess amount could properly be described as goodwill for tax purposes. The value of the franchise agreements themselves was considered to be nominal. Hence the Commissioner decided in favour of the taxpayers that the consideration represented goodwill for rollover relief purposes, and that no apportionment of proceeds was necessary under TCGA 1992, s 52(4).

HMRC’s view

The Special Commissioner’s decision in Balloon Promotions appears contrary to HMRC’s view on goodwill in franchises, as stated in the Capital Gains Manual. The guidance states that a franchise is an asset for capital gains tax purposes, but that ‘It is not regarded as goodwill and therefore is not within any of the classes of asset in TCGA 1992, s 155’ (i.e. for rollover relief purposes) (see CG68103). The manual also indicates that the free goodwill of a franchised business belongs to the franchisor, and that the franchisee never acquires an interest in that goodwill. HMRC also state that the only goodwill capable of being generated by success of the franchisee’s business is personal goodwill, which is not capable of sale (see CG68107).

The Special Commissioner commented that case law authorities cautioned against an over-analytical approach to goodwill, and questioned the approach of HMRC in the Capital Gains Manual of separating goodwill into three main categories, i.e. personal, inherent and free (see CG68012). This resulted in the restriction in roll-over relief to specific categories. This categorisation was partly derived from the ‘zoological’ definition of goodwill, i.e. identifying four types of customer in terms of cats, dogs, rabbits and rats (see CG68011), which the Commissioner pointed out was considered to be of limited value in Whiteman Smith Motor Co Ltd v Chaplin [1934] 2 KB 35.

The Commissioner stated that the correct approach was to consider goodwill as a whole. Goodwill could be sold separately from the premises in which the business was carried on. The exact composition of goodwill varied between trades, and in different businesses in the same trade. The existence of a restrictive covenant was also indicative that goodwill was sold by the vendor.

Application

The decision in Balloon Promotions is potentially good news for franchisees. However, the terms of the franchise arrangements and ultimately any sales agreement for the businesses are likely to be important factors when considering goodwill. The Special Commissioner in the above cases held that the franchise agreements did not give PizzaExpress ownership of the goodwill attached to the restaurant businesses. Nor did the business goodwill attach to the PizzaExpress brand. The Commissioner also considered that the contribution made by the business owners towards the ‘added value’ of their businesses was an important factor, which was acknowledged to be an essential characteristic of goodwill. The goodwill created by this added value was separate and distinct from the goodwill owned by PizzaExpress, and formed the basis for the ‘excess consideration’ that represented goodwill in the sales agreements.

The Balloon Promotions case also highlights the general importance of properly valuing assets in a transaction such as a business sale, to avoid a possible ‘just and reasonable’ reapportionment by HMRC under TCGA 1992, s 52(4), and for rollover relief purposes under s 152(11).

Finally, the fact that the Special Commissioner questioned the approach of HMRC in the Capital Gains Manual concerning goodwill also underlines the general point that the HMRC manuals do not carry the force of law, and that the views expressed in them are open to challenge in appropriate circumstances.

Mark McLaughlin CTA (Fellow) ATT TEP
April 2006

The above article was first published in Busy Practitioner, a monthly Newsletter by Tottel Publishing. For further information and to order, click here