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Tolley's Practical Tax by Roger Jones

Roger Jones considers the significance of goodwill on transfer of a business and mistakes that can be made.The recent Special Commissioners' decision of Colley and Another v Clements [2005] STC (SSCD) 633 makes interesting reading. Seemingly, Mr Colley and Mr Hillberg, having traded in partnership for some time, transferred the partnership business to a limited company. However, there was no documentation to record what had actually been done.

Evidence produced was that the individuals' tax returns for 1999/2000 showed partnership income but no disposals of assets. The company's return for the year ended 31 August 2000 showed an asset of goodwill stated at £250,000. Accounts were filed at Companies House on the same basis.

• On enquiry by the Inland Revenue, it was stated that the partners had sold goodwill to the company for £125,000 each and retirement relief was claimed. Unfortunately, neither of the partners had reached the minimum qualifying age of 50.

• The partners then sought to claim rollover relief under TCGA 1992, s 162. This was refused because the entire business had not been transferred to the company in exchange for shares.

• The partners then claimed holdover relief under TCGA 1992, s 165 maintaining that they had received no consideration for the goodwill and that the original accounts of the company (although filed at Companies House) were incorrect.

It comes as no great surprise that the Special Commissioner dismissed the taxpayers' appeal.

So, what went wrong? I am aware of many incorporations which have proceeded satisfactorily without any document of transfer. However, in some cases, this may prove to be false economy, none more so than when the business carries substantial goodwill.

The nature of goodwill

The real place to start is by establishing the nature of goodwill and its component forms. Many people refer to the goodwill of a business, seemingly with scant knowledge of what it really is. The Oxford English Dictionary summarises it as:

'right granted by seller of business to trade as his successor'.

I have previously put it as the excess value that an independent purchaser might be prepared to pay for a business over and above its worth as a collection of assets.

The concept is important. Goodwill may be a current right but it can only be of value when a business is transferred. It is an intangible appendage to a business and cannot exist in isolation.

The leading judgment on the meaning of 'goodwill' was delivered by Lord MacNaghten in IRC v Muller & Co's Margarine Ltd. [1901] AC 217. He said this:

'What is goodwill? It is a thing very easy to describe, very difficult to define. It is the benefit and advantage of the good name, reputation, and connection of a business. It is the attractive force which brings in custom. It is the one thing which distinguishes an old-established business from a new business at its first start.'

Business transfer

When a business is transferred, the purchaser will be acquiring a number of things. There will usually be tangible assets, such as plant and machinery, fixtures and fittings, stock etc. There might also be premises and possibly the continuing services of employees. If he wishes to continue the business in its present form, the transfer may involve a number of intangibles such as leases, franchises etc and the all important goodwill. In an arms length transaction, it is likely that this will be documented in a contract of sale. Maybe a single price will be agreed for the deal but, increasingly commonly, the consideration will be apportioned between the various components. This enables the parties to the transaction to cater for differing tax treatments. Stock, for example, is a revenue item and plant and machinery or fixtures and fittings may require capital allowance adjustments. Capital assets may be subject to capital gains tax.

So far as goodwill is concerned, the vendor may realise a capital gain on disposal. The purchaser's treatment will depend on the medium of trading. If the acquirer trades in his sole name or through a partnership, his purchase is of an unrelievable capital asset. However, if the acquirer is a limited company, then there is almost certainly the scope to write off the goodwill under Financial Reporting Standard 10 and take a corporation tax deduction in accordance with the corporate intangibles regime of FA 2002, Sch 29 .

Incorporation

The incorporation of an existing business is simply a special case of a business transfer where the vendor and purchaser are connected. The proprietor(s) of the original business will usually be the same as the shareholder/director(s) of the company but, as such, they are acting in totally different capacities. How often have you heard the proprietor of an owner managed company say 'it's my company, I can do what I like with it'? Not so; it may be under his control but it is a totally separate legal entity. Transactions between individuals and the company may have legal and taxation consequences. Instil in your clients the mantra 'the company's money is not my money' and fewer mistakes will occur if they can be persuaded to obey it.

Thus, the transfer of business assets from sole trader or partnership to company ought always to be adequately documented. This is not to say that a formal sales contract is required in all cases. In many small businesses it may be sufficient to prepare a simple sales invoice for stock and, perhaps, other assets. The considerations in this area are beyond the scope of this article.

Real problems come with intangibles, especially goodwill. Since you cannot see it, feel it, pick it up and pass it around, how exactly do you transfer it? In my view, this is an area in which a document of transfer is not merely advisable but essential. This need not be excessively complex. It records the sale and purchase of assets between connected parties. It needs to state:

• details of the parties;

• details of the assets transferring - stock, goodwill, plant and equipment, contracts, licences, cash, debtors etc;

• a statement that the business is being sold as a going concern (for VAT).

The tax implications must be borne in mind especially as regards goodwill. It is not a matter to be undertaken lightly and best advice has to be to get a competent commercial lawyer to draft the document.

Why all the fuss?

Unincorporated businesses have always been capable of transfer to a company but, until recently, the decision to do so was a commercial one. However, for several years, tax issues have taken the lead and the number of businesses taking this step has soared.

Initially, there was a reluctance to transfer goodwill for full value. First, it attracted stamp duty and, second, unless retirement relief was available, there was likely to be a large chargeable gain. More likely, goodwill would be gifted or transferred at undervalue with any resulting gain being held over under TCGA 1992, s 165. Times change though. Stamp duty is now largely redundant but goodwill had, in any case, been removed from liability in 2002. As regards capital gains tax, business asset taper relief can now accrue at a rate of 75% after only two years. This equates to a maximum tax rate of only 10% and some have, perhaps over-enthusiastically, seen this as a planning opportunity. A credit balance can be created on the director's loan account of the new company at minimal tax cost giving the freedom to draw down without further liability when the company trades profitably.

And just as night follows day, HMRC enquiries follow bad planning. So what can have gone wrong?

• the goodwill may not be transferable at all;

• the value attributed to it is excessive;

• the company claims relief where none is due.

Classification

In the Muller judgement, Lord MacNaghten recognised that there may be different components to goodwill and early judicial interpretation looked at the location of the business and the habits of its customers. This led to what is now known as the zoological classification. In Whiteman Smith Motor Co Ltd v Chaplin [1934] 2 KB 35, the Court identified four types of customer:

• the dog, who stays faithful to the person and not the location;

• the cat, who stays faithful to the location and not the person;

• the rabbit, who comes because it is close and for no other reason;

• the rat, who is casual and is attracted to neither person nor location.

If we look at the modern classification, the similes become apparent.

Personal goodwill is related to the skills and personality of the proprietor. This may be the case with a well known photographer or celebrity chef. The customer comes to the business because of the person and can be seen to behave like the dog. Many small businesses display this type of goodwill.

Inherent goodwill attaches to the location of a business. Customers go there because of where it is, behaving like a cat or a rabbit. The location of the premises is convenient. There are many businesses that fall into this category but can include hotels, restaurants and petrol stations.

Free goodwill is the true worth of the business over and above the assets comprised in it. It reflects the behaviour of the rat that will go to any business, anywhere. But, there is an overlap because the dog, cat and rabbit can all contribute to this type of goodwill. It might therefore be divisible into two kinds: adherent free goodwill and separable free goodwill. The adherent variety still attaches to the premises, more in the character, licensing etc which allow the business to continue. Again, this attracts the cat, dog or rabbit. The second variety is separable free goodwill, generated by the rat.

Finally, it must be recognised that some types of business do not have goodwill at all. A common example is farming.

Fungible

Despite the separate descriptive characteristics, a business has only one goodwill. The parts of it are inseparable. Where the different types are present in one business, they become part of an indivisible whole.

Goodwill is a fungible asset. You can add to it and take away from it but all along there is only one goodwill. That is not to say that all goodwill is the same thing. It may grow or diminish as parts are acquired or disposed of but the parts cannot be separately identified.

Transfer

HMRC takes the view that personal goodwill cannot be sold as it is inseparable from the individual.

Just as personal goodwill attaches to the individual, inherent goodwill is regarded as part of the premises and cannot be transferred without them. If the premises are leasehold then some part of the goodwill may attach to the lease.

The adherent free goodwill attaches to the premises. It can be disposed of along with the premises either in one transaction or separately but, if the premises are retained, then this part of the goodwill must be retained too. The last division, the separable free goodwill is the type that we are all looking for. This can be transferred as a separate asset in its own right.

Valuation

Having established the nature of the goodwill attaching to a business and whether it is truly transferable, the value must be considered. Until the last few years, scant attention was paid to this in incorporation transactions. Most of these proceed in a manner such that any capital gains arising can be held over under TCGA 1992, s 165. In effect, if goodwill is gifted, no immediate gain need be realised.

Then, along came taper relief which, following early tinkering, afforded a 75% reduction of the gross gain on business assets after a qualifying holding period which could be as short as two years. Suddenly, everyone wanted to sell the goodwill of their businesses to newly formed companies. And how many of them had been told by that well known tax adviser, 'a mate down the pub', that you can get £30,000 out tax free. The logic behind this story goes:

Value of goodwill in business £30,000

(sold to company for proceeds outstanding on director's loan account)

Business asset taper relief ( 22,500)

Chargeable gain 7,500

CGT annual exemption (to cover) ( 7,500)

Taxable gain nil

And the flaws in the argument? First, we have seen that the goodwill may not be transferable at all. Second, you cannot just put a value on goodwill at £30,000 or any other convenient figure. The number of stories around, suggesting this possibility is frankly alarming. It must be properly valued by reference to the results of the business.

Detailed computational aspects are beyond the scope of this article. Do remember that, even having accurately quantified the value of goodwill, this does not change the nature of it. If all, or a major component to it, is personal to the proprietor then it still cannot be transferred.

HM Revenue & Customs' view

An article in HMRC Tax Bulletin 76, April 2005 focuses on the problems with transfer of goodwill to a newly formed company. Classification is not mentioned so one must look at the commentary with the supposition that the goodwill is of a type that is freely transferable. In considering the valuation placed on goodwill at incorporation, HMRC will want to know the steps which have been taken to establish the reasonableness of the figures. It will look whether reasonable efforts were made to carry out the transaction at market value by using a professional valuation. In this context it would normally regard a professional valuation as including one carried out by a named independent and suitably qualified valuer on an appropriate basis. But in some instances it may be necessary to establish what steps were taken to arrive at the value.

The HMRC commentary goes on to make suggestions as to the effect if the value placed on the goodwill was excessive.

First, the excess value may be employment income. In straightforward cases, this is unlikely. It could be a possibility where an established company acquires a sole trader business and wants the individual proprietor as an employee. The excess value paid might not be in respect of goodwill but rather an inducement to take up employment.

Second, the excess value may be a distribution. This is probably the better view. In the majority of cases in which goodwill is transferred from sole trader to company it might be expected that the transferor will have received any overvalue in his capacity as shareholder, rather than as an employee/director. In such cases the excess value will, for tax purposes, be treated as a distribution by virtue of ICTA 1988, s 209(2)(b) or s 209(4) .

A third possibility is that the excess value might be a loan to the participator, taxable under ICTA 1988, s 419 but the Tax Bulletin article does not dwell on this.

Intriguingly, HMRC suggests the possibility that an inadvertent overpayment might be unwound. Where it is agreed that this is possible, 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, effective 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 ICTA 1988, s 419 .

Some commentators favour the use of a 'market value adjuster' in the document of transfer to prevent inadvertent overpayment. In this case, the proceeds for goodwill might be expressed as £x or such lesser amount as may be agreed with HMRC.

Write off

The possibility of a tax-free draw down on profits is not the only motive for selling goodwill to a company. In some cases the expenditure may be written off under the intangibles regime in FA 2002, Sch 29 . However, where the goodwill was acquired from a related party, a tax deduction may only be claimed if the goodwill was created wholly after 31 March 2002. This relief will be of little use as yet. There can be very few businesses brought into existence from 1 April 2002 that have subsequently incorporated. Bearing in mind that a business has only one goodwill, no relief is due if it was trading before that date even if there has been significant growth in recent years.

Conclusion

At which point we may have gone full circle. It is possible to sell goodwill to a company in a tax efficient manner. However, it has to be the correct type of goodwill and properly valued. A proper legal document of transfer is much to be preferred.

Whereas transfer at undervalue presents no problems as the resulting gain may be held over, an excessive payment may present a problem. Intriguingly, HMRC seem to permit unwinding of the situation where it occurred inadvertently but it would be wise to plan carefully at the outset and not rely on this concession.

February 2006

Roger Jones

Roger Jones is Senior Tax Manager at Larking Gowen in Norwich but the views expressed are personal and do not necessarily represent the opinion of the firm. His book "Incorporating a Business" comprehensively addresses issues of goodwill in this context; the second edition is published by Tottel Publishing

The above article was first published in Tolley's Practical Tax, 17/02/2006, and is reproduced with the kind permission of LexisNexis UK.