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We must have a sixth sense at RJP because just a couple of months ago we blogged about the need for businesses to plan early to be able to incorporate into a company they own, and to obtain tax relief on existing goodwill. Now, with effect from midnight on December 3rd following the Autumn Statement 2014, this opportunity has unfortunately disappeared.
The new legislation which was announced and came into force on December 3rd means that sole traders, partnerships and LLPs wishing to incorporate their business into a limited company which they own, will no longer be able to claim entrepreneurs’ relief on the value of goodwill transferred. Whilst it remains possible, on incorporation, to pay capital gains tax on the value of goodwill transferred, the rate of tax applying will now be 28% rather than 10%, as was the case with the benefit of entrepreneurs’ relief. Whilst it also remains possible for the company’s shareholders to draw down on the value of the goodwill transferred with no additional tax liabilities, the overall tax rate applying will now increase significantly.
As a result, the immediate tax benefits on incorporation have effectively been removed.
A worked example to illustrate how this will affect business owners
Before December 3rd 2014
The Smith Partnership is valued at £100,000 and decides to incorporate into The Smith Company Limited, owned by the same individuals. The Smith Company Ltd buys the goodwill (£100,000) from the old partnership and with the benefit of entrepreneurs’ relief, the partners pay capital gains tax of £10,000. The limited company does not have the immediate funds available to pay the £100,000 due to the shareholders, but as profits accumulate (net of corporation tax of 20%), the shareholders can withdraw the amount owed to them free of any additional tax charge. The company will have to generate gross profits of £125,000 (£125,000 – 20%) to generate net profits of £100,000. The total tax charge is £35,000 (35%) based on gross income of £100,000 for the individuals and they receive net income of £90,000.
After December 3rd 2014
In the same example as above, the capital gains tax payable by the partners is £28,000 whilst the amount owed by the company to the shareholders remains £100,000. The company will still have to generate gross profits of £125,000 to generate net profits of £100,000. The total tax charge is £53,000 (53%) based on gross income of £100,000 for the individuals and the amount they receive is reduced to £72,000.
It is clear that the increase in the tax payable by the individuals effectively means incorporation is no longer a tax effective planning strategy.
Removal of corporation tax relief on connected goodwill
An additional restriction was also introduced on December 3rd – until this date, a company acquiring goodwill from a business owned by the same individuals was able to amortise (or depreciate) the cost of that goodwill over its useful life, and claim corporation tax relief for that amortisation i.e. effectively write off against tax the cost of acquiring connected goodwill. This relief is no longer available and again, the change only applies where incorporation involves the acquisition of a business owned by the same individuals as those owning the company – i.e. on the incorporation of a business by its owners.
Another example of the changing morality of tax
What is noticeable about these legislative changes is that they were introduced by George Osborne during the recent Autumn Statement as examples of policies to curb ‘aggressive tax avoidance’. This is a perfect example of what we have described in a recent blog as the changing morality of tax; whereby what is legal and accepted practice can become relegated to the grey area of ‘tax avoidance’ literally overnight, because the government wants to increase its falling tax receipts. Until last week, claiming entrepreneurs’ relief and corporation tax relief on transferred goodwill was a perfectly legitimate use of tax legislation; now it has become an example of ‘aggressive tax avoidance’.
Many business owners choose to incorporate for a variety of reasons, and because there have been tax benefits to doing so does not make the claiming of those benefits aggressive. This change to the legislation mean the tax benefits of incorporation are severely curtailed and are likely to make business owners – either sole traders, partnerships or LLPs – question whether or not they are better off remaining unincorporated.
If you would like to discuss this change and the tax implications for your business, please contact Lesley Stalker by emailing las@rjp.co.uk.
