Nichola Ross Martin's Tax Consultancy

At a glance

Goodwill is an intangible asset; when an existing business is incorporated its goodwill can be sold to a new company together with the tangible assets of the business for cash.

• Goodwill can be difficult to value as valuation is not an exact process, see Valuation (of goodwill) on incorporation.
• A sole trader who is incorporating may think about placing a high value on his business order to maximise his sale proceeds and utilise Capital Gains Tax Exemptions and reliefs, such as Entrepreneurs’ Relief.
• The proceeds of the disposal of goodwill may be left as a loan payable to the individual in his new office of director/shareholder following incorporation (see there are worked examples in Incorporating an existing business).

Corporation tax relief

• Under the Corporate Intangibles regime, the new company is unable to obtain tax relief on goodwill where it has been was acquired from a connected person (the sole trader who is incorporating) if he set up the business before March 2002.
• Goodwill will need to be amortised in the accounts of the new company, this may have a major effect on the new company’s distributable profits for some years after the purchase (the rate of write off is normally decided when setting the accounting policy e.g. over three to twenty years). This may make it undesirable to place too higher value on goodwill. The position would be worse if the company does not obtain tax relief on this write off.

• HMRC have been noted to challenge cases where the new company writes off goodwill over a short time frame (2 or 3 years).
• The write off must be determined according to GAAP (see Corporate Intangibles regime), and if the write off is over a short period, say less than 5 years, this may indicate that goodwill was over-valued in the first instance.
• HMRC may challenge cases where it considers that goodwill is overvalued.
• We note that HMRC selects cases carefully and will only challenge a valuation that seems abnormally high.

Tax Tips

• Value goodwill on an arm's length basis.
• Where the business is run from a commercial property or attractive location you may require a commercial valuation by a surveyor or land agent.
• Select a reasonable period for amortisation in the new company: its can be reviewed year on year.

Overview

Goodwill is created in many ways and is established as a business develops:

• Relationships that are built up with customers and suppliers. These may be in tangible form that can be evidenced by the existence of contacts, mailing lists, interaction in social media websites and business to business websites and forums.
• Brand awareness that has been created via relationships with customers and suppliers but that is also established by advertising, promotion and sponsorship.
• The products or services of the business will serve to strengthen the brand and inspire goodwill amongst customers.
• The individual(s) running the business will, in the different way that they operate, contribute to goodwill of the whole.

Goodwill also arises as a result of the location and premises in which a business is based, this is considered in Goodwill: trade related properties .

In 2009 following a court case (see Goodwill: trade related properties) HMRC was forced to rewrite much of its guidance on goodwill. The current position is that each business has to be considered according to its individual circumstances.

A business does not always need to be profitable for goodwill to exist, this can makes valuation of some new or innovative businesses extremely difficult.

Overvaluation of goodwill

Whilst is not very easy to challenge the existence of goodwill when a profitable business has been established. HMRC may makes a challenge on the basis that goodwill is overvalued when sold to a company.

If HMRC is successful, the excess (however this will be determined, as valuation is not an exact science) would be taxed as either:

• A income distribution – it is taxed as if it is a dividend (s1000 CTA 2010).
• A loan – providing that the amount is repayable to the company. There will be a tax benefit charge if the amount exceeds £5,000, and a tax charge under s455 CTA 2010 if the loan is outstanding more than nine months following the end of the accounting period.
• Employment income – as earnings (s62 ITEPA 2003) or as a benefit (s203 ITEPA 2003) and subject to NICs. The company will obtain corresponding tax relief for the amount treated as employment income.

In the majority of cases involving close companies any overvalued excess of goodwill will be taxable as a distribution because the seller has become a shareholder.

Anti-avoidance measures

HMRC may sometimes take the view that goodwill is personal to the business owner and cannot be sold. This defines goodwill in its narrowest of forms, as it presupposes no goodwill has been created from customers, contacts etc and it is difficult to see how a genuine business could exist without those. However, it is also possible for goodwill to be challenged in the context of special anti-avoidance measures that apply when occupational income is sold for a capital sum.

Although these anti-avoidance measures are rarely used by HMRC in the context of incorporation: they might apply where an individual has a right to some future income stream and then seeks to sell this to a company in order to convert it into capital. The measures would impose an income tax charge. The measures effectively mean that goodwill, in relation to occupational income is entirely personal.

Planning points

Use of a professional valuer

• HMRC are less inclinded to challenge the valuation of goodwill where it has been valued professionally.
• HMRC may expect a surveyor to be used when there is land and property to be valued.
• The expertise of any valuer engaged depends on the nature of the business and the type of assets to be valued.
• In many instances an accountant will have the necessary expertise.
• For valuation methods, see Valuation (of goodwill) on incorporation.

The Arm's length test?

Any valuation should meet the arms’ length test. Broadly, would the company have acquired goodwill at this cost from an unrelated third party?

An arm's length test may also be misleading, because one of the advantages of incorporation, from the new company's perspective, is that it purchases a business that its directors know all about. A company might therefore be prepared to pay slightly more than it would if it were to acquire the same business from an unconnected party.

Reducing the risk of a challenge by HMRC

Over the years there have been few reports of HMRC challenging valuations of goodwill as the majority of advisers treat valuation with the seriousness it deserves.

• Valuation is never an exact science; it relies on judgement, and in all but the very simplest of cases a valuation will require a considerable amount of work.
• It can difficult on a practical level for HMRC to challenge a valuation of goodwill because the costs are prohibitive. It will need to launch an enquiry. It may commence this by using its inspection powers under Sch 36 FA 2008 in order to take a look at the accounts of the new company. It will then need to inspect the records of the sole trade that was incorporated. Such enquiries are costly and so any challenge is likely to be in cases where goodwill obviously has been given an artificially high valuation.
• Taxpayers can obtain assurance by writing into HMRC's post transaction valuation check service by completing form GC34. They will need to provide full details of how the valuation was arrived at. The cost of doing this may be a deterrent for taxpayers.
• Where Entrepreneurs' Relief is claimed the taxpayer will be required to disclose details of his disposal on his tax return. Where incorporation relief applies a gain is deferred and it may, as a consequence, be less likely to be reviewed by HMRC.
• When a sole trader sells his business to his company, various non-standard disclosures may be required to be made in its accounts in accordance with the Companies Act 2006, with reference to related party transactions and transactions with directors. Care should be taken in drafting these, and following the introduction of iXBRL tagging, advisers may need to consider how these notes are tagged.

Small print and links

There is no provision in the taxes acts which gives a set of rules on the valuation of goodwill on incorporation. Valuation is taken for tax purposes on the open market basis as required by TCGA 1992 and established over the years by case law.

The rules governing the disposal on incorporation derive from:

Capital gains reliefs in TCGA 1992, see Capital gains reliefs: disposal of business assets

The Corporate Intangibles regime: CTA 2009, see Goodwill and the intangibles regime