There have been endless arguments between taxpayers and HMRC as to what exactly constitutes Goodwill. The one thing both sides agree on is that Goodwill is what is left when you take away all the other assets a business includes.
Suppose I own a business that makes furniture. If I decide to sell the business, I shall expect to be paid for the “tangible” assets – the factory premises, the machinery, the raw materials and the stock of finished furniture. I shall also expect to be paid for “intangible” assets, such as my patent for the ultimately comfortable reclining chair. On top of this, however, there is the fact that my business has a reputation, and some loyal customers, and will provide a comfortable profit for the purchaser. It is an example of the whole being greater than the sum of its parts.
The additional price I expect to be paid for the business, over and above the value of the factory and its contents, is the price to be paid for Goodwill. The purchaser is not just buying a factory and some chairs from me – he is buying an up and running business that will make him a good profit.
From a tax perspective, Goodwill is an “intangible” asset. In the case of a sole trader or a partnership, a sale of Goodwill is a disposal of a capital asset, and CGT will be payable on any gain that is made. The rules for Goodwill were changed as far as companies are concerned, by the 2002 Finance Act, but that is a topic for another article. Here I am concerned with the tax treatment of Goodwill for sole traders and partnerships, and some of the tax planning opportunities associated with it.
If a sole trader or a partnership business is “incorporated” – that is, transferred into a limited company controlled by the sole proprietor or partners – this will be a deemed disposal of the business assets giving rise to a capital gain, based on the market value of the assets when they are transferred. One way to deal with this is to transfer the assets as a gift to the company, and “hold over” the gain that arises, but it is also possible to have the company pay for the assets, by creating a loan account with the former proprietor(s).
Let us assume that the Goodwill of my furniture business is worth £200,000. If I charge my new company £35,200 for the Goodwill, then I can make a claim to “hold over” the rest of the gain, and make a gain of £35,200 on the Goodwill. Assuming I have owned the business for at least two years, I will be entitled to 75% business taper relief on that gain, which reduces it to £8,800. My annual exempt amount for CGT is £8,800, which means that I pay no CGT, but my company now owes me £35,200.
One of the problems with a limited company is extracting the profits from it. Generally the most tax-efficient way is to pay dividends, but a shareholder who pays tax at the 40% rate will still have a liability to income tax of 25% on the dividend. In the case of a dividend of £35,200, the income tax would be £8,800, but because my company owes me £35,200, it can repay that loan to me before I need to take any dividends. I have therefore saved £8,800 in tax on the profits I extract from the company.
It is possible to take this further – if the company pays me the full market value for the Goodwill of £200,000, then I shall make a capital gain of that amount. Again assuming I have had the business for two years or more, business taper relief will reduce that gain to £50,000. After allowing for my annual exempt amount of £8,800, the CGT on the gain is £16,480, which I have to pay, but the company now owes me £200,000. If instead of repaying this loan, the company paid me dividends of £200,000, the tax on those dividends would be £50,000, so I have saved £33,520.
This sounds too good to be true, and there are some pitfalls to watch out for:
Given the tax advantages, it is tempting to push for the highest possible value for Goodwill. The problem is that if the company pays me more than the market value of the Goodwill, HMRC will argue that it has given me a taxable benefit by doing so.
The value of Goodwill is inevitably a matter of opinion, so it is difficult to be certain what is the correct price for it. HMRC recognise this problem, and in their Tax Bulletin of April 2005, they offered to allow overpayments for Goodwill in these circumstances to be “unwound”, by the loan account being reduced, provided the following conditions were satisfied:
There had been no deliberate intention to overvalue the Goodwill, AND
The Goodwill had been “professionally valued” before incorporation
“Professionally valued” means using the services of a suitably qualified specialist – your tax adviser should be able to recommend someone.
“Inherent”, “Personal” and “Free” Goodwill
Goodwill comes in several forms for tax purposes, but a particular problem arises with what HMRC call “inherent” Goodwill.
My furniture business probably has no “inherent” Goodwill – because it does not matter where the factory is – but if you think of a pub, the Goodwill there cannot really be treated as separate from the actual building, or if it can, it is the Goodwill generated by the way the landlord runs the place and his personality, and this is “Personal” Goodwill.
HMRC take the view that:
“Inherent” Goodwill (as in the case of a pub, restaurant, or similar business) cannot be transferred without transferring the premises as well. In many cases the most tax efficient thing to do would be to transfer the trade and Goodwill into the company, but retain personal ownership of the business premises, but this may not be possible where “inherent” Goodwill is involved.
“Personal” Goodwill cannot be bought or sold. Given that the slave trade has been abolished, it is difficult to argue with this proposition.
For tax planning purposes, therefore, we are left with “Free” Goodwill – which is the Goodwill of the business that is neither “inherent” in the business premises, nor “personal” to the individual who runs it.
In the real world, most businesses have a mixture of all three types of Goodwill, which is why professional advice is essential before engaging in any transactions involving the transfer of Goodwill to a company.