Chris Thorpe looks at issues surrounding goodwill on the incorporation of a business.
When a business (usually a sole trade, but could be a partnership or LLP) incorporates, there is a disposal of the business assets to the new limited company. Capital gains tax (CGT) is, therefore, the main relevant tax; although stamp duty land tax (or its Scottish or Welsh equivalent) is far more troublesome if land is being conveyed.
‘Incorporation relief’ or ‘holdover relief’ are potentially available to defer the CGT on chargeable gains, or the owner could just pay the CGT – possibly at 10% if business asset disposal relief (BADR) is available. This latter option is frequently used, although the goodwill within the business requires some pause for thought.
What is goodwill?
Goodwill is not defined in TCGA 1992 but was described by Lord MacNaughten in the case of IRC v Muller & Co [1901] AC 217 as being:
‘….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. The goodwill of a business must emanate from a particular centre or source.’
The difficulty lies in that last sentence – whence does the goodwill emanate? Is it the individual trader (i.e., do his customers come back just because of him personally)? Or is it the business’s location?
In the case of Whiteman Smith Motors co Ltd v Chaplin [1934] 2 KB 35, the different types of goodwill were categorised in animal form: dogs (being loyal to the person) represent ‘personal’ goodwill (i.e., it is the person’s individual reputation that brings back the customers); cats (being loyal to premises) represent ‘integral’ goodwill to the land or buildings or the brand; likewise, rabbits (being attracted by mere propinquity) are attracted to the business because they don’t want to go elsewhere – the local pub being a classic example. Rats have no such attachments or loyalties, they don’t care whence or from whom they obtain their products or services – their goodwill is ‘free’ goodwill, and it is this which is the intangible asset sold to a new company on incorporation.
What does this mean in practice?
In short, the question is whether free goodwill actually exists in the business or not, and whether any incorporation monies or value received are corresponding disposal proceeds. So, if rollover relief has been claimed on proceeds for free goodwill (within TCGA 1992, s 155), but that goodwill is personal or inherent, the relief will not be due.
Conversely, BADR will be denied on free goodwill on incorporation, but not if that extra value is inherent in a qualifying property being disposed of.
The valuation of goodwill, as much as its existence, is often a source of potential problems. For example, suppose a trader values his goodwill at £12,300 (a completely random figure!), sells it to his new company on incorporation (with no CGT relief) and leaves the proceeds outstanding on a directors’ loan account, all of which he later draws down tax-free. HMRC argued that the majority of the goodwill is actually personal, thus was not separable and sold to the company; only £5,000 worth of goodwill is free, so the rest of that £12,300 drawn down is actually a dividend.
Practical tip
Consider what type of goodwill the business possesses – be sure that it isn’t just the owner or the premises which bring the punters back regularly. If you’re sure it’s ‘free‘ goodwill, don’t over-value it on incorporation and risk any proceeds being subsequently taxed as dividends; get a post-transaction valuation check (on form CG34) if in doubt.
