Ken Moody delves into some murky aspects of capital gains tax entrepreneurs’ relief, and highlights some possible pitfalls and planning opportunities.
Entrepreneurs’ relief (ER) is a valuable relief, which can reduce the capital gains tax (CGT) rate on qualifying business disposals to only 10%. However, ER is not a relief to be taken for granted and, for a relatively short piece of legislation, gives rise to more than its fair share of potential pitfalls.
One area which appears to be fraught with misconceptions is the distinction between a ‘material disposal’ of ‘business assets’ and an ’associated disposal’.
The legislation (at TCGA 1992, s 169(I), (2)) recognises three types of ‘material disposal’ i.e. of:
(a) a business or part of a business;
(b) assets used in a business at the time the business ceases to be carried on; or
(c) company shares.
The business/shares must, broadly, be owned for one year ending with the date of disposal.
Business vs assets used in the business
Firstly, what is a business? Clearly, this must include the goodwill of the business; otherwise, what could (a) possibly refer to? If the trading premises were sold at the same time that would also appear to be within (a), but usually the disposal will occasion the cessation of the business; and so (b) could also apply.
If the purchaser of a business does not require, for example, the business premises, the sale of the property following the sale of the business would qualify under (b) above, provided that the sale takes place within three years of the date of cessation (TCGA 1992, s 169I(4)(b)).
On the other hand, if a property which had been used in the business became surplus to requirements and was sold some time before the sale of the business, ER would not be available, as the disposal would be within neither (a) or (b). HMRC have, however, confirmed that if a business is sold but the vendor continues to operate the business between contract (i.e. the date of disposal for CGT purposes) and completion, although technically the disposal precedes the cessation, HMRC would not pursue the point (see ICAEW Taxline 1/12).
Otherwise, the only circumstance where the sale of an asset prior to cessation would qualify for ER would be if the asset were sold with part of the business, which would therefore qualify under (a) above.
Part of a business
As to what counts as part of a business, this has been the subject of several tax cases dating back to the old CGT retirement relief, though with some recent decisions directly concerning ER. It is not possible to consider these decisions in depth, but a few principles may be identified:
- If the sale makes no difference to the way in which the business operates, it will probably be regarded as a sale of assets, rather than part of the business (McGregor v Adcock [1977] STC 206);
- The question is whether the taxpayer has disposed of part of a business, not whether the purchaser has acquired a business (Jarmin v Rawlings [1994] STC 1005);
- The sale of business premises and the sale of the business itself nine months later could not be treated as a single transaction, and the sale of the premises could not be treated as the sale of part of the business in Purves v Harrison [2001] STC 267;
- In the recent case of Gilbert v HMRC [2011] UKFTT 705 (TC), Mr Gilbert had carried on a business of selling food on commission for nine different suppliers. He sold the customer database for one of those suppliers to the supplier itself. He claimed ER on the basis that he had sold part of his business. HMRC rejected the claim, but the First-tier Tribunal allowed relief on the basis that the sale was a going concern capable of separate operation, as distinct from the mere sale of assets.
Where an asset is sold following cessation of a business, it is important to note that all TCGA 1992, s 169I(2)(b) (see above) requires is that the asset was in use for the purposes of the business at the time it ceased to be carried on. Whilst s 169I(4) requires that the business must be owned for one year to cessation, it does not place any minimum period of ownership of the asset in question, nor that the whole of the asset should be so used.
Therefore if the asset were a shop with a flat above which is let, the whole gain on disposal (within three years of cessation) should qualify for ER (relief may be denied under TCGA 1992, s 169L(4) if it could be argued that the property is held as an investment, though this seems unlikely). It is essential to be clear on this, because this is where confusion with “associated disposals” often arises.
Associated disposals
ER is available for a disposal which is associated with a material disposal of either an interest in a partnership or shares in a company. The associated disposal rules (TCGA 1992, s 169K) have no relevance to sole traders and therefore any disposal by a sole trader must be within either s 169I(2)(a) or (b). And while s 169I(2)(b) imposes no minimum period of ownership, for the purposes of s 169K(4) the asset be in use throughout a period of one year ending with the earlier of the disposal of the partnership interest/shares or the cessation of the business.
There are further conditions, i.e. s 169K(3) requires that the disposal must be made as part of the withdrawal from participation in the partnership/company business. However, in practice HMRC do not interpret this strictly, and do not even require any reduction in the hours worked for example (see HMRC’s Capital Gains manual, at CG63995). Although s 169K does not place any timeframe for the disposal of an asset used by a partnership or company to be regarded as associated with a material disposal, HMRC consider that there should be ‘no significant interval between the two disposals’.
In practice, HMRC allow between one and three years from the date of the material disposal for an associated disposal to occur, depending upon whether the business is continuing and what the asset is used for meanwhile (CG63995).
Restrictions
Another source of confusion concerns legislation (TCGA 1992, s 169P), which restricts ER for associated disposals in certain circumstances. It does not have any relevance to a material disposal of business assets within s 169I (2)(a) or (b).
In the example given earlier of a shop, if the business was carried by, say, a limited company, then if the disposal of the property were associated with a material disposal of shares in the company, s 169P would apply to restrict ER to the part of the gain which represents business use.
Relief is also restricted under s 169P on a time basis if the asset is in use for the purposes of ‘the business’ for only part of the period of ownership. Since ‘the business’ referred to must be the business of the partnership or company, it would appear to follow that earlier use by a prior sole trader business would not count as use for the purposes of ‘the business’. This seems inequitable and possibly unintended, but there is no HMRC guidance on the point.
Finally, ER is restricted where, after April 2008, rent is paid by the partnership or company, by reference to whether a full market rent is paid. So for example, if the rent charged were 50% of a full market rent, only 50% of the gain on an associated disposal would qualify for ER. For a company, the answer might be to draw extra dividends instead, but if there is a mortgage on the property, relief for the interest is only allowable against property income.
Practical Tip:
There may be an opportunity to claim ER on an asset which is not used for business purposes if the asset can be brought into business use for a period of time before cessation of the business since, as noted earlier, TCGA 1992, s 169I (2)(b) does not place any restriction on the period of time for which the asset must be so used nor is relief restricted for earlier non-business use.
Obviously, any such proposal would need careful consideration, and may only be viable if the business is a sole trade or (possibly) a partnership.
