What Is Goodwill?
It is easiest to define goodwill by saying what it is not. It is not anything tangible owned by the business, such as plant and machinery, and it is not intellectual property such as patents or know-how. It is not the building in which the business is carried on – though this last is at the heart of the problem discussed in this article.
If you are buying a business that is running successfully, you should expect to pay more for it than you would for its individual parts such as stock, raw materials, and machinery if you bought them separately.
You are not just buying these items; you are buying the profit-making capacity of the business, its reputation, and its loyal customers. It is the extra that you pay for this intangible quality of the business that is the price you pay for goodwill.
If a limited company buys goodwill, for example if it buys the business of a sole trader, it can get a tax deduction for the cost. There are certain rules concerning goodwill bought from “connected” parties, but these are outside the scope of this article.
Broadly speaking, having bought the goodwill, the company will then amortise its cost (reduce it each year by a certain percentage), and the amount amortised each year can be treated as a deduction from the company’s profits for tax purposes.
The Goodwill Problem
The problem is that there are certain kinds of goodwill that HMRC maintain cannot be sold separately from the business premises. This is described as “adherent” goodwill, because the theory is that it “adheres” to the building in which the trade is carried on.
If you have a business making “idjets” (high tech widgets), selling your idjets on the internet to your customers, the fact that you manufacture the idjets in a factory in Slough is essentially irrelevant to the value of the goodwill of your business. I can buy your business, close the factory in Slough, and open another in East Cheam.
Provided I manage the transfer of the plant and equipment to the new factory properly, and keep the flow of idjets running smoothly, the value of the business (that is, the value of the goodwill) will remain the same.
This kind of goodwill is known as “free” goodwill, in the sense that it is not tied to any particular person or place. The customers do not care where the idjets come from, as long as they perform as idjets should.
If, on the other hand, you have a pub, I cannot buy it and transfer its trade to a new location. The goodwill of a pub is of two types. Firstly, there is the personality of the landlord, whose sunny disposition and care for his customers keep them loyal to his house.
This is “personal” goodwill and HMRC take the view that it is incapable of being transferred or sold. If you went to your local pub and found a new, grumpy, landlord, who informed you he had bought the old landlord’s pleasant personality so he was sure you would get along with him, you would laugh – and walk out.
The other aspect of a pub’s goodwill is the building itself. This arises partly because it is specially adapted for being a pub – with a cellar, beer engines, and so on, as well as having planning permission and so on to be run as a pub. It also arises from the character of the building and its location – in a busy street or in a picturesque village, or wherever.
This type of goodwill, say HMRC, is “adherent” to the pub premises, and cannot be transferred separately from them. It is difficult to argue against their view in the case of a pub.
Why Does It Matter?
This distinction between “free” and “adherent” goodwill is significant for tax purposes. If the goodwill is “adherent” to the premises, it is part of the cost of those premises, and the purchaser will have to pay Stamp Duty Land Tax on the purchase price.
If you do not sell the freehold but instead grant a lease as a way of transferring the goodwill, then if the lease is for under 50 years, at least part of the premium (the shorter the lease, the larger the proportion) will be treated as a payment of rent in advance and taxed on the seller as income. A capital gain on “free” goodwill attracts CGT at 18%, or even 10% if (as is probable) the seller qualifies for Entrepreneur’s Relief; the “rent” element of a premium for a lease will be charged to income tax, at up to 40%.
A New View of Goodwill?
HMRC do not only apply this line to pubs. They also take the same view on a number of trades, including petrol stations, cinemas, hotels, restaurants, and nursing or care homes. In all these cases they would argue that there was no goodwill that could be separated from the building, and so the adverse tax consequences described above applied to the purchase price – anything attributed to goodwill was in fact a payment for the premises themselves.
There used to be a list of these types of business on their website, but this mysteriously disappeared a few months ago, and since then we have been waiting to see if they were having a change of heart. HMRC had taken a bit of a pasting in the Courts for their restrictive view of adherent goodwill, and we hoped for good news.
On 29 January, a “Practice Note” appeared on their website, setting out the new view of goodwill.
Like most HMRC pronouncements, it was extremely complicated, but the good news was that it recognised that on a sale of a business with “adherent” goodwill, there would also be a sale of some “free” goodwill. The question was how much.
The method proposed for valuing “free” goodwill in these cases is almost incomprehensible, and will require the services of a Chartered Surveyor if you are to have a chance of arguing the point with HMRC, but shorn of its obscurity, it essentially says that you find the difference in price between the premises empty of customers and equipment, and the same premises up and running profitably.
You then do some complicated algebra to take account of the cost of fitting the place out and subtract that from the difference, and the result is the value of the free goodwill.
Interestingly, the two examples chosen to represent the two extremes of free goodwill are “a small local pub” (only “nominal” value for the free goodwill) and a fully operational “nursing home” (with “substantial” free goodwill).
If you are currently disputing a “free goodwill” issue with HMRC – and such disputes are quite common – then make sure your advisers are aware of this change of practice by HMRC – you can find it at http://www.hmrc.gov.uk/svd/goodwill.htm
James Bailey
