Lee Sharpe looks at the incorporation of a business, and some issues affecting incorporation relief for capital gains tax purposes.
This article is prompted by reader feedback. Based on that feedback, there appears to be some misunderstanding about how capital gains tax (CGT) incorporation relief (under TCGA 1992 s 162) works and when it is available. A specific issue appears to be in relation to directors’ loan accounts (DLAs), as set out below.
Here, we are assuming that the business owner incorporates his or her business and then becomes the sole director and shareholder in the new company.
Incorporation routes
There are two distinct routes to incorporation:
Route 1: ‘Sell’ the assets to the company – the new company buys the assets from the business owner. The consideration could be in the form of cash, or it could be in recognising that the company now owes the former business owner a substantial sum of money, through the DLA.
Example 1: Sale of business upon incorporation – DLA credit
John incorporates his bakery business to his newly-created company. He likes the idea of the company owing him a large sum, that he can draw down tax-free over the next few years. He bought the business for £500,000, and it is now worth £1 million:
From an accounting perspective for the company:
Dr Fixed Assets £1 million
Cr Director’s Loan Account (or Bank) £1 million
While John may be able to draw down on his DLA tax-free, this is because the DLA is effectively the same as having received £1 million in cash; he will have suffered a significant capital gain on disposing of the business, of around £500,000. Practically speaking, a lot of that DLA is going to go towards paying off John’s CGT bill on his next tax return.
Route 2: ‘Gift’ the assets to the company – no money or other consideration is given by the company in exchange for the valuable assets. For eligible businesses (i.e. generally those that qualify as ‘trading’), it may be possible to claim gift relief (under TCGA 1992, s 165). Assets are gifted across so as to give rise to neither a gain nor a loss, so the business owner suffers no CGT on the transfer. The transfer is on an asset-by-asset basis, and not all assets need to be transferred. There is no effect on the DLA because the transfer is by way of gift. It is possible to tweak the transfer by making it at under-value or discount, so there remains an element of gift albeit with some consideration, but that is beyond this short article.
Transfer of business for shares
Alternatively, businesses may claim incorporation relief (under TCGA 1992, s 162). Here, the owner transfers the entire business as a single entity across to his new company in exchange for the company’s shares. For tax purposes, it is the shares that now hold the value of the business. This article focuses on incorporation relief.
Example 2: Incorporation relief in action
Jane decides to incorporate her buy-to-let (BTL) property business. She bought the properties for £1.4 million and the mortgages on the properties are £1.1 million; the properties are now worth £3 million. Overall, the business itself is worth £1.9 million, net of the mortgages.
Jane is looking at a capital gain of £1.6 million, but cannot afford to pay such a large CGT bill. A normal BTL property business is ineligible for ‘gifts relief’ (under TCGA 1992, s 165) because it is not trading; but it may be eligible for incorporation relief under TCGA 1992, s 162, where it satisfies the criteria as a business. Jane, therefore, plumps for incorporation relief:
Dr Fixed Assets £3 million
Cr Mortgages £1.1 million
Cr Share premium, etc. £1.9 million
(Note: shares’ nominal value ignored for simplicity).
Jane has received no money (or anything equivalent to money). In this example, the shares are worth £1.9 million, but for CGT purposes deduct the gain held over into them of £1.6 million, so £300,000 is the shares’ base cost going forward. It is no coincidence that, in this simple example, the shares have effectively ‘inherited’ Jane’s CGT base cost for the properties, less the value of the mortgage debt also taken on by the company. All of Jane’s gain has been rolled into the new shares, so she will pay CGT only when she sells or otherwise disposes of the shares.
In this case, incorporation relief is relatively straightforward because the shares are worth more than the gain being held over, and there is no consideration received for the business, other than the shares.
Note that the net value of the business is not credited to the new DLA in the company; if it were, that would be a real consideration for the property business, basically as good as cash, and undermining the claim for incorporation relief. I understand from feedback from a reader that some agents appear to be crediting the new company’s DLA with substantial amounts, so let’s look at the effect on incorporation relief if that happens.
Example 3: Some shares plus some consideration
Joseph has the same facts as Jane, but this time the company offers £1.4 million standing on loan account in part consideration for the business transfer. The business is worth £1.9 million, net of mortgages, so there is still a non-DLA/cash element to the transaction.
The consideration attributable to the shares is, therefore, £1.9 million less actual consideration of £1.4 million = £0.5 million.
The gain that can be held over into the shares is therefore:
£1.6 million (gain) x £0.5 million share consideration/(total consideration £0.5 million shares + £1.4 million DLA) = £0.42 million.
The balance of the gain (roughly £1.2 million) is chargeable immediately.
Practical Tip:
It has been reported that some advisers are using relief under TCGA 1992, s 162 on incorporations but leaving substantial sums in the DLA. This is not ‘wrong’ as the legislation permits the use of incorporation relief where there is ‘real’ consideration alongside the shares in exchange. However, the greater the value ascribed to the DLA on incorporation alongside the shares, the less gain will be postponed into the shares – and the more gain will be chargeable immediately. So, significant sums in the DLA will limit the extent of incorporation relief under s 162 and how much capital gain may be postponed, and increase the gain that is immediately chargeable to CGT.
