Mark McLaughlin highlights a potential trap for business owners seeking capital gains tax incorporation relief.
HM Revenue and Customs (HMRC) recently commenced a ‘One to Many’ campaign, targeting taxpayers who incorporated property businesses in the tax year 2017/18 but reported no capital gains tax (CGT) liability in their tax returns on the basis that ‘incorporation relief’ applied in full.
That’s a relief
Incorporation relief (TCGA 1992, s 162) is broadly subject to the following requirements:
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A person who is not a company (i.e., a sole trader or individual partner) transfers to a company a business as a going concern;
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The whole assets of the business (or possibly excluding cash) are transferred to the company; and
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The consideration for the transfer is satisfied wholly or partly by the issue of shares in the company to the person transferring the business.
The relief works by reducing the base cost of the shares by the capital gains on the disposal of chargeable assets of the unincorporated business. Those gains are ‘rolled over’ on incorporation and effectively deferred until a later disposal of the shares. There are apportionment rules where the consideration is not wholly in shares.
Business liabilities
The cost of the shares to the former sole trader or individual partner is the value of what was given for them (i.e., the value of the business, broadly the difference between its assets and liabilities).
Strictly speaking, business liabilities taken over by the company represent additional consideration for the transfer, so incorporation relief ought to be restricted. However, by HMRC concession (D32), business liabilities taken over by the company may be ignored when quantifying any consideration received for the business other than the shares.
Nudge, nudge…
HMRC’s ‘One to Many’ campaign involves sending out ‘nudge’ letters. Taxpayers are asked to check certain aspects of their incorporation relief claims, including:
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The capital gain on incorporation was not greater than the value of the business that was transferred; and
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When calculating incorporation relief, the amount of any gain held over did not exceed the value of any shares received.
HMRC’s ‘One to Many’ campaign nudge letters imply that some taxpayers automatically assume incorporation relief is available, particularly where all business assets are transferred, and only shares are issued. However, there are traps to avoid. For example, capital gains rolled over cannot exceed the base cost of the shares; otherwise, incorporation relief might be restricted. This can happen where liabilities transferred are relatively high, so the net asset value of the business is low.
If the assets have large inherent gains, it may be impossible to roll over all the gains, as the base cost of the shares cannot go below zero. Thus, if there is a high level of debt in the business, and the debt is being transferred to the company along with the assets of the business, advisers should consider the level of potential capital gains arising.
Practical tip
Be careful where a debt is being refinanced through the company. For example, if the company takes on fresh debt and uses the funds to repay borrowings of the sole trader or partner, that could cause a restriction in incorporation relief on the basis that the repayment represents consideration other than in the form of shares, which is not covered by incorporation relief. Thus, a large and unexpected CGT liability might arise.
