The Autumn Statement 2014 announced that entrepreneurs’ relief (ER) will no longer be available to reduce Capital Gains Tax (CGT) on the incorporation of a business.
The new ruling from HM Revenue & Customs (HMRC) means any company acquiring a business, from a sole trader or partner, which is a ‘close company’ and to which ‘the seller is related’, will be liable for CGT when a payment for the reputation and customer relationships associated with that business (the ‘goodwill’) is made.
Prior to the change, and if the business qualified for ER, the tax rate chargeable was 10%. Since 4 December 2014 however, ER no longer applies where goodwill is sold to a company as the measure seeks to restrict Corporation Tax deductions when goodwill is acquired from a ‘related’ party on incorporation. In such a case, CGT remains at 18% for basic rate taxpayers and 28% for higher rate taxpayers.
The measure was introduced to remove the unfair advantage available to proprietors of businesses to extract funds from the business at a low rate of CGT using ER, rather than the normal rates of income tax and national insurance contributions. Those affected by this new measure are predominantly sole traders and partners.
However it could still be beneficial for businesses to incorporate and sell goodwill because CGT at 18% or 28% could be a cheaper alternative to extracting money from a company than drawing a salary.
But be careful! When a business is incorporated, the company that has been created usually has little or no cash to pay for goodwill. In turn, the payment is left as debt and the proprietor cannot access the money initially; but CGT is required to be recognised immediately.
However, if you incorporate a business shortly after 5 April you may have up to 22 months before CGT needs to be paid. This is because CGT is required by 31 January following the end of the tax year in which the goodwill was sold.
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Image by Darren Wamboldt/Bergman Group. From <http://www.aei.org/>