The Finance Act 2015 has made major changes to entrepreneurs’ relief which will undoubtedly have a major impact on the growth of many small businesses.
One of its measures will restrict the availability of this relief when transferring goodwill on incorporation.
The other will limit the availability of tax deductions for the amortisation of goodwill transferred to the successor company on incorporation.
Both these changes, in our opinion, are ultimately bad for business and have been ill thought through.
When a sole businessman or woman, or a partnership, has reached a certain size, it is often sensible to transfer the business into a company (a process called incorporation).
If the trade is transferred to the company in return for shares, there is a relief to prevent any capital gains tax arising. Alternatively, if the business has a trade that could be sold to a company, the sale would generate a capital gains tax charge of just 10% (under the entrepreneurs’ relief). But why would you do that?
If you price your business’s goodwill at £100,000 and sell it into a company, the £100,000 gain will carry a tax charge of £10,000, which you won’t need to pay until January 31 2017.
The new company does not have any money, so it now owes you £100,000, which it can repay as it makes profits, and there is no further tax on the repayment of a debt. So, for the sake of paying £10,000 tax on incorporation, you are able to take £100,000 out of the company tax free – in contrast to the income tax and National Insurance contributions payable on salaries or the income tax on dividends.
Unfortunately, HMRC closed down this opportunity on December 3 2014. This means that most incorporations will use the special tax reliefs. Rather more unfortunately, this legislation potentially reduces the opportunity for people to retire from a business and sell that business in a sensible way.
Let’s imagine that Paul and Art want have a song-writing partnership and Art wants to retire. Paul agrees to set up a company to buy the business from both of them. Paul incorporates using the relief mentioned above and Art agrees that the company will pay for his share out of future profits. Art will claim entrepreneurs’ relief at the 10% CGT rate. So far, so good, as the new legislation does not cause a problem.
However, difficulties arise if Art and Simon are closely related, such as brothers or father and son, for example. In such cases, because they are related, the new rules do not allow Art to retire from the trade and claim entrepreneurs’ relief. There is no apparent policy reason for this, and it is largely a problem caused by rushing the legislation through with no time for consultation.
Similarly, if Art is a sole trader and sells to his friend Paul’s company, Simon Ltd, Art can sell his business and, we hope, claim entrepreneurs’ relief at the 10% CGT rate. Again, this works unless Paul requires Art to take, say, a 5% shareholding in Simon Ltd. In that case, Art will not receive entrepreneurs’ relief, simply because he becomes a shareholder in the company, even though it is only a very small shareholding.
Again, there is no policy reason behind this restriction: it is just a lack of time to consult. In our view these changes to the Finance Act are too wide and will inhibit commercial transactions.
The other major change is that, whichever method is used to incorporate the company, it will not be allowed a tax deduction when it writes down the goodwill in its accounts if any member of the previous partnership is a shareholder in the company. In many cases, this was a generous relief that we might not be able to afford in austere times. But this change was also not adequately consulted on and leaves some major commercial unfairness that needs to be resolved.
The government responsible for these changes now has the opportunity to review them as it sets out its agenda for business for the next five years. In the interest of supporting growth of UK small businesses I sincerely hope it will revisit the Finance Act’s contents at its earliest opportunity.
In the meantime, we have been looking at ways in which the effects of these changes can be mitigated with longer term retirement planning. So, if you have clients looking to incorporate their business or to retire from partnerships, please get in touch to see if we can help.