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Replies to Queries - 2 - Partner reward

26 June 2002
Issue: 3863 / Categories:

K, P and R trade in partnership, distributing janitorial products. The partnership is ten years old and purchased goodwill of £20,000 and this is currently valued at £80,000. K and P are husband and wife, but P (the wife) has little involvement in the partnership.

Five years ago another party, E, became involved in the business, but was not included in the partnership. He contracted his services on a self-employed basis.

K, P and R trade in partnership, distributing janitorial products. The partnership is ten years old and purchased goodwill of £20,000 and this is currently valued at £80,000. K and P are husband and wife, but P (the wife) has little involvement in the partnership.

Five years ago another party, E, became involved in the business, but was not included in the partnership. He contracted his services on a self-employed basis.

The plan is to incorporate and K, R and E are to run the company. P will have no active role within the new company. The proposal is to sell the business to the company for £120,000, comprising £40,000 of stock and motor vehicles and the goodwill valued at £80,000. K and R would like to acknowledge E's contribution to building up the partnership which is estimated to be about one quarter of the £80,000. How do they go about it?

(Query T16,029) - Maid of Ayrshire.


Incorporation of a business and its assets, including goodwill, will normally lead to a capital gains tax charge on the transferor. To avoid the cashflow problems of this and defer the gain, one normally follows one of two routes:

* section 162, Taxation of Chargeable Gains Act 1992 - Providing for rollover relief; or

* section 165, Taxation of Chargeable Gains Act 1992 - Providing a holdover relief.

If retirement relief is applicable, this can be used in conjunction with the above, but it is obviously not necessary in this case.

Section 162 requires all the assets of the existing business to be transferred to the new company at market value. This can exclude cash, and it is not necessary to transfer any liabilities either. The new company then exchanges its shares, either wholly or in part. Any part of the consideration in cash is not subject to rollover relief.

The problem with section 162 is that the transfer relief is only available for the share part of the consideration, and this can mean that capital is effectively tied up until the eventual disposal of the company.

Section 165, which actually describes itself as 'gifts for business assets', gets around this problem by allowing the consideration to be in cash or by way of a loan. The workings are very different: a company is formed and shares are issued. Only then is the transfer of the various business components effected. Goodwill is normally sold for a nominal figure, and the other assets are sold at accounting value - the lower of cost and net realisable value. The consideration is paid by cash or left on a director's loan account.

In both cases, stamp duty applies on the transfer. Under section 162, this will be higher because of the market value rule (and this includes the valuation of stock), but, under section 165, lower because normal accounting principles of valuation are followed. Hence it is beneficial not to increase the value transferred by debtors, and so one can leave these out and collect them separately if necessary.

So which method would be the most useful to you?

First, do you really want to get rid of P? She might be useful in the future for some tax saving for the husband. You might do well to consider issuing different classes of shares to allow dividends to be paid to whom you want when you want.

Secondly, do you want E to be paid in cash, or given some share capital as his reward?

You will have to make up your mind before you find the right answer.

Section 162 should not be ruled out totally; you may issue redeemable shares as well as ordinary ones, and these would allow capital to be extracted at a future date (subject to Inland Revenue clearance, as one does not want to fall foul of anti-avoidance legislation). Using the section 162 method, the business could be exchanged by K, P and R in exchange for shares. Once that had gone through, each could then gift a proportion of his/her shares to E. This would be uncomplicated if K, P and R all had their annual exemptions for capital gains tax available, because combined they will cover the total of £20,000 which is being given to E, and this would be straightforward to put in place.

Section 165 represents no problems. E would be issued a share with the others when the company is first set up. The balance of the consideration is in cash/loan, and K, P and R can do what they want with it - gifting some to E if that is what they really want. - Albertine.


The plan is presumably that E should receive his fair share, i.e. one-quarter of £80,000, of the value of the goodwill when the business is incorporated.

As a first step the company is created with, say, £100 of share capital, split equally between K, P, R and E. Given that P will have little active involvement in the company, it could be that separate classes of shares would be desirable. In this way, differing contributions to the business can be reflected in the level of dividends that are paid.

Next the businesses would be incorporated and the important point is the use of the plural, as E will also be incorporating his sole trader business into the company. The partnership of K, P and R would be paid £100,000, split as to £40,000 for stock and motor vehicles and £60,000 for goodwill. E would be paid £20,000 for the goodwill of his business. The consideration payable could be left on loan account as tax paid funds to be paid out as and when required.

For tax purposes, the sale of goodwill gives rise to a capital gain. Strictly the proceeds are deemed to be open market value because the disposal is to a connected person. However, if open market value would be greater than the actual proceeds, the additional gain can be held over by making an election under section 165, Taxation of Chargeable Gains Act 1992.

On this basis, the gain on the goodwill for each of K, P and R will be £13,333, before allowing for indexation on the cost of £20,000. E would have a gain of £20,000, as his goodwill has no cost. Given that E would receive more than a quarter share of the rise in the value of the goodwill, the allocation may have to be amended. If E received £15,000, with the balance going to the others, this would ensure that each person receives one-quarter of the uplift in the goodwill value.

The Inland Revenue might seek to argue that the value attributed to the goodwill of E's business is less than £15,000. Consequently, if E was paid £15,000, steps would be taken by the Inland Revenue to tax the difference as if it was an emolument subject to both pay-as-you-earn and National Insurance contributions. However, I will assume that the suggested values for goodwill are reasonable.

If we make this assumption, no tax is likely to be payable as, on the facts provided, each party would qualify for 75 per cent business asset taper relief. The gain after taper relief would only be £3,750 and so this should be covered by the capital gains tax annual exemption for each of K, P, R and E.

The first of three side issues is relevant if the clients are elderly, as any amounts credited to directors' loan accounts will not qualify for business property relief.

Secondly, is it wise to transfer the motor vehicles into the company given the new régime for company cars and for the fuel benefit? Calculations should be performed to determine if it would be better for the cars to be owned personally.

Finally, the goodwill will come under the new régime for intellectual property and so, amongst other things, if it is later sold at a profit by the company, it will be taxed as a profit and be subject to corporation tax. If the businesses did not incorporate, a disposal of the goodwill would still be taxed as a capital gain on which 75 per cent taper relief would be available. - Hodgy.


Extract from reply by 'Lane':

It is convenient that stamp duty is no longer payable on transfers of goodwill.

To dispense with the rollover relief requirement to transfer the whole business for shares, recourse is possible to the enterprise investment scheme. This would permit the take-up of shares to be restricted to the desired extent, perhaps with some residual tax liability on chargeable gains but with the benefit of loan accounts capable of later withdrawal.

Editorial note. The use of the enterprise investment scheme involves a cash subscription for shares in the company which then purchases the business. The return of value rules are the main pitfall.

Issue: 3863 / Categories:
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