Replies to Queries - 3

Distributing goodwill

Our clients are a professional partnership comprising three partners and three qualified staff. The partners wish to incorporate the practice to take advantage of lower corporation tax rates and qualified staff will have the opportunity to become directors and shareholders, rather than partners. Goodwill will be sold by the existing partners to the company, although because of the connected persons rules there will be no tax allowance on the acquisition cost.

However, the qualified staff believe that some of the goodwill is inherent in them and consider that if payment is made to the partners, they should also receive payment. The partners are comfortable with this principle and are aware of their own capital gains tax position. However, what is the tax position of the existing qualified staff who will receive a payment from the newly-incorporated company for the goodwill inherent in them? Those staff have no acquisition cost, but have all been employed by the practice for well in excess of two years. If, say, each employee were to receive £30,000, would this qualify for 75 per cent taper relief, thus reducing the gain to an amount less than the annual exemption, or would this be treated as a distribution?

As a matter of fact, it is believed that goodwill is inherent in the employees, but we are not at all sure that the legislation properly acknowledges that. None of the persons are related to each other in any way.

Readers' views are welcomed.

(Query T16,170) - All for one.

It is common when a partnership is incorporated to sell the goodwill to the new limited company. This is because the partners may have some available retirement relief and also are likely to be entitled to maximum business asset taper relief. By considering the relief available, it will be possible to sell the goodwill for such a price as to result in a gain that is covered by the annual exemption.

Having done this, the tax-free proceeds of sale will be left as a loan to the company for later withdrawal instead of taxable income.

It may be worthwhile considering a higher sale price for the goodwill such that a tax liability is created, as the rate of tax payable on incorporation may be very attractive when compared to the rate that will apply on extracting a salary or dividend. For example, a gain covered by 50 per cent retirement relief and 75 per cent taper relief will suffer an effective rate of tax of just 5 per cent. The difference between the value of the goodwill and the consideration can be covered by gift relief.

Whilst it is clear that the business itself has goodwill which will be a chargeable asset in the hands of the partners, it is less clear that the employees possess a capital asset that they could sell and realise a capital gain. A search of the Inland Revenue's Capital Gains Tax Manual confirms that, as a concept, an individual may have personal goodwill (paragraph CG 68194).

Assuming that this personal goodwill does exist and is a chargeable asset for capital gains tax purposes, then it should qualify as a business asset for taper relief. Whilst the employees are not in business on their own account and do not own any shares, paragraph 5(2)(d) of Schedule A1 to the Taxation of Chargeable Gains Act 1992 includes as a business asset one used for the purposes of any office or employment held by the individual in a trading business.

'All for one' asks whether the disposal could be treated as a distribution. This clearly cannot be the case because none of the employees is a shareholder in the company.

Notwithstanding the comments above concerning capital gains tax, it must be questionable whether the employees actually possess anything that they can sell for a significant capital sum. Working for a professional partnership, the employees will presumably be bound by their contracts of employment not to solicit clients following termination of their employment and not to make use of information gained during the course of their duties of employment.

This being the case, the Inland Revenue will argue that since the goodwill has little or no market value (because with the restrictive covenant in place, no one would buy it), any sum paid is derived from employment.

Alternatively, it will argue that the sum is actually a payment for a restrictive covenant and hence taxable under section 313, Taxes Act 1988. If there is some doubt as to whether an income tax charge or a capital gains tax charge should apply, section 37(1), Taxation of Chargeable Gains Act 1992 gives priority to an income tax charge.

If the payments are made to the employees outside the payroll, on becoming aware of the facts the Inland Revenue will almost certainly seek pay-as-you-earn and National Insurance contributions on the grossed-up amount of the payments from the company. Combined with interest, penalties and professional fees, this could prove to be extremely expensive for the client. Some other means of incentivising the staff, such as a share scheme, would seem to be preferable. - Wentworth.

It does seem that anything coming to an employee from his employer is liable to be regarded as 'perquisites and profits whatsoever' included by section 131, Taxes Act 1988 in 'emoluments' charged by section 19.

Inherent goodwill of a capital nature was recognised in Bridges v Bearsley 37 TC 289. It arose through the early build-up of the 'Meccano' business by staff who became directors and expected, but did not obtain, recognition in the founder's will. The family therefore made arrangements whereby shares were ultimately transferred to them.

In the Court of Appeal, Lord Justice Morris contrasted the systematic and recurring nature of remuneration, payable for some specified services rendered. It was held that the shares were personal gifts, not derived from the directorships.

Apart from the difficulty of making valuations before returns, the incorporation would involve the termination of the existing contracts of employment with the staff, who will have to be re-engaged by the company. If so, the proposed £30,000 is an amount significant in the context of section 148 of the Taxes Act 1988, which would exclude income tax if the amount was not otherwise taxable under Schedule E.

Such terminal receipts attract much Revenue attention (most recently, see its Tax Bulletin, February 2003, at pages 999 to 1001). If the capital nature of the goodwill allocations is denied, would the partners be willing to pay the costs of a hearing before the Special Commissioners, the arbiters of facts? - Bear.

Extract from reply from 'Badwill':

In Commissioners of Inland Revenue v Muller & Co Margarine Limited (1901) AC 217, Lord MacNaghten gave this interpretation of goodwill.

'What is goodwill? It is a thing very easy to describe, very difficult to define. It is the benefit and advantage of the good name, reputation and connection of a business. It is the attractive force which brings in custom. It is the one thing which distinguishes an old-established business from a new business at its first start.'

The Inland Revenue's Capital Gains Tax Manual at paragraph CG68,000 et seq. provides additional information. Depending on the nature of the partnership, the reason(s) for obtaining business etc., the goodwill may have a much reduced value from that which 'All for one' has in mind. The valuation of goodwill is often also a real problem if the business is property based, such as that of a hotel or restaurant, or operates by virtue of a licence or franchise.

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