I act for a successful trading limited liability partnership (LLP) of two individuals who have only been trading for just under two years, but have made substantial profits. Acting on the advice of a third party, the individuals have each formed their own wholly-owned limited company, and these two limited companies have then been introduced as equal partners in the LLP, such that profits will be divided equally in four ways.
I act for a successful trading limited liability partnership (LLP) of two individuals who have only been trading for just under two years, but have made substantial profits. Acting on the advice of a third party, the individuals have each formed their own wholly-owned limited company, and these two limited companies have then been introduced as equal partners in the LLP, such that profits will be divided equally in four ways. The reason given was that the profit shares of the limited companies will only be subject to corporation tax of probably 19% compared to 40% if it continued to accrue to the individual partners.
My concern is that the introduction of the two limited companies as partners in the LLP (for no payment) represents a disposal of goodwill by the individual LLP members to connected parties at market value and as such my clients will each face a capital gains tax liability, albeit with 50% business asset taper relief.
Do readers agree with this analysis and, if so, is there any way of reversing the effective capital gains tax disposal?
Query T16,670 — Lovely Rita.
Reply by The Snark:
For most direct tax purposes, a trading limited liability partnership (LLP) is treated in exactly the same fashion as an ordinary partnership. For capital gains tax therefore, each partner (let us call them A and B in this case) is treated as owning his proportionate share in all the assets of the business. The treatment of gains on transactions between partners is set out in HMRC Statement of Practice D12.
Assuming that Mr A owns 100% of the newly created
A Ltd and Mr B 100% of B Ltd, each individual will be connected with his own company.
If A Ltd and B Ltd have been validly introduced into the partnership, paragraph 7 of SP D12 will treat each former partner as having transferred an interest in his rateable share of the partnership assets to his respective company at market value. This applies to all assets, not just goodwill. As a result, the individuals my have realised capital gains. However, if no proceeds were paid, the gain may be held over under the provisions of TCGA 1992, s 165.
I might question the valid introduction for two reasons.
- First that the LLP, being rather more formal than many small partnerships, should have a document of constitution. What does this say about the introduction of new partners?
- Second, what evidence is there of a transfer of goodwill? Whilst tangible assets might be transferred by delivery, there ought to be a document evidencing the transfer of an intangible like goodwill.
The position is additionally complicated here in that the two new partners are companies. Therefore, assuming valid transfers, part of Mr A's business has been incorporated into A Ltd (equally Mr B and B Ltd). On the face of it, this will produce similar capital gains tax considerations as an inter-partner transfer of assets at market value. Gains may arise but these can be held over under s 165.
In this case, as far as goodwill is concerned, not only is there need for a document of transfer, but there is the preliminary question of whether the goodwill is transferable at all. We are not told what sort of business is being operated. Not all businesses necessarily carry any goodwill which, in essence, is the excess value that an independent purchaser might be prepared to pay for the business in excess of its worth as a collection of assets. If the business does have goodwill, is it transferable?
Goodwill may be categorised as personal, inherent and free. Personal goodwill attaches to the individual business proprietor and is not easily transferred at all; this might be the case with a celebrity chef or well-known photographer. The goodwill of many small businesses falls into this category.
Inherent goodwill attaches to some particular feature of the business, commonly the premises from which it operates. This might be the case with an hotel and it cannot be transferred without the property. Only if these two hurdles can be overcome and there is true free goodwill can it be transferred.
Taking all of this into account, if there has been a properly documented transfer of free goodwill, there should be no outstanding capital gains tax liability if holdover claims are submitted. Why then is there a supposed need to reverse the disposals (of all assets, not merely the goodwill)?
Is this the optimum position to have reached? It might have been preferable for the two companies to pay for the goodwill transferred to them. Having no funds, the consideration could have been satisfied by credits to the directors' loan accounts in the companies. This would crystallise gains for Mr A and Mr B but, dependent on valuation, 50% business asset taper relief and the personal annual exemptions, the amount payable might be tolerable. This would leave each of them with credit balances on their loan accounts on which they would be free to draw without further tax liability as the companies accumulate profits. Even better, as the goodwill will have been created after 31 March 2002, the company could claim a tax deduction for its cost under the corporate intangibles régime in FA 2002, Sch 29.
As to some of these issues, Lovely Rita should see the article 'Goodwill and Incorporation' in HMRC's Tax Bulletin 76 (April 2005).
Finally, if the business does trade successfully, the companies must retain their respective shares of profit. If they loan the funds back to the partnership, even in the form of a credit balance on partner's account, there will be liabilities under TA 1988, s 419.
Reply by The Weather Man:
The goodwill, if there is any, may not be a problem. Depending upon the nature of the business, the goodwill might be personal, i.e. relating solely to the individual partners themselves and thus be incapable of transfer.
As mentioned in the reply to the recent query 'Disincorporations' (Taxation, 28 July 2005, page 473), a review of HMRC's views on the different types of goodwill would be worthwhile. Lovely Rita should also be aware that HMRC seem to be taking a close look at purported transfers of goodwill on incorporation, which can lead to unwelcome tax problems. If there is goodwill this could either be retained by the partners or if transferred could be sold for an amount that would result in a chargeable gain below the exempt amount and any balance of value could be gifted, with the gain held over under TCGA 1992, s 165.
Perhaps more importantly, is this a settlement? When I read through ITTOIA 2005, s 625 (formerly TA 1988, s 660A), this would seem to apply 'if there are any circumstances in which the property or any related property … is payable to the settlor'. The exemptions in the following subsections do not appear relevant. The one possible redeeming point is that, in Tax Bulletin 69, HMRC states that they believe that the section applies where: 'shares subscribed at par in a company by one person where the income of the company derives mainly from a different person'. As this is the same person(s), perhaps
s 660A does not apply. If that is not the case, the settlement provisions could presumably be argued in most close company incorporations.
