The owner(s) of a an unincorporated business (eg, a sole trade or partnership) might decide to incorporate for various reasons. For example,
- to secure the protection of limited liability,
- for tax planning reasons,
- to facilitate future changes in ownership of the business.
Before they do so they should consider the many and varied tax implications of incorporation. The following notes concentrate solely on the Capital Gains Tax (CGT) issues that arise as part of the incorporation process, but other tax issues on incorporation are discussed elsewhere on this website.
The first thing to understand is that the person(s) incorporating their business will be deemed to be ‘connected’ to the new company they form, and that any transfer of assets between ‘connected person’ is deemed to take place at ‘open market value’ (OMV) for CGT purposes.
Assuming the business has increased in value since it was started up, OMV at the time of transfer will be higher than cost, so, on the face of it, there will be a CGT charge on incorporation, even if no money changes hands. In the absence of any tax relief the owners would have to pay the CGT from other resources, and that fact would be enough to prevent most incorporations.
Fortunately, there are 2 such tax reliefs that are readily available, and they mitigate what would otherwise be a harsh result.
1. Incorporation Relief – s162 TCGA
Incorporation Relief applies automatically to defer the CGT charge arising in situations where ALL the assets (except cash) of the unincorporated business are transferred to the Ltd company and the consideration received by the transferor is either a) wholly in shares issued by the company or b) partly in shares issued by the company.
In the case of a) the whole of the individual’s capital gain is deferred by being ‘rolled over’ into the cost of the shares acquired in the new company (ie, it reduces the costs of those new shares for CGT purposes, so the gain is deferred on incorporation, and will only crystallise if and when the shares are sold in the future)
OMV of business assets as at the date of incorporation = £201,000. Most of that costs is accumulated goodwill, so the original cost of assets transferred is just £1,000. Capital Gain on the increase in the value of the business = £200,000.
No cash changes hands. The transfer receives £201,000 of share capital in Newco in return for the business.
Rather than having to pay CGT on the £200,000 gain when the business is incorporated, the gain is 'rolled over into the cost of the shares.
However, if the shares are sold in the future, the deemed acquisition costs will be just £1000 (the £201,000 nominal value of the shares less the rolled over gain of £200,0000 ) - ie, the tax liability crystallises on the future sale.
In the case of b) the proportion of consideration received which is not shares in the new company is charged to CGT immediately, whilst the gain relating to the proportion of consideration received which is in shares in the new company is rolled over into the cost of those shares – ie, as in a) above.
In either case, it is important to note that the company’s own CGT cost of the assets it acquired is the market value of those assets at the time they were transferred. This is a useful outcome where the business owners might be considering an onward sale of some or all of the assets from the company, because if the company sells the assets before they have increased much in value there may be very little (or zero) tax to pay.
Conor and Declan, run a profitable partnership business. They have operations in Sawrey, Hawkshead, Ambleside and Windermere, and the business owns a number of buildings, all of which have increased greatly in value over the years. They would like to sell some of the buildings because they believe they could make better use of the locked up value by redeploying it. Unfortunately, if they sold the properties they would incur significant CGT liabilities, so that has put them off this course of action.
In any event, they decide to incorporate the business, and the whole of the consideration they receive is share capital in Newco. They benefit from Incorporation Relief, so there is no CGT to pay on the transfer. Furthermore, the company has acquired all the partnership properties at market value as at the date of incorporation, so when the company does subsequently sell the properties on there is no tax to pay, except to the extent there has been a further increase in value,.
Ellie and Aurelia are partners in a successful restaurant in Grasmere. The business has grown quickly and although they love the business they also have half an eye on a future sale.
They incorporate their business and soon after they are approached by a buyer. They could sell the shares in their new company or they could simply sell the assets. The buyer would prefer an asset purchase because it reduces his risk and the costs of due diligence that would be incurred on a share purchase. This suits Ellie and Aurelia too because the underlying assets haven’t increased in value so there is no tax to pay on an asset sale. They (or their company) thereby retain all the proceeds of sale, which are now available to reinvest in their next venture.
If they hadn’t incorporated, or they’d sold the shares, they would have a had a large capital gains tax liability.
Whilst Incorporation Relief is automatic, it is possible to disapply it by filing an election to do so with HMRC. This might be desirable if you wish to ‘bank’ a favourable tax rate. See https://www.gov.uk/government/publications/incorporation-relief-hs276-self-assessment-helpsheet/saf#how-you-can-elect-not-to-have-incorporation-relief for the time limits if you need to make this election.
2. Holdover Relief - s165 TCGA
Alternatively, the owners of an un-incorporated business may not wish to transfer ALL of their business’s assets to the new company.
For example, if the unincorporated business owns a property, they may want to keep it out of the company in order to ringfence it from trading risk, to avoid Stamp Duty Land Tax charges, and/or to provide a tax effective means of future profit extraction. In that case, Incorporation Relief is not available, but Holdover Relief may be.
Holdover Relief is available when the transferor receives less than market value for the business assets transferred or gifts them outright. The company’s own asset cost is then the transferor’s original cost (or the amount of consideration actually paid if that is higher), and some or all of the gain is once again deferred, but this time it will crystallise when the asset is sold on by the company (not when the shares are sold by the owner).
Holdover relief must be claimed by both donor and recipient, unless the gift is to a trust, in which case only the donor makes the claim. The claim must be made with 4 years of the end of the tax year in which the disposal was made.
NB. It is possible to use s162 or s165 in such a way that you receive just sufficient cash to use up your CGT annual exemption(s), and thereby realise some tax free cash drawings on incorporation.
Both of these tax reliefs can be very useful if you are considering incorporation, but you will need to think carefully before deciding on one or the other if you want to achieve the best outcome.
You can contact me, David Sutton, on 015394 32540 or 07881 286903 if you need further advice on this matter