We have the following situation:
A sole trader has sold the goodwill in his business to a brand new company in which he is a director and 33% shareholder. The other 2 directors each hold 33% and were previously unnconnected to the sole trader. The goodwill price was negotiated between the 3 individuals and the agreed amount was credited to a loan account.
HMRC have enquired into the sole trader's personal tax return and have disputed the goodwill valuation, saying that it is excessive (even though it was freely negotiated between the parties).
Are the sole trader and the company actually connected parties for CGT purposes? if not, are HMRC's views on the valuation irrelevant anyway? are there any other angles of attack we should be watching out for?
Any thoughts welcome.
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Thanks. Then that rules out
Thanks. Then that rules out a conspiracy among the three shareholders to support each other's inflated goodwill values!
I think that TCGA S286 (6) and (7) make your client and the company connected persons for CGT purposes:
TCGA92/S286 (6) a company is connected with another person ifthat person has control of the company, orthat person and persons connected with him together have control of the company.TCGA92/S286 (7) persons acting together to secure or exercise control of a company are connected witheach other, andpersons acting on their direction.
So HMRC are entitled to say that market value must be substituted for the actual price paid, if different. But you are entitled to retort that the price paid is self-evidently market value as it was freely negotiated at arm's length.
What are the numbers?
How much are we talking about here. Presumably your client is paying CGT on at least a part of the goodwill amount?
I suppose the HMRC view is that whilst your client may be paying tax at 10% (if Entrepreneur Relief is being claimed) they can then withdraw the loan account tax free. I am not certain that the fact that the unconnected other parties were happy with the arrangement will help on the valuation point as the entire sum could just be remuneration agreed in advance and dressed up in this way to benefit from CGT treatment - that may be the HMRC suspicion.
I'm not sure that I agree with John...
... that the two co-shareholders should be considered persons that are going to act with the transferor to exercise control of the company. They could go on to act together to exercise control against the transferee.
What's probably fatal though is S.845 CTA 2009. If you're dealing with new goodwill, as I suspect, then the transferee and the company are "related parties", as defined in S.835, because the transferee is a participator in the company.
S.845 then says that the transfer of an intangible asset to a company from a related party takes place at market value for all purposes of the Taxes Act (even TCGA 1992).
If it were old goodwill, I'd have expected a S.162/S.165 route, so that the valuation issue would be moot.
The goodwill in question is old goodwill. The reason the S162/165 route was not taken is that the sole trader did not wish to effectively give away 2/3 of the business to the other 2. Does this mean that S845 is not in question?
Yes
If it doesn't fall within the intangibles regime, S.845 can't apply. The other part of your response also demonstrates a bargain at arm's length and that the others aren't acting with him to exercise control.
So I'd be in the not connected camp. The only other way that HMRC can get a market value transfer is (the point Robert Hobbs alludes to) that market value applies under S.17(1)(b) TCGA 1992:
"where he ... disposes of the asset ... in consideration for or recognition of his ... services ... in any office or employment ... rendered or to be rendered by him ..."
Are HMRC saying there's connection? On what basis do they consider that market value applies?
Excess over Market Value
I agree with Steve that S17 will probably get you to an MV point for CGT so that the proceeds will be reduced in your CGT comp. You are then left with the excess which could be considered as earnings under s62 ITEPA or a benefit under s203. The prospect of income tax and possibly NIC is not very attractive for your client but may be a nice win for HMRC depending on the numbers. There is also a CT angle here for HMRC assuming that the Goodwill has or is to be amortised and tax relief claimed.
There is an old HMRC Bulletin from 2005 (Number 76) which is now archived (but still available online) and this appears to remain current for this topic. This sets out exactly what HMRC are challenging and that is the overvaluation of the goodwill to gain an inflated current account. The bulletin states that it is also possible to treat the overvalue as a distribution if trading has not commenced when the transfer takes place or, alternatively if there has been a professional valuation of the goodwill that the overvalue can be "unwound" without tax consequences.
The one thing I don't understand in your case however is that you say the goodwill is "old" which suggests that it has not been the subject of a recent valuation exercise and has been purchased or acquired from a previous transaction. If it is truly old and without any valuation being applied to your clients benefit then providing this detail to HMRC should result in them closing their enquiry down fairly promptly.
The valution agreed bewteen the directors was £220k. HMRC are arguing for £50K. The business is a solicitors practice with an annual fee income of £600k, although profitability is fairly modest (about 60k). So potentially there is an overvaluation of £170k, although we will contest this strongly, but that's another matter.
The goodwill is "old goodwill" i.e. the business was in existence prior to 1/4/02, therefore no deduction for amortisation can be claimed by the company. So it sounds like the main danger is that the excess is assessed as earnings. If we were to lose this argument, would they allow us to simply adjust the entry in the loan account?
Valuation
As you know, the goodwill of a solicitors' practice is commonly a multiplier of fee income, adjusted for the structure of the business, etc. If you are using profitability as a basis, you would multiply adjusted profits by a higher figure according to the nature of the business and market, etc.,, say 3, so your valuation would not appear to be that far out. We have been successful negotiating for solicitors' practices with the Revenue using multipliers.
As for the substitution of any revised figure in the loan account, it depends what was in the purchase and sale agreement. We work with the lawyers to cover this point so that the final value can, in effect, be substituted after the contract date. What was in their agreement?
I'm pretty sure the average sales price for an accountantcy practice is around 1-1.5 times the recurring turnover, It should therefore be quiet easy to prove, or not, your goodwill figure on a similar basis.Not sure what Solicitors practices sell for but there must be some info out there.
"If we were to lose this argument, would they allow us to simply adjust the entry in the loan account?"
This to me is basically saying ye we just did it to create the loan balance and provide advance remuneration. The seller would be losing out on the difference in goodwill less the tax charge.
Change in valuation
I believe you can. However if the director has withdrawn his loan then you have S455 issues.
You have a sole trader that makes £60k. Allowing for a lawyer to replace him as an employee say £40k+nic = £44k that means '' profits ''are £16k ...3 years profits = £48k
How much would you pay for a business that makes £60k that you have to run?...
Accountants multiples are higher as we get repeat business. Lawyers tend not to, so this isnt a valid point here.
To me 1.5 to 2 of profits not unreasonable therefore £100000 would seem a sensible figure to push for an agreement.
I know various lecturers in the past have stated that something along lines of
'Or whatever figure is finally agreed upon'
Means you can just adjust the accounts....
Anybody else know the exact wording??