Key features of the incorporation and disincorporation reliefs in TCGA 1992

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1 Changing horses 1 of 6 04/09/ :17 Published on Taxation ( Home > Changing horses By: Andrew Goodall 03 September 2014 Changing horses Key features of the incorporation and disincorporation reliefs in TCGA 1992 KEY POINTS The principle behind both reliefs is that changes to business structure should not be inhibited by tax charges. Incorporation relief is not lost if some business assets are not transferred. It is possible for the incorporation relief to apply to partners in limited liability partnerships. Disincorporation relief is time-limited for five years from April For disincorporation relief to apply, the qualifying conditions in TCGA 1992, s 59 must be met. Capital gains tax incorporation relief, rollover relief on transfer of business, has been around for a long time. In contrast, disincorporation relief was enacted only last year, when the government estimated that around 610,000 companies, about 40% of those in the UK, would be eligible for relief against corporation tax on chargeable gains. In each case, the policy rationale is that tax charges should not act as a barrier to proposed changes in the structure of a business. The interaction of these reliefs with others, such as entrepreneurs relief (TCGA 1992, s 169H) and holdover relief for gifts of business assets (TCGA 1992, s 165), is outside the scope of this article. Note also that non-capital gains tax matters, such as potential liability for VAT and stamp taxes, need to be considered. Incorporation relief This relief applies on the transfer of a business to a company where the transfer meets the conditions set out in TCGA 1992, s 162. It is automatic and no claim is required, but since 2002 the transferor has been able to make an election under s 162A for the relief not to apply. HMRC provide general guidance on incorporation relief in their Capital Gains Manual at CG65700 onwards. The conditions for s 162 relief are met if:

2 hanging horses 2 of 6 04/09/ :17 a person who is not a company transfers to a company a business as a going concern, together with the whole assets (the old assets ) of the business, or together with the whole of those assets other than cash; and the business is so transferred wholly or partly in exchange for shares (the new assets ) issued by the company to the transferor. Guidance on the meaning of business is provided at CG65715, where HMRC note that the term goes wider than trade. However, at the time of writing there is no reference in the manual to the Upper Tribunal s decision in Ramsay v HMRC [2013] UKUT Reversing the decision of the First-tier Tribunal, the Upper Tribunal held that the letting of flats in a single large building was sufficient in nature and extent to amount to a business for the purpose of incorporation relief. The degree of activity outweighed what might normally be expected to be carried out by a mere passive investor. A company includes a body corporate or unincorporated association but does not include a partnership (see s 288). Effect of the relief Broadly, the effect of incorporation relief is that an amount is deducted from the gain arising on the disposal of the old assets. That amount cannot exceed the cost of the new assets but, subject to that, it is found by applying the fraction A/B to the gain on the old assets, where: A is the cost of the new assets; and B is the value of the whole of the consideration that the transferor receives for the business. The amount deducted on disposal of the old assets is apportioned between the new ones. In calculating the chargeable gain on a subsequent disposal of a new asset, the apportioned sum is set against the costs of acquisition etc allowed under s 38(1)(a). HMRC concession D32 states that, if a company takes over business liabilities (as opposed to personal liabilities, see CG65745), HMRC are prepared for the purposes of s 162 not to treat those liabilities as consideration for the transfer. The relief is not precluded by the fact that some or all of the liabilities of the business are not taken over by the company. HMRC provide examples at CG65750 to CG65765 illustrating the computation of incorporation relief. See also HMRC s Helpsheet 276 ( Election The taxpayer may elect, no later than the relevant date, that s 162 shall not apply. An election may be worthwhile if a sale of the company is being considered, for example, and entrepreneurs relief would be available. The relevant date is the second anniversary of 31 January after the tax year in which the transfer took place, or the first anniversary of that date where the transferor disposes of all the new assets by the end of the tax year after the one in which the transfer took place. Partnerships

3 Changing horses 3 of 6 04/09/ :17 Incorporation relief is available to individuals who are partners (even if one or more of the other partners is a company) where the whole of a partnership business is transferred to a company. Relief is calculated separately for each partner and is not precluded if some partners receive cash, or shares and other consideration. See CG65700 and the Partnership Manual at PM Note, however, that there is no equivalent relief for the corporate member. What if the arrangement is a limited liability partnership (LLP)? Pete Miller of The Miller Partnership suggests two possible ways to transfer such a business to a company. First, and simplest, the business of the LLP could be transferred to the company and the LLP struck off or wound up. Alternatively, the members could transfer the LLP to the company, which would carry on the partnership s business. Miller said that strictly, in this second scenario, it may be necessary to hive the business up into the company, then liquidate or strike off the LLP. Also, of course, the LLP still has to have two members, so one of the original members may have to stay in place, albeit with no profit-sharing rights until the LLP is wound up, he said. Miller has seen correspondence indicating that HMRC will accept s 162 relief as applicable to either of these scenarios. What if the business of the LLP is to be transferred from its individual members to a corporate member? Miller said HMRC had confirmed in correspondence with the Chartered Institute of Taxation that they would, subject to all the other conditions being satisfied, accept that s 162 can apply to the individual members where an LLP transfers its business to the corporate member in exchange for shares in the corporate member. Miller said: HMRC s analysis is based on TCGA 1992, s 59A(1)(b), which treats any dealings by the LLP as dealings of its members. HMRC therefore say that the transfer of a business by an LLP will be treated as a transfer by its members, so that s 162 relief should be available to any individual member who receives shares in exchange for the business. Disincorporation relief This relief defers the chargeable gains that would otherwise be subject to corporation tax on the transfer of a business from a company to a shareholder until the shareholder disposes of the asset(s). In 2011, the government asked the Office of Tax Simplification (OTS) to explore the case for a disincorporation relief to remove tax barriers facing business owners who no longer wished to operate through a limited company. Many businesses were incorporated between 2000 and 2006 to take advantage of favourable rates of corporation tax. The responses to an OTS discussion paper indicated that the key drivers for disincorporation of businesses included administration savings, privacy, National Insurance savings for employees (making them partners instead) and symmetry of the tax system. All respondents thought that a narrow relief, holding over any tax charge on goodwill, would be a positive step. Some preferred a wider relief but could see that this would need greater policing and anti-avoidance provisions.

4 hanging horses 4 of 6 04/09/ :17 The OTS recommended a relief to enable a company holding internally generated goodwill, plus land and buildings and machinery and plant used wholly for the trade, to pass [those assets] to an unincorporated structure, with no tax charge arising on the company, and no distribution charge on the shareholders, as a result of the transfer of those assets. As explained below, machinery and plant were excluded from the relief enacted in FA Partnerships The OTS report said the beneficiaries of disincorporation relief would include older companies whose shareholdings no longer reflected the respective time invested by individual shareholders. With a limited liability partnership, which is taxed as an unincorporated entity, profit sharing arrangements could easily be changed, it said. However, the OTS said it did not propose extending disincorporation relief to transfers of trades from companies to LLPs, adding that operating as an LLP does not provide the same level of administrative savings as operating through a partnership or sole trade. Miller told me: The policy reason for disincorporation relief is to allow people to revert to sole trader or general partnership status and reduce the administrative burdens and costs. On that basis, there is no policy reason to allow disincorporation into an LLP because there will be no administrative savings. Since the members of an LLP are taxed individually, there are of course no tax savings on disincorporation of an LLP into a general partnership (ie a Partnerships Act 1890 partnership). But there is also no tax charge on disincorporating from an LLP into a general partnership. That is, the tax code treats both as being transparent for tax purposes, so there is no change in status from a tax perspective in going from an LLP to a general partnership or, indeed, on incorporating a general partnership into an LLP. Consultation HM Treasury said all respondents to its consultation in 2012 favoured a disincorporation relief, claiming that tax is the main barrier to disincorporation. The government wanted to allow eligible businesses greater flexibility to choose the most appropriate legal structure in which to operate. The new relief, to run for five years from April 2013, would: allow a company to transfer goodwill and an interest in land to its shareholders so that no corporation tax charge on the company arises on the transfer; not extend to tax charges on the shareholders that might arise where, for example, the assets are distributed; and apply to companies with qualifying assets not exceeding 100,000. The qualifying assets would be limited to goodwill and land and buildings used in the business. Plant and machinery, which was unlikely to give rise to a capital gain, would be excluded. The OTS proposal for a time limit would enable the government to review the relief in five years to see if it is meeting its objectives and is still needed. The relief

5 Changing horses 5 of 6 04/09/ :17 HMRC provides general guidance on disincorporation relief [1], and there is detailed guidance in the Capital Gains Manual at CG65800 onwards and the Corporate Intangibles Research & Development Manual at CIRD FA 2013, s 58 to s 60 provide that a claim to disincorporation relief may be made when a company transfers its business to some or all of its shareholders, the transfer is a qualifying business transfer, and the transfer date (determined by s 58(3)) falls within the period of five years from 1 April 2013 to 31 March There is no requirement for the company to be struck off or dissolved. There is a qualifying business transfer if conditions A to E, set out in s 59, are met. Broadly, these conditions are as follows. The business must be transferred as a going concern, together with all of the assets of the business or all of those assets other than cash. The total market value of the qualifying assets of the business, ie goodwill and land not held as trading stock, is no more than 100,000. The market value is the price that the asset might reasonably be expected to fetch on an open market sale. All of the shareholders to whom the business is transferred are individuals, including individuals who are members of a partnership other than an LLP, and each of them held shares in the company throughout the 12 months ending with the business transfer date. A claim must be made jointly by the company and all of the transferee shareholders within two years of the business transfer date, and is irrevocable. Broadly, the effect of disincorporation relief is to defer a capital gain until the shareholder disposes of the asset. This is set out in new TCGA 1992, s 162B and s 162C and CTA 2009, s 849A. The disposal and acquisition of each qualifying asset transferred (other than post-fa 2002 goodwill, see below) are deemed to be made for a consideration equal to the lower of: (a) the sums allowable as a deduction to the company, under TCGA 1992, s 38, on the disposal; and (b) the asset s market value. This is illustrated in Mrs A and A Ltd below. Post-FA 2002 goodwill If post-fa 2002 goodwill is transferred, new CTA 2009, s 849A applies and the transfer is treated as being at: the lower of the tax written-down value of the goodwill and its market value, if the goodwill has been written down for tax purposes; or the lower of the cost of the goodwill and its market value, if the goodwill is shown in the balance sheet but has not been written down for tax purposes; or nil, if the goodwill is not shown in the balance sheet (for example because it MRS A AND A LTD Mrs A has owned shares in A Ltd for five years. A Ltd s qualifying assets are land worth 50,000 with a base cost of 20,000 and pre-2002 goodwill worth 25,000 with a base cost of nil. The business is transferred to Mrs A and a joint claim for disincorporation relief is made. The effect of s 162B(2) is that disposal and acquisition of the land are treated as made for a consideration of 20,000, and the disposal and acquisition of the

6 hanging horses 6 of 6 04/09/ :17 has been generated internally). HMRC provide examples of the operation of these rules at CIRD43150 to CIRD Shareholders goodwill are treated as made for a consideration of nil. Source: HMRC Capital Gains Manual at CG65840, example 1. Each company shareholder will then take on a fraction of the base cost corresponding to his or her percentage ownership of the asset. There is no relief against tax charges that might apply at shareholder level. The Treasury s response document said: Many of the businesses at the smaller end of the spectrum may not face a shareholder charge at all. For example, if the company is wound up, the capital gains tax annual exempt amount might cover some or all of the capital gain. And if the assets are distributed as income, there will be no additional tax charge if the shareholders are basic rate taxpayers. However, HMRC s guidance at CG65800 reminds shareholders that they may still be liable to income tax or capital gains tax on the transfer of assets to them by the company, where, for example, the asset is distributed or transferred below market value. Uncertainty The decision whether to disincorporate a business will not be an easy one, and the 100,000 limit will give rise to uncertainty in some cases. Estimates of the market value of goodwill, and the proportion of businesses that would like to disincorporate with or without the relief, were cited as key areas of uncertainty around costing of the measure at Budget However, the relief will be welcomed by some business owners wishing to reduce the burden of administration. As is the case with incorporation relief, capital gains are not the only issue and attention to detail will be important. Back to top Categories: Business [2] Capital Gains [3] Corporation Tax [4] Tax Topic Tags: Comment & Analysis [5] [6] [6] [6] [6] [6] Source URL: Links: [1] [2] [3] [4] [5] [6]