May 052013

One of the key tax issues when a sole trader or partnership incorporates an existing business is the treatment of goodwill. In particular, can the new company claim tax relief for writing down the goodwill after acquiring the business?

This should be possible for those who started business recently – by which we mean, those businesses set up from 1 April 2002 onwards. But if your business is more established, then we have a problem…

UPDATE From 3 December 2014 it is no longer possible to claim tax relief for internally generated goodwill in line with the accounts when incorporating a business. This is due to the announcement in the Autumn Statement of 2014 restricting deductions for goodwill when a close company acquires a business from an individual or partnership, and the company is related to the seller(s). 

However, the following article is still relevant to the question of when a person becomes entitled to shares in a company that are to be issued to him under a contract.

Why is tax relief important?

Under accounting standards, a company acquiring goodwill as part of the business is required to amortise the cost in its accounts. This impacts the profit and loss statement – ideally, a tax deduction should be available, otherwise there is a mismatch between taxable and accounting profits.

In short, if writedowns aren’t available, the company ends up being taxed on more money that it has earned.

So is it possible? Yes, but…

There’s always a but isn’t there?

Under the intangibles legislation, tax relief is available for goodwill amortisation, either in line with the accounting treatment, or at a flat 4% rate1. Unfortunately, this treatment only applies to goodwill created or acquired after 1 April 2002 (“new goodwill”). Goodwill created before that date – “old goodwill” – is excluded from the intangibles regime until such time that the business is sold to an unrelated third party2.

What is an unrelated party? Broadly, it is a party that has no connection with the seller – someone from “outside the family”. So a corporate group cannot trigger tax relief on old goodwill by transferring the business from one member to another. Similarly, individual sole traders cannot transfer the business to their own personal company. In each case, there is no substantive change in the identity of the business owners. For old goodwill to be brought into the intangibles regime, the buyer needs to be a complete outsider.

Accordingly, the incorporation of a longstanding business is unlikely to benefit from tax relief. This is apparent from the diagram below, showing how a partnership is incorporated. There is no loss of economic control to an outside party – the business owners are simply exchanging their partnership holdings for shares in the new enterprise.

A closer analysis – from Partnership to Company

Incorporation partnership 1

We shall assume that the business takes the form of a partnership3, though the analysis also works in the case of a sole trader. We shall assume there are just three partners and that the business was set up before 1 April 2002. Accordingly, the goodwill is old goodwill and doesn’t automatically qualify for tax relief.

A brand new company is set up to acquire the business assets in consideration for issuing shares to the partners. This is a tax neutral event – any capital gains arising from the business sale are rolled over into the new shares.

But how can the company obtain tax relief? This is only possible if it can be shown that the company is not related to the business owners at the time that the goodwill is acquired.

The key question is: “When do the partners become entitled to acquire the shares in the new company?” It is at this point that the parties become related on the grounds that4:

  • The company is close – broadly under the control of five or fewer people; and
  • By virtue of being entitled to the shares, the partners are participators in the company5.

It is therefore crucial that the goodwill passes to the company before the partners are entitled to their shares. If the goodwill passes at this time or later, all is lost.

It is important that none of the partners are shareholders when the company is first set up. Otherwise, all the parties are related from day one – even before any business agreement is signed. Even a single partner with a single share taints everyone. The shareholding partner is related to the company by virtue of his equity stake. This drags in all the other partners – even though they hold no shares at this stage, they are related to the company through their link with the single equity-holding partner6.

So when do the partners become entitled to the shares?

The answer is normally, when the parties enter into the business sale agreement. But the goodwill also passes at this point, or later, depending on what the agreement says. It cannot pass before the agreement is signed. In other words, it cannot pass before the partners are entitled to their respective shareholdings, and therefore it cannot pass before they become related. Accordingly, tax relief is not available.

This point arose in the case  HSP Financial Planning  Ltd v Revenue & Customs [2011] UKFTT 106 (TC) where the facts were similar to those described above. The company argued that the partners did in fact become entitled to the shares after the goodwill had passed, but the claim was rejected. There were two main arguments:

  • According to the documentation, the goodwill was deemed to have been transferred with effect from the opening of business, even though the business sale agreement was signed later that afternoon. This retrospective transfer was required as a “normal matter of business efficacy”. This argument was rejected – whatever the parties might say, property is transferred when the law says it is – simply backdating the transfer won’t work.
  • The business sale agreement was either a conditional contract, or there was a condition precedent to the effect that the obligation to issue the shares didn’t arise until the goodwill had been transferred. This is not normally the case with a straightforward agreement. The tribunal didn’t accept this argument either – the business sale agreement was a normal agreement, giving rise to mutual obligations, all of which arose when the contract was concluded. So the obligations for the company to issue the shares and for the partners to transfer the business arose at the same time.

Note that it doesn’t matter that the partners are unrelated to the company begin with, or only became related as a consequence of the business sale. The crucial question is whether they are related at the time the goodwill is acquired – which is in accordance with the words used in the legislation.

A point of explanation on the conditional contract/condition precedent argument. This was perhaps the best shot for the company. There is a distinction between:

  • A normal contract, where the parties are under mutual obligations to perform their respective duties from day one; and
  • A conditional contract/condition precedent, where certain obligations – even the whole of the contract itself – don’t even exist until some later specified date.

The distinction is easy to understand in theory, but can be difficult to draw in practice.

For normal contracts, the parties’ obligations exist from the date the contract is made. It may be that there are various dates set for those obligations to be performed, but no one can deny that the obligations are live and kicking from day one.

So if, after the agreement is signed, the company says that it won’t issue the shares after all, this constitutes a breach of contract. The partners are entitled to the remedy of specific performance – they can go to a court to compel the company to deliver.

It doesn’t matter that the company doesn’t actually have to issue the shares until a few days, weeks or even months after the agreement is signed. The time for performance may not have arisen, but the actual obligation to perform exists from day one, and the company breaks it by saying that it isn’t going to go ahead with the deal.

This is not the case with a conditional contract/condition precedent. The obligation doesn’t come alive until a later specified event, or date set out in the agreement. If, before that event or date, the company reneges, specific performance doesn’t automatically follow – it is not possible for a court to enforce an obligation that isn’t there.

As stated previously, the distinction can be difficult to draw in practice. In theory, it might be possible to draft a contract in the appropriate manner, but a successful argument is likely to be tricky. In the HSP case, the company argued that there was a “scintilla” of time between the goodwill passing and the obligation to issue the shares. Arguments based on there being a split second between two events are always going to be difficult.

Implications of the HSP case – what if there were six hundred partners instead of five?

In the HSP case, the parties were related because the partners were participators in a close company. “Close” normally means “small” – companies with five or few participators. It is tempting to see this as a result that only applies to small businesses – there were only three partners in the HSP case (which is why our example only had three partners).

So what if there were ten partners, or even one hundred? Suppose we are talking about incorporating a City law firm or accountancy practice (assuming that the relevant regulatory rules permit this). Surely, tax relief for goodwill amortisation should be available for larger businesses?

Surprisingly, the answer is no. If one looks closely at the above argument, one finds that the company is a close company no matter how many partners there are. The actual number is irrelevant.

This is because all the partners are effectively treated as one person. For example, take a partner with only a 1% partnership share. This person clearly does not control the whole enterprise. But the size of the shareholding he is to receive in the company includes the shareholdings of all the other partners because they happen to be his associates. So, in spite of a 1% share of the business, in tax terms he controls the whole company. And this argument applies to each and every one of the partners, no matter where they are in the pecking order7

Incorporation 2 experiment 3 - font 28

This sounds like a bizarre result. It is even more bizarre when one realises that after the partnership is wound up, the company ceases to be close – the new shareholders no longer have the necessary connection with each other, for the simple reason that they are no longer partners. So tax relief is denied on the basis of a relationship that exists only for the short period of time that it takes to set up the company, transfer the business over and dissolve the partnership.

Yet on another level, the result makes sense. As we mentioned at the beginning, bringing old goodwill into the intangibles regime requires selling the business to an outsider. But this isn’t what incorporation is about. The process of incorporation involves changing the structure of the way in which the business operates, but doesn’t change the identity of the people who own it. In short, this is not a sale to an outsider.

Final point on close companies

It is important to note that a close company participator isn’t simply a shareholder. If this were the case, tax relief for goodwill would in fact be available on incorporation. This is because a person doesn’t become a shareholder until his name is registered in the company’s books8. This is an event that will inevitably take place after the business sale agreement is signed, and therefore after the goodwill has passed.

Unfortunately, because the definition for participator includes people who are entitled to acquire shares, as well as those who already have them9, the parties become related at the wrong moment in time.


HSP Financial Planning Ltd v Revenue & Customs [2011] UKFTT 106 (TC).

Greenbank Holidays Ltd v Revenue and Customs Commissioners [2010] UKFTT 109 is mentioned in the HSP case, a company acquiring a business from a fellow group member attempting to obtain tax relief on old goodwill.

HMRC Manuals on related parties CIRD 45000 – partnerships are covered at CIRD 45200 to CIRD 45270. HMRC’s opinion that the company is close no matter how large the partnership, is found at CIRD45260.

  1. CTA 2009 ss 729-731.
  2. CTA 2009 s 882.
  3. By partnership, we shall include  limited liability partnerships (“LLPs”) as well as general and limited partnerships. An LLP is a corporate vehicle but is taxed as if it were a proper partnership.
  4. CTA 2009 s 835(5)(a), CTA 2010 ss 439, 454(2)(a).
  5. Note that they don’t actually have to become shareholders to be participators – it is sufficient that they have an entitlement to the shares – CTA 2010 s 454(2)(a).
  6. The single shareholder is a participator and his partners are his associates – CTA 2010 s 448(1)(a). Both participators and associates are related to the company under CTA 2009 s 835(5)(a).
  7. Note the wording used here – the single 1 per center controls the company but not the actual business. He cannot unilaterally make any stupid decisions that could be harmful – although he controls the company, so does everyone else.
  8. National Westminster Bank plc v IRC (1994) STC 580 HL.
  9. CTA 2010 s 454(2)(a).
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Satwaki Chanda

Satwaki Chanda

Satwaki Chanda is a tax lawyer with a First Class degree in Mathematics. Called to the Bar in 1992, he is the Editor of Tax Notes.
Satwaki Chanda

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