In a previous article we saw how the Government spoilt everyone’s fun by abolishing corporate tax relief on goodwill when acquiring a business. But there may be a silver lining to our goodwill cloud, though how long this will last remains to be seen.
(This article can be downloaded in pdf format at Academia.edu.)
At the end of the previous article, there was a question to ponder for those who like little puzzles. That question is restated here:
“Does the loss of the tax deduction for purchased goodwill have any adverse implications for the IP rollover rules?”
We shall now investigate this matter further. We shall find that far from having an adverse impact on IP rollovers, the new rules on goodwill yield an unlooked for benefit:
When IP is sold and the proceeds reinvested in other IP, the tax is deferred, but is paid in installments over the lifetime of the new asset. However, when the second asset is goodwill, the tax is paid at the end, when the business is sold.
We shall now see why this is the case.
(In this article we shall use the term IP to cover all intangibles including goodwill as well as intellectual property).
A recap on the IP rollover rules
Recall that a rollover is a means of deferring tax when a business asset is sold and replaced with another. The idea is that since the sale proceeds have been reinvested, the tax doesn’t become due until the second asset is sold and the funds become available to discharge the liability.
The way in which rollover relief is given is that the sale price of the old asset and the cost of the new are both reduced by “the amount available for relief.” If all the sale proceeds have been reinvested, this is normally the sale proceeds (realisation) less the cost of the old asset1. We shall assume this to be the case in the example given below.
The consequences of a reduction are as follows:
- An immediate tax charge is triggered, but this is limited to clawing back any tax relief already claimed in respect of the old asset;
- The remainder of the tax is deferred, being effectively paid in installments over the economic life of the new asset;
- This is a consequence of the fact that the cost of the new asset has been reduced. A reduction in cost means lower tax deductions than would have been the case if rollover relief hadn’t been claimed.
Example of how an IP rollover works
We shall use some of the numbers in the example from our previous article on IP rollovers.
For the old asset we shall assume:
- The original cost is £7m;
- The tax written down value is £5m – in other words, at the time of the sale, the company has received £2m worth of tax deductions;
- The sale price is £10m – and therefore the taxable gain is £5m, being the excess of the sale price over the tax written down value.
For the new asset assume:
- The purchase price is £12m;
- We further assume that this asset has a useful economic life of 12 years. This would normally give rise to an annual tax deduction of £1m.
Since all the sale proceeds have been reinvested, the amount available for relief is the excess of the sale proceeds over the original cost:
Now let us see what the effect of this reduction is for both the old asset and the new.
First, the tax liability on the old asset is recalculated:
A tax charge of £2m, being the amount of relief previously obtained. This leaves a remaining £3m which has not been brought into the tax net.
For the new asset, we find that the annual tax deductions must be revised:
So instead of deducting £1m per year, the annual deduction is reduced to £0.75m, or, stated another way, the company’s annual profit is boosted by £0.25m. Accordingly, the reduction of £3m in taxable profits in respect of the old IP is balanced by an increase in profits contributed by the new IP.
Note that £0.25m x 12 = £3m. In other words, the tax on the £3m is in effect being paid over the life of the new asset.
But we can’t claim a tax writedown for goodwill anymore!
Since tax relief is no longer available, a company is worse off in tax terms compared to the position before 8 July 2015 when the new rules came into force. However, this fact is not relevant to our investigation. The relevant question to ask is:
After 8 July 2015, what is the tax position if the company rolls over the old IP into purchased goodwill, and how does this compare with the position where no rollover takes place?
Let us go through the legislation again to find out what the calculation looks like, using the same numbers as before.
The legislation tells us to deduct the amount available for relief from the sale proceeds of the old IP and the cost of the new. We still have a figure of £3m as before, and the tax calculation for the old IP is exactly the same. So is the calculation for the new IP – the goodwill – except for the very last line of the table.
As we know by now, no deduction is allowed for goodwill. But this is the case irrespective of whether or not a rollover claim is made. Unlike the first example, the £3m reduction in taxable profits isn’t balanced by a corresponding decrease in tax deductions on the new IP – because for goodwill, there were never going to be any deductions to begin with. As a consequence, rolling over into goodwill doesn’t contribute towards the increase in profits that is necessary for the deferred tax to be collected on an installment basis.
So when does the tax become payable?
When the goodwill is sold of course!
However, in order for the deferred tax to be recovered, the price paid for the goodwill must be at least £12m. Since we are no longer permitted to write down the goodwill for tax purposes, the profit is calculated by deducting the adjusted cost of £9m2. Note that the new rules only treat losses as non-trading expenses3 – so if the profit would normally be treated as a trading receipt, it remains a trading receipt.
But what would be the case if we sold the goodwill for £9m instead? This could still amount to an economic profit, for the company would still have written down its goodwill in its accounts. However, no tax is payable on this profit since sale price equals tax cost. The “loss” of tax is not a real loss – since relief has been denied for the goodwill writedowns, the tax has effectively been paid. But the deferred tax that was rolled over into the goodwill – all of it is gone.
How long will this last?
So now you know what to do!
The above result is a direct consequence of the new rules forbidding companies from claiming tax relief on goodwill writedowns when buying a business. When rolling IP into goodwill, the deferred tax cannot be collected because the mechanism for doing so is missing. The result is that the tax is paid not in installments as would normally be the case, but when the goodwill is realised on a sale of the business. The position is exactly the same as would have been the case for capital asset rollovers.
But how long will this last? Will there be further legislation seeking to collect the deferred tax on the same installment basis that would have applied before the rules were changed?
Only time will tell. For now, there is a small silver lining to the goodwill cloud – but as with all English summers, it is only a matter of time until it starts raining again!
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