Converting from a sole-trader or partnership arrangement to operating through a company can produce immediate tax savings. However, HMRC has various powers which can claw them back. When might these be used?
Transferring a business – anti-avoidance
At one time you could sell your unincorporated business to a company which you wholly or partly owned and pay capital gains tax (CGT) at just 10% on any gain (up to £1 million) you made from the transaction. In effect, this meant you were extracting future income from your business at a low tax cost. This tax-saving strategy was eroded by anti-avoidance rules introduced in December 2014. The effect of these is to increase CGT to the normal rates of up to 20%. But there are other less well-known anti-avoidance rules which can increase the tax rate significantly more.
Selling your income
HMRC is turning to obscure anti-avoidance rules more frequently to impose income tax rates of up to 45% instead of CGT. These rules can bite if you’re a key or the only income generator for your business and you sell or transfer it to a company which you will generate income for. The types of business at risk are professions or vocations such as accountants, lawyers, architects, medical practitioners, artists, writers, etc.
HMRC use of the anti-avoidance rule
HMRC can only use the anti-avoidance rules if both the following conditions apply to the transaction:
- it’s made to “exploit the earning capacity of an individual in an occupation”; and
- one of the main objects is to avoid income tax.
Tip. Apart from having to demonstrate that both conditions apply, the rules only affect payments to the extent that they relate to your personal future earning capacity (goodwill). They can’t apply to payments for other assets. Example. John is a freelance consultant. He employs two assistants. He sells his business to a company which he owns. It pays John £400,000 for equipment, the lease of the trading premises, and the value of goodwill (essentially future profitability).
The anti-avoidance rules can’t apply to the payment for the equipment or the lease. Neither can it apply (assuming the anti-avoidance conditions are met) to the value of the goodwill apart from that directly resulting from John’s future ability to generate income/profit. Therefore, they won’t apply to the value that John’s assistants add to the business.
Transfer of personal goodwill
In our example HMRC might claim that “personal goodwill”, i.e. the value of John’s expertise and reputation, can’t be transferred to the company. While true to some degree HMRC’s view is too narrow. For example, professional firms (accountants, solicitors, etc.) are often sold when, say, the practitioner retires. The new owner pays for the client list even though the outgoing owner will not continue in the business.
Tip. Challenge any attempt by HMRC to apply the anti-avoidance rules. For them to apply it must able to show beyond doubt that the conditions are met and establish how much less the business would have been worth without your future input. You can refer to the arguments in Villar v HMRC 2018 where the First-tier Tribunal refused to accept that the anti-avoidance rules applied to a leading surgeon who incorporated his business.
This article has been reproduced by kind permission of Indicator – FL Memo Ltd. For details of their tax-saving products please visit www.indicator-flm.co.uk or call 01233 653500.