Have changes in Entrepreneurs’ Relief meant that Incorporation has lost its ‘tax appeal’?
From a tax standpoint incorporating your business – moving from being a sole trader to become a limited company – has always been seen as an attractive option.
With the new financial year we have seen the main rate of corporation tax fall to 20% so it would seem that this ‘tax appeal’ makes going down the PLC route an attractive option. However, changes announced in last year’s Autumn Statement have made incorporation lose its lustre for some small businesses. As a result many businesses and individuals who may have been considering incorporating should now pause to decide whether it is still worthwhile.
Entrepreneurs’ Relief: Tax breaks and goodwill
The principle behind Entrepreneurs’ Relief is to reduce the capital gains tax payable on gains arising on the incorporation of a business. It also reduces the rate of tax on certain disposals from 28% to 10%.
Some businesses will find that they are carrying a significant value of “goodwill” – the intangible assets such as reputation, customer relationships, and value of continuing contracts – when they decide to incorporate. It has been the ability to realise this additional value in the business at lower tax rates that has made incorporation particularly attractive, and has caused HM Revenue & Customs (HMRC) to question valuations and even the existence of goodwill in some cases.
However, under the changes announced last December, the goodwill element of the business is now excluded from the assets that qualify for the 10% rate. This part of the gain will now be taxed at the higher 18% or 28% rates instead. The Government has essentially decided that the combination of the 10% tax rate for the business owner, alongside corporation tax relief for the successor company, on a value that is hard to determine with accuracy, amounts to an abuse of tax laws.
Although this is a curtailment of Capital Gains Tax (CGT) and corporate reliefs, these rules, which apply to all business transfers taking place on or after 3 December 2014, are being used to target incorporations that HMRC views as a ruse used by income tax and NIC avoiders. This is because where a business operates as a sole trader or partnership, the individuals are taxed on the business profits at rates that are considerably higher than corporation tax rates.
Recognising goodwill on an incorporation created the possibility of taking profits after a total tax burden of 28%, against a combined top rate of 47% when income tax and National Insurance are considered. For this reason, incorporation has been an attractive option for many. HMRC, however, has not been so keen on the discrepancy in tax rates. Hence the Revenue’s decision to exclude goodwill from being a qualifying business asset, bringing the tax rate down to comparable to a higher rate taxpayer.
Some relief for Entrepreneurs’ Relief
Entrepreneurs’ Relief continues to be available on incorporations – it’s only that the value of goodwill is excluded as an asset. For those businesses whose value is substantially attributable of goodwill, owners will now be heavily hit by a CGT bill if they choose to realize the gains on the other assets.
Indeed, the effect of this restriction of corporate tax relief could lead to a significant drop in the amount of free cash available to business owners, and as a result may put many of them off incorporating.
Incorporation can, however, still be an attractive option. If there is no need or desire to extract all of the cash from a business, or if significant cash needs to be retained to fund the business, incorporation may be worthwhile. This is because in both of these instances, the company actually provides a shelter at a lower tax rate than that afforded to an individual in a sole trade or partnership.
There are other routes to incorporate a business, including exchanging the assets for shares, which do not give rise to a CGT liability but these do not generate the loan account that made it so attractive for many people. In reality, incorporation never was a magic bullet for saving tax, even if some saw it as such. What also shouldn’t be overlooked is the fact that some individuals and businesses just don’t operate well with the administrative requirements that companies bring. Above all, it is these practical considerations that should be weighed against any tax saving that might be achieved through incorporation.
For more insight and advice on taxation, wealth management and the correct form of business structure contact HW Fisher Chartered Accountants private client team.