Incorporation Relief

Posted on May 2, 2023 - News

A client wants to incorporate their existing sole trade and so I am considering tax efficient ways of achieving this, including Incorporation Relief. The trade has various debts including bank loans and I would be grateful for clarification as to how these interact with the Incorporation Relief.

As you mention, there are various ways to incorporate a trade, a gift, a sale for consideration or a sale for shares. Ideally, there should be a formal deed of gift or contract for sale and so legal advice will be required. It may be possible to rely on a “de-facto” transfer, but this will be dependent on the actual facts involved. See the recent First Tier Tribunal case of 2 Green Smile Ltd & Anor v HMRC [2023] UKFTT 15 (TC) which held there had been a “de-facto” transfer from a partnership to a company.

Incorporation Relief under s162 TCGA 1992 states that all assets of the business, other than cash, must be transferred wholly or partly for shares. If the entire consideration is shares, full relief will be due – but, as noted below, cannot exceed the value of the shares being acquired. If only part of the consideration is shares, only part of the gain will qualify for relief.

Incorporation Relief = Gain x Value of Shares/Total Consideration

The legislation is silent on liabilities and so the taking over by the company of such liabilities would ordinarily be non-share consideration. However, HMRC’s Extra Statutory Concession D32 states that HMRC are prepared not to treat the transfer of business liabilities as consideration. As this is a concession, it should be claimed not assumed. See CG65745 for HMRC’s guidance. If the company repays or refinances the liabilities, this is not the same as transferring the labilities which will require some form of novation and so is a particular complication involved with Incorporation Relief where business liabilities are to be transferred.

I mentioned above, that even with full Incorporation Relief, the gain being rolled over cannot exceed the value of the shares. This is confirmed by HMRC at CG65765 and can be illustrated by the following example.

A sole trader incorporates his business, transferring goodwill of £300k and trade debts of £150k. What Incorporation Relief is available?

With ESC D32
Gain x £150k/£150K = 100% of the gain is within Incorporation Relief.

Without ESC D32
Gain x £150k/£300k (shares and debts) – 50% of the gain within Incorporation Relief.

This only tells us half of the story as the gain held over cannot exceed the value of the shares and so the quantum of the gain on the disposal of the goodwill needs to be considered. The value of the shares here is prima facie £150,000 (assets less debts). If we consider two different costs for the goodwill, £0 and £200k, the results are as follows:

Zero Cost – Gain of £300k
With ESC D32, although 100% of the gain can be rolled over, the value of the shares is only £150k and so that is the maximum amount of Incorporation Relief available. The balance of the gain, £150k, remains chargeable to CGT.
Without ESC D32, only 50% of the gain can be rolled over i.e., £150k. As the shares are also worth £150k, the result is exactly the same as with ESC D32.

£200k Cost – Gain of £100k
With ESC D32, the entire gain of £100k can be rolled over into the £150k value of shares, leaving the net cost of the shares as £50k.
Without ESC D32, only 50% of the gain, £50k can be rolled over leaving the net cost of the shares as £100k but with the remaining £50k of the gain being chargeable to CGT.

There may be other issues with an incorporation, such as HP contracts or leasing agreements that cannot be transferred to the company without the permission of the HP or leasing company. For Incorporation relief, the business may include a car that if transferred to the company would mean a car benefit would arise to the director.

Each incorporation should be considered on the particular facts involved and it may well be that Incorporation Relief is unsuitable.