In this month’s article in his ‘Keep it Simple’ series, Neil Da Costa tackles a topic that features regularly in tax exams and perplexes students: incorporation relief.
When an unincorporated business is transferred to a limited company, the disposal takes place at market value. This creates a large CGT liability for the sole trader. To avoid this, HMRC have introduced s162 TCGA 1992 incorporation relief.
This allows the sole trader’s gain to be postponed until the shares in the company are sold in the future.
Incorporation relief (IR) automatically applies if three conditions are satisfied. These are:
• All business assets transferred to the company except for cash.
• Business transferred as a going concern.
• Consideration wholly or partly in shares.
Consideration wholly in shares
If consideration is wholly in shares, the entire gain arising can be deferred under incorporation relief.
The majority of a sole trader’s assets such as current assets, machinery and cars are exempt assets, and the only chargeable assets are likely to be buildings and goodwill. The deemed market value of the shares is the market value of the sole trader business at the date of incorporation.
Simple example: Jakub
(consideration wholly in shares)
Jakub has been running his surveying business for many years as a sole trader. He is now planning on expanding the business so has decided to incorporate into a limited company. Assume the business is worth £900,000. The only chargeable assets are the office building and goodwill. The gain on the building is £400,000 while the gain on the goodwill is £100,000. All the conditions for incorporation relief are satisfied.
Solution to Jakub
The market value of the shares is the market value of the business – £900,000 and HMRC will automatically apply incorporation relief to the transaction.
This means that the gain arising of £500,000 will be deducted from the value of the shares to reduce the base cost of the shares down to (£900,000 – £500,000) = £400,000 base cost.
Consideration partly in shares and partly in cash
The gain arising due to cash will crystallise immediately. The gain deferred under incorporation relief is restricted to market value of shares/market value of total consideration. The gain crystallising immediately is eligible for business asset disposal relief.
Simple example: Jakub
Once again, Jakub is transferring his business to a limited company but chooses to take cash consideration of £200,000. This means that the deemed market value of shares is computed as a balancing figure (£900,000 – £200,000 = £700,000).
All the conditions for incorporation relief are satisfied.
Jakub has an annual exemption available and has not claimed any business asset disposal relief in the past.
Solution to Jakub (part consideration in cash)
The gain postponed under incorporation relief is restricted to market value of shares/market value of total consideration.
£500,000 x 700,000/900,000 = £388,889.
The base cost of the shares will be £700,000 – £388,889 = £311,111.
The gain crystallising immediately due to cash will be £500,000 – £388,889 = £111,111.
This gain is eligible for business asset disposal relief and will be taxed at just 10%.
Jakub’s CGT liability will be £111,111 – £12,300 = £98,811 x 10% = £9,881.
Election to disapply incorporation relief
The sole trader can make an election to disapply incorporation relief within two years from the tax return filing date. The benefit of the election is it allows the sole trader to maximise the business asset disposal relief claim at the date of incorporation.
If goodwill is transferred to a close company (controlled by 5 or less individual shareholders) business asset disposal relief cannot be claimed.
Simple example: Jakub Same as earlier, Jakub transferred his business to a company with consideration wholly in shares. All the conditions for incorporation relief are satisfied.
Jakub makes an election to disapply incorporation relief.
Solution to Jakub (election to disapply incorporation relief)
The gain on the building is £400,000 while the gain on the goodwill is £100,000 and will crystallise immediately.
The cost of the shares is unchanged at £900,000.
The gain on the building is eligible for business asset disposal relief so the CGT is £400,000 x 10% = £40,000.
The gain on the goodwill of £100,000 is not eligible for business asset disposal relief as the company is wholly owned by Jakub so is a close company.
The annual exemption is allocated to the gain taxed at a higher rate, so the CGT is £100,000 – £12,300 = £87,700 x 20% = £17,540.
The total CGT liability is £40,000 + £17,540 = £57,540.
• Neil Da Costa is a Senior Tax Lecturer with Kaplan in London. He is the author of Advanced Tax Condensed, which summarises the entire syllabus using memory joggers. He is a passionate advocate for mental wellness and diversity.