What is incorporation relief?
Incorporation relief (IR) enables a postponement or deferral of a capital gains tax (CGT) charge on the disposal of an unincorporated business by a sole trader (or partnership) to a company in exchange for shares in that company.
The CGT charge arises on chargeable assets (e.g. goodwill, land/buildings of the business) of the business transferred to the company at rates of 18% and/or 28%.
A sole trader may wish to transfer the business to a company for various reasons. A company offers the advantage of limited liability and a possible reduction in the tax charge on profits (e.g. sole trader liable at 45% income tax versus 20% corporation tax payable by the company).
However, on incorporation, the company’s future trading losses cannot be offset against the sole trader’s other income. In addition, although a CGT charge may be deferred, stamp duty land tax may arise on any land transfer.
What conditions need to be satisfied?
To take advantage of IR requires that the business is transferred as a going concern; that all the assets of the business are transferred to the company (possibly apart from cash); and consideration for the transfer must consist wholly (or partly) of shares in the company issued to the sole trader.
Example 1 – Incorporation of a sole trader
Tommy Tiger, a sole trader, decided to incorporate his business.
He transferred all the business assets to his new company Tommy Tiger Limited (TTL) in exchange for an issue of ordinary shares in TTL.
Now, Tommy owns all the ordinary shares in TTL and henceforth the business, which he formerly carried on in his own name, is now carried on by TTL.
How does IR work?
The way in which IR applies is to deduct from the base cost of the shares the aggregate capital gain arising on the assets transferred to the company.
Example 2 - Base cost of shares
Tommy’s sole trader business (see Example 1) was worth £125,000.
On making the transfer to TTL, capital gains on the various assets amounted to £75,000.
Under IR this aggregate gain of £75,000 is deducted from the value of the shares (i.e. £125,000), giving rise to a base cost of £50,000 for the shares in TTL.
The base costs of the assets to TTL are their market values.
Were Tommy to sell the shares in TTL in the future for, say, £250,000 then his capital gain arising on the share sale would be [£250,000 - £50,000] i.e. £200,000.
Example 3 - Partial relief
Tommy’s brother, Harry, also operates a business worth £125,000.
On making the transfer to a new company, Harry Limited (HL), capital gains on the various assets amounted to £75,000.
Unlike Tommy, in exchange for transferring his business to HL, Harry receives cash of £25,000 plus shares in HL worth £100,000.
As Harry did not just receive shares in HL, IR is restricted.
Accordingly, of the aggregate gain of £75,000 only £60,000 [i.e. £75,000 x [100,000/125,000]] is held over.
Incorporation relief applies automatically
If the relevant conditions are satisfied, IR applies automatically.
However, the sole trader can elect for IR not to apply, subject to time limits. One example where it may be advantageous to disclaim IR would be where shares in the company are sold within one year of the incorporation and, as a consequence, entrepreneurs’ relief would be inapplicable (because the shares had not been held for one year).
Value added tax
VAT is not normally problematic on incorporation, as it is usually the case that the transfer is the transfer of a business as a going concern.
Stamp duty land tax
SDLT may be payable on the market value of any transfer of land to the company (this is so whether IR applies or not).
Third party sale or emigration
Where a business is to be sold, the typical scenario is that the vendor wishes to sell shares in a company but the purchaser wishes to just purchase the underlying assets of the business (effectively leaving behind with the vendor any hidden liabilities etc., within the company).
In the case of a sole trader, selling just the assets may result in a large CGT charge being incurred. One possible solution is for the sole trader to incorporate the business (with IR applying) and for the company to then sell the business to the purchaser, in which case no CGT charge arises until the shares in the company are sold.
It may be that a sole trader proposes to emigrate at some point in the future. He might therefore consider transferring the business to a company (IR applying) and, once abroad (i.e. non-UK resident), then disposing of the shares without a UK CGT charge arising.
Whilst IR is a useful relief, care must be exercised on incorporation as to claim it may not always be advantageous.