An act of goodwill

10 February 2009

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In the current economic climate, the focus of attention seems to fall mainly on struggling businesses. But not all businesses are suffering to the same degree. For those in a stronger position, now may be a good time to pick up the business of weaker rivals at a good price. If you do, then you may be able to take advantage of a fairly useful tax break.

Since 2002, if a company acquires goodwill from a third party, then it is entitled to a deduction against its corporation tax profits for the amount of goodwill written off.

A company can write off this goodwill over a number of years and claim a deduction against corporation tax. In perhaps as little as four years, the full amount paid for goodwill can be offset at a saving of between 21% and 28%, depending on the rate of tax paid.

For a company, this makes it far more sensible to purchase the goodwill and other assets of a business, rather than acquire shares in a third party company where there would be no such deduction.

What is allowed?

Suppose Company A negotiates a deal to buy the goodwill of a business from Company B for £300,000 and incurs legal fees of £20,000 in the process.

The amount A can set against its corporation tax profits is the full amount, £320,000. The legislation defines expenditure for this purpose as including "expenditure for the purpose of acquiring or creating or establishing title to the asset". The legal fees are incurred in acquiring the asset, so are included.

Another company, Company C, disputes A's title to the goodwill and a legal battle ensues. A incurs a further £70,000 of legal fees before the matter is settled out of court in A's favour.

Again, A is able to claim a deduction for the additional expense. Expenditure on an intangible asset (such as goodwill) includes "expenditure for the purpose of maintaining, preserving or enhancing, or defending title to the asset".

That's all very well, but suppose C had won and A was unable to use the goodwill. It has incurred expenditure of £390,000 in total, but it can no longer operate that business.

Once again, the deduction would be allowed. "Expenditure" is defined as "including abortive expenditure" so even if C were to win, A can write off the amount it has spent.

So, if a company negotiates to buy the goodwill of a business and loses, it can still write off its expenditure against corporation tax in line with accountancy practice.

If, however, the same company negotiates to buy the shares of the other company instead of the business and loses, it cannot claim anything. The expenditure is capital, so there can be no deduction against profits and there is no asset acquired, so no capital loss either.

And the logic for this? Well, if you ever work it out, let me know.

This is all very well for companies, but a sole trader or a partnership cannot claim such a deduction for acquiring the goodwill of another business. So, how can they benefit?

Suppose Harry set up a business to sell souvenirs when he heard that London was to host the Olympic Games. He is a sole trader and acquired the right to use the Olympic logo on merchandise. Business is doing well in the run-up to the games and Harry decides that it is time to incorporate his business, so he transfers the goodwill and other assets to his company Olympic Memories Ltd. He reckons his goodwill is worth £100,000.

The effect of transferring the goodwill to the company at full value is that Harry has a capital gain on the full amount, but with the benefit of entrepreneurs' relief he pays tax at only 10% (£10,000).

Surely, since Harry is connected to the company, he cannot write off the goodwill?

Actually, yes he can - because the goodwill was created after the legislation was introduced in 2002, he is able to deduct the amount paid from profits and so, over the course of the next few years, reduces the corporation tax bill by £100,000 at a minimum of 21%, or as much as 28%.

So, for the cost of tax of £10,000 paid by Harry, his company benefits by £21,000, at least. At the same time Harry can draw the whole £100,000 from his company with no further tax. Which is cheaper than a salary or a dividend.

Note: This only applies to the transfer of goodwill created or acquired after 1 April 2002. If the business was around before that date, it won't work. However, as time passes, more businesses will be able to benefit in this way from incorporating.

It is not often that HMRC are given to acts of goodwill, but this is one instance where it is worth looking into.

About the author

This article was contributed by David Young, Chairman of the UK200Group Tax panel. His long experience in tax includes spells as a District Inspector in the Inland Revenue and on the other side of the fence in both industry and consultancy.

UK200Group is an association of separate and independently owned and managed accountancy and lawyer firms, and as such each has no responsibility or liability for the acts or omissions of other members. UK200Group does not provide client services and it does not accept responsibility or liability for the acts or omissions of its members. www.uk200group.co.uk

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