Use preference shares to ‘turn on’ BADR for goodwill on incorporation?
11th September 2023
Posted in Articles, Business Asset Disposal Relief by Forbes Dawson
Before changes in the 2015 Finance Act, it was fairly common for sole traders and partnerships to sell their trade and assets (including goodwill) to a new company and pay only 10% tax on any gain. This was possible because a sale of goodwill to a connected company could benefit from Entrepreneurs’ Relief (ER) which is now called Business Asset Disposal Relief (or BADR). The changes stopped ER applying to a sale of goodwill to a connected company. However, there are no similar restrictions when shares in a trading company are redeemed by a shareholder.
Preference shares and section 162 incorporation
A ‘section 162 incorporation’ works by a sole trader or partnership transferring all their business to a company in exchange for shares. To the extent that shares are comprised in the consideration then any gain from the business disposal can be deferred into the cost of the shares to be crystallised when the shares are disposed of. After the shares have been held for two years, then providing other BADR conditions have been met (which they usually will have been for trading companies) then BADR should be available for any disposal events. The section 162 relief can apply for any shares which are issued in a company (and not just ordinary shares). Therefore, it should be possible for a significant part of the consideration to comprise of preference shares.
Example
Hannah and Paul run a florist business which has a goodwill value of £2m. On 1 September 2023 they sell this business to a company for the following share consideration:
1. 20 £1 ordinary shares (10 each).
2. 1,999,980 £1 redeemable preference shares (999,990 each).
Full section 162 relief is applied on the transfer and so for tax purposes the shares have a nil base cost. Because BADR conditions are met after two years then any preference share redemptions from 1 September 2025 should qualify for BADR. For example, a £500,000 redemption should trigger capital gains tax of £50,000.
Also, it should be possible for Hannah and Paul to extract funds on an annual basis to use their capital gains tax annual exemptions (although this has been cut to £6,000 for 2023/2024 and will be further cut to £3,000 from next year).
Forbes Dawson view
Given the fact that the BADR lifetime allowance was cut to £1m in 2020, larger businesses with other chargeable assets may not be affected so much by the ‘goodwill restriction’. I am thinking here particularly of businesses which may have large gains on trading properties. However, the use of preference shares will in many circumstances provide welcome flexibility for the individuals in their new shareholder roles.
