Incorporation relief (IR): Conditions and problems

16 August 2022

Importantly the relief applies automatically if the conditions are met, although an election can be made to disapply.

advice : Tax

Businesses become companies for many reasons. The main reason used to be tax savings. However, the differences in tax rates between the self-employed and the company mean that unless the profit is in excess of approximately £50,000, then the increased time spent on administration as a company might not make it worth incorporating for tax savings only.

When the decision to incorporate has been made, the transfer is subject to Capital Gains Tax (CGT) as it involves the disposal by the sole trader or partnership owner of chargeable business assets to the company. However, the charge can be deferred using Incorporation Relief (IR). 

To take advantage of IR relief, the business must be transferred as a going concern, all the assets (apart from cash) must be transferred and consideration for the transfer must consist wholly (or partly) of shares in the company issued to the sole trader. 

The ownership of land or buildings is transferred into the name of the company (if the property is to be subject to a mortgage then it will require a re-mortgage).

The disposal is usually taking place at ‘market value’ on the basis that the parties are ‘connected persons’. The market value is the amount that the property might reasonably expect based on the open market. A company is ‘connected’ to another person if that person has control of the company or if persons connected with them have control. 

Under an IR claim, the CGT charge is ‘rolled over’ until the person transferring the business disposes of their company shares. The rolled over gain is then deducted from the cost of the shares such that the gain on sale, comprises the amount of gain rolled over and the gain made on the increase of the final sale price over the market value. If part of the consideration for the transfer is in cash, then the amount of gain rolled over is reduced proportionately.

Importantly the relief applies automatically if the conditions are met, although an election can be made to disapply. A claim may not be possible because not all of the business assets are to be transferred, or because the exchange for shares means that the value can only be withdrawn by the sale of those shares and, being a private limited company, the market for those shares will be restricted. IR may also wish to be disapplied should the gain be covered by the annual exemption or if there are losses brought forward available to offset.

IR claim could be refused, when the sole trader or partnership has a loan intended to be transferred to the company. Legislation requires that IR only applies to the extent that the consideration is shares but the taking-on or settlement of a debt is strictly considered for the transfer. The difficulties could arise with the lender where the loan moves from the private clients into corporate hands, with different borrowing criteria. 

If the company were to take out a loan and used that to repay the owner’s personal loan, such consideration is not covered by ESC D32, and the IR would be restricted. In practice, the lender and borrower agree to new refinancing terms on the understanding that the loan will be taken over by the company shortly after. The owner uses the advance to repay their existing debt, enabling the loan to fall within the concession, such that IR is then fully available. 

For more information please visit the official government website.

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