Goodwill - when a rat is a dog
16 May 2007 in Capital gains, Case law The trend in recent years for the incorporation of sole trades and partnerships has often displayed the sale of goodwill by the proprietors to the new company.
Free, separable goodwill (rat goodwill) is capable of recognition for tax purposes and is, therefore, saleable, whereas personal goodwill (dog goodwill) attaches to the proprietor, his skills and personality, is not recognised as separable and is, therefore, incapable of sale.
Where goodwill has been sold (usually producing a capital gain and a credit loan balance to the erstwhile proprietor) but is more dog than rat, there will have been no recognisable asset capable of sale to the company and the consequences of the purported transaction will fall to be re-analysed. Typcially, this will involve the cancellation of the capital gain arising to the sole trader or partner, and taxing the price payable as either a distribution or earnings.Whilst HM Revenue & Customs are attracted towards the reclassification of earnings, which are thereby liable to not only income tax but, also, to national insurance contributions, the validity of such an approach is questionable in a straightforward incorporation scenario.
It should not be overlooked that it might be possible to seek to void the transaction ab initio on the ground that the company acted ultra vires in the manner in which it entered into the contract. In which case, the entirety of the transaction would fall to be reversed, with any purchase monies already paid by the company still belonging in equity to the company. Often, this route produces the least painful outcome to the proprietor who mistakenly thought his dog was a rat.
The Revenue published their views on the inappropriate recognition of goodwill in April 2005 (Tax Bulletin 76).
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