The CIOT have been in discussions with HMRC in relation to the valuation of goodwill in trade related properties. They kindly let me join in.
HMRC’s current view is that the only realistic way to value a trade related property is to estimate the profits that can be generated from the property by a reasonably efficient operator (REO) carrying on the same type of business from the premises, capitalise such profits and deduct the value of chattels (and any other assets that the REO needs to operate the business).
But doesn’t that value the business, not the property? No, it doesn’t value the business; it values a business. The business that the REO would carry on from the premises would be the same type of business as the actual business but might well operate differently from it.
But surely the value is still not the value of the property; it is the combined value of the property and goodwill? That depends on what you understand by goodwill. When I first studied accountancy I was told that it is the value of the super-profits that can be generated from the business. If that is right, the profits of the REO do not include goodwill because all that he will generate is the basic profits that anyone can make from running the business. Goodwill is not defined for tax purposes, with one exception namely CTA 2009, s 715(4) says that for the purpose of the intangible fixed assets regime “goodwill has the same meaning it has for accounting purposes and includes internally-generated goodwill”. That is not particularly helpful as goodwill is not defined anywhere for accounting purposes. The nearest UK GAAP comes to a definition is in FRS 10, which does not contain a definition of goodwill but does define “purchased goodwill” as the difference between the cost of an acquired entity and the aggregate of the fair value of that entity’s identifiable assets and liabilities, i.e. it does not seek to put a value on goodwill but merely looks on it as the excess price the business is sold for over the value of its identifiable assets. That is not a very satisfactory definition if one is seeking to identify what goodwill is. The FRS has no need to do this as it is simply concerned with reflecting that excess cost in financial statements. There is no definition of internally-generated goodwill, but the FRS does not need to identify that asset as it forbids its being recognised in the accounts.
Does HMRC’s approach mean that the goodwill in a property-related business is a different animal to goodwill in any other business? Not necessarily. It depends on the business. With a retail shop for example the value of the shop reflects the rent that an occupier can be expected to pay, and that in turn is probably a function of the profit that a reasonable efficient retailer can expect to generate from trading at the shop. My recollection of basic economics is that profit is the reward for risk, that rent is the reward for land, salary the reward for labour and interest the reward for capital. Provided that the profit that a reasonably efficient operator can be expected to generate is struck after recognising the reward for those other elements, it ought not to matter unduly which of them is taken as the base to capitalise. For businesses that do not need a location, goodwill often represents the value of something else. For example, goodwill of an accountancy practice depends on the customer list and that of a consultancy business on the employee’s contracts.
So why isn’t a shop valued by reference to the profits that a reasonably efficient operator can generate? Firstly shops can be readily used for a number of different trades. The value of a shop to a greengrocer may be different to that to a stationer or a toy retailer, so the value is not directly tied to the trade carried on there. Secondly shops are often sold separate from the business carried on whereas this rarely, if ever, happens with trade-related properties, so there is a real open market for shop premises but there is no actual open market for trade-related premises. Such businesses are virtually always sold as going concerns.
My client has told me that the valuer has given him a figure for goodwill? In most cases you will find that he has not. What he would probably have told the client is that the value of the property in its use in the business is X but its value if the business had ceased would be Y and the client has assumed that the difference between the two figures must be the value of the goodwill. Alternatively the client may have obtained a valuation of the property from one person and a valuation of goodwill from someone else who is not familiar with the fact that the value that a surveyor will provide for a trade-related property should already reflect the value of the part of the profits that a reasonably efficient operator could generate as such profits are already reflected in the property value.
But surely some trade-related properties are sold without the trade; for example currently a lot of former pubs are sold to people who want to convert them to residential use? Yes, but that is not what your client will have sold. Logically the price that an owner-occupier is prepared to pay to acquire a business, the premises of which are designed or adapted to his specific trading needs, should always exceed the price that someone who wants to change the use of the premises will be prepared to pay if that change of use will require substantial conversion costs. Where this does not apply the obvious inference is that the business is a liability and can have no goodwill value.
The figure that HMRC are putting forward for goodwill seems unreasonably low; how can that be? It may reflect the reality! HMRC say that (ignoring the cost of the equipment) the price at which a newly built but fully equipped nursing home can be sold at the current time is virtually the same as the value of an operational nursing home. This suggests that, unless there is something special about the nursing home, it has no goodwill as no one is prepared to pay extra for possible super-profits. It is well known that there is a large oversupply of public houses, so in most cases there may well be in reality no goodwill in a pub either.
My client’s sale agreement allocates the price between property and goodwill. It was an arm’s length sale so how can HMRC refuse to accept the split that was agreed at arm’s length? HMRC’s view is that what was sold is the package and that the arm’s length price is the price of the package. They are not bound by the apportionment agreed where it is unreasonable on the facts (Capital Gains Tax Manual, para 14773, E V Booth (Holdings) Ltd v Buckwell 53 TC 428).
What should I do about cases that are under enquiry? HMRC are seeking to settle them but they are only likely to do this if you accept their basis of apportionment. Ask them what assumptions they are making about the profit that an REO would make and consider whether these reflect the reality of your client’s business. If not, try to get HMRC to adjust their REO’s profit figure to reflect it.
What if I think that HMRC’s approach is wholly unreasonable? You of course have a right of appeal to the First-tier Tribunal. You could seek to challenge HMRC’s valuation basis. However, as this reflects the RICS Guidance Note GN1, you are likely to have difficulty in finding a property valuer who is prepared to appear as an expert witness to support a different approach unless there is something unusual about your case. It is important to realise that this is not simply HMRC trying to get as much tax as possible. The HMRC approach is actually the Valuation Office Agency (VOA) approach and the VOA approach is the RICS approach. The International Valuation Standards Council (IVSC) standards also recognise that Trade Related Properties need to be valued differently from other properties and their approach (“the value of such property represents the trading potential”) is similar to the RICS approach, although their methodology is not identical.
What are trade-related properties? Neither the VAO nor the RICS has produced a list. It is any property where the property is designed or adapted for the specific needs of an individual trade, it would need substantial expenditure to convert it for use in a different trade, and, unless the trade has been discontinued, it is abnormal for the property to be sold without the trade being taken over by the purchaser. Examples are pubs, hotels, care homes, nursing homes, petrol stations, restaurants, casinos, cinemas and theatres. The essence of such a property is that it is designed or adapted for a specific use and the resulting lack of flexibility means that the value of the property interest is normally intrinsically linked to the returns that an owner can generate from such use.
Aren’t apportionments for tax purposes normally made on an A over A + B basis; why should this be different? Because the HMRC view is that B is not capable of being independently valued. It is what is left after deducting A from the value of the business. As that attributes the whole of the marriage value to B (which is not liable to SDLT and in appropriate cases attracts the corporation tax intangible assets regime), that is likely to be beneficial to your client.
Are HMRC right? Maybe! But a lot of people – including I believe some partners in major firms of surveyors – do not agree.
The starting point must be the legislation. For capital gains tax this is section 52, TCGA 1992, which states that any necessary apportionment shall be made of any consideration or of any expenditure and that this must be done on a just and reasonable basis.
For the intangible assets legislation it is s 856, which states, “If assets are acquired together, any values allocated to particular assets by the company in accordance with GAAP must be accepted for the purposes of this Part. If no such values are so allocated, so much of the expenditure as on a just and reasonable apportionment is properly attributable to each asset is treated for the purpose of this Part as referable to that asset. If assets are realised together, so much of the proceeds of realisation as on a just and reasonable apportionment is properly attributable to each asset is treated for the purposes of this Part as proceeds of the realisation of that asset”. Accordingly on an acquisition, there is no requirement for a just and reasonable apportionment if for accounting purposes the company has apportioned the cost between the property value and goodwill in accordance with GAAP.
For SDLT, it is paragraph 4, Schedule 4, FA 2003, which provides that consideration attributable in part to matters making it chargeable consideration and in part to other matters must be apportioned on a just and reasonable basis.
What is just and reasonable must be a question of fact in each particular case. However an apportionment that does not recognise the existence of goodwill at all is unlikely to be just and reasonable, provided of course that the business in fact has goodwill.
The Special Commissioners in Balloon Promotions Limited v Wilson rejected HMRC’s definition of goodwill based on the RICS GN1. They also rejected that of goodwill as an accounting concept and stated that goodwill is a legal concept. As far as I am aware, HMRC do not challenge this analysis. They did not of course appeal the decision. However they say that this is because in Balloon Promotions the parties had agreed the apportionment on alternative bases, so the case could not be authority on how to value goodwill for tax purposes.
Next we came to GN1. There is a difference of opinion between CIOT and HMRC as to the interpretation of GN1. What this seems to us to say is that trade-related properties are commonly sold in the market only as operational entities, so what should be valued is the operational entity. HMRC seem to infer from this that the value of the property is the value of the operational entity less the value of the chattels. CIOT believe that the valuation of the operational entity is the value of the property, goodwill and chattels together and that value accordingly needs to be apportioned in accordance with the relevant tax legislation, however difficult it may be to do this.
The examples that HMRC have given us suggest that under their REO approach the basis of valuation generally adopted does not make any allowance for reasonable proprietors’ remuneration.
Where the apportionment falls to be made in accordance with GAAP, HMRC quote as the basis for their view, FRS 10, para 6 of FRS 7, para 56 of FRS 15 and para 85 of FRS 15. I question the use of these parts of FRS 15 as para 56 is dealing with the revaluation of assets already used in the business and para 85 seems to say no more than if the value and life of the trading potential of a business is inherently inseparable from that of the property, the two cannot be depreciated using different methods.
My view is that the relevant para of FRS 15 is para 6, which states that a tangible fixed asset (such as a property) should initially be measured at its cost. Accordingly an apportionment on acquisition in accordance with GAAP should reflect this requirement. FRS 7 deals with accounting on acquisition. I accordingly believe the cost of the property falls to be determined in accordance with FRS 7. This states that the fair value of a tangible fixed asset should be based on market value if assets similar in type and condition are bought and sold on an open market or on depreciated replacement cost in other cases (para 9). As both HMRC and the RICS say that trade-related properties are not bought and sold in the market (it is an operational entity including the property which is bought and sold); my view is that both the property and the chattels ought to be valued at depreciated replacement cost. FRS 10 states that purchased goodwill should be capitalised and classified as an asset on the balance sheet. It defines purchased goodwill as the difference between the cost of the acquired entity and the aggregate of the fair value of that entity’s identifiable assets and liabilities. I accordingly believe that, under UK GAAP, the value of the operational entity should be arrived at by ascertaining the fair value of the property on its own and of the chattels, both on a depreciated replacement cost basis, and treating the balance of the combined value as goodwill in accordance with FRS 10. This is not just me. My firm’s accounting guru agrees with my analysis.
Where an apportionment needs to be made on a just and reasonable basis, this method of apportionment seems to me more just and reasonable than that adopted by HMRC.
So what should I do? HMRC have a concern that taxpayers are putting forward a goodwill value based on the difference between the value of the operational entity and the value of the building on the assumption that the trade had ceased. I agree with HMRC that this is an incorrect basis.
HMRC accept that the reasonably efficient operator is not the actual operator, and that there is a goodwill value where the actual operator can generate greater profits than those assumed to be achievable by the REO. Accordingly when instructing a valuer to value a trade-related property, it is important to discuss with him the assumptions that he makes in adjusting the profits actually achieved to reflect those that he believes could be achieved by an REO and that he understands what the actual operator does differently particularly what reward he allows for proprietor’s labour and for risk of capital (including personal guarantees). Point out to him what particular features of your client’s business make it different to the run-of-the-mill pub or nursing home (or whatever the business) and what effect that you think that those features have on turnover. The price paid to acquire the operational entity (or for which it is sold) is likely to reflect the trade of the actual operator, not that of the REO. Accordingly it may be sensible to obtain a valuation at the date of the acquisition in all cases, as the difference between the price actually paid and the figure that the valuer believes would be paid by an REO ought to be the minimum value of goodwill, irrespective of what method of apportionment of the overall acquisition cost is adopted.
There are obviously some cases that are a bit out of the ordinary. For example the disused pub that has closed down. HMRC’s approach is that the REO will need a bit of time to rebuild the trade so would pay the fully operational price subject to a time discount. Is this realistic? If I frequent a pub and if it closes down, I look for another. If the first one re-opens under different management I will not go back if I am happy with the new one. Am I unusual? HMRC’s approach seems to assume that the old customers will flock back. And what about a new build nursing home? HMRC say that they sell for roughly the same price as an existing one, but an accountant who specialises in nursing homes has told us that he disputes this.
The feedback that the CIOT has got from preliminary enquiries is that goodwill normally seems to be around 30% of the purchase price of a nursing home. One of the purposes of this article (the other is to make members aware of HMRC’s view) is to ask Tax Faculty members to share with me their experiences in this area.
You can e-mail me at firstname.lastname@example.org. I would particularly like to hear from people who have persuaded HMRC to accept a goodwill value in excess of around 20% of the overall purchase price.