Self-generated goodwill has to be valued when a business is sold as a going concern, and if it commenced before 1 October 2001, the time-apportionment method of valuation can be used.
One of the assets to which a value is assigned when a business is sold as a going concern will often be self-generated goodwill. Several factors need to be considered when determining the base cost of such goodwill, particularly when it commenced before 1 October 2001.
The questions that are usually asked in relation to self-generated goodwill are the following:
- Is it an asset?
- Can time-apportionment be used to determine its valuation date value when it is acquired before 1 October 2001 and, if so, does it have a cost and when does it commence?
Is it an asset?
The word ‘goodwill’ is not defined in the Act although it is included in the definition of ‘intangible asset’ in para 16.
In Jacobs v Minister of Agriculture 1 Colman J stated that:
‘goodwill is an intangible asset pertaining to an established and profitable business, for which a purchaser of the business may be expected to pay, because it is an asset which generates, or helps to generate, turnover and, consequently, profits’.
Paragraph (a) of the definition of ‘asset’ in para 1 includes:
‘property of whatever nature, whether movable or immovable, corporeal or incorporeal …’.
In CIR v Estate CP Crewe & another2 in relation to the determination of estate duties, Watermeyer CJ said that:
‘what is meant by property is all rights vested in him which have a pecuniary or economic value’.
Since goodwill (whether self-generated or purchased) has pecuniary or economic value and comprises incorporeal property, it is an asset for purposes of the Eighth Schedule.
Can time-apportionment be used to determine its valuation date value when it is acquired before 1 October 2001?
SARS notes in its Comprehensive Guide to Capital Gains Tax (Issue 9) that time-apportionment may be used to determine the valuation date value of self-generated goodwill ‘in appropriate circumstances’. The time-apportionment method is permitted under para 26(1)(c) when the expenditure incurred on the asset before, on and after the valuation date is known. The various time-apportionment formulae are set out in para 30. The main formula is Y = B + [(P − B) × N/(T + N) in which P is the proceeds, B is the expenditure allowable under para 20 before valuation date, N is the number of years before valuation date and T is the number of years on or after the valuation date.
In simple terms, the formula adds the portion of the overall gain (P − B) that relates to the pre-valuation period (N/[T + N]) to the pre-CGT expenditure (B) to arrive at the valuation date value (Y). N in the formula is limited to 20 years if expenditure is incurred in more than one year of assessment before the valuation date. The value of B will normally be nil unless additional businesses were acquired and goodwill was purchased. Self-generated goodwill is a by-product of other expenditure such as staff salaries and marketing expenditure and of other assets such as a building located in a sought-after location, licences and trademarks. Expenditure deductible against income is excluded from base cost under para 20(3)(a), while expenditure on other assets relates to such assets and is not actually expenditure on goodwill 3. Consequently, self-generated goodwill will usually have expenditure of nil for the pre-CGT period unless additional goodwill has been purchased during that period. Since goodwill is indivisible,4 purchased goodwill must be regarded as a cost of improvement under para 20(1)(e).
It needs to be determined when self-generated goodwill was first acquired to determine ‘N’ in the formula. SARS cites various foreign sources in its guide on this question but, unfortunately, they are either unhelpful or in conflict. For example, the UK revenue authority states that the date of creation of an asset is a question of fact based on the evidence available (true, but what evidence?). The case cited from the United States applies the super profits methodology used for accounting purposes. Australia applies the legal concept of goodwill which recognises that goodwill can be present even in the absence of profits. SARS does not state which of these views it supports, and simply concludes that the onus rests on the taxpayer to prove the values of the various variables in the time-apportionment formulae.
It is submitted that both the accounting and legal concepts of goodwill have roles to play when it comes to time-apportionment.
Before 1982, South Africa had no guidance on the accounting treatment of goodwill. In 1982 the Accounting Practices Committee (APC) of SAICA issued Discussion Paper 3 ‘Accounting for Goodwill’, which indicated that goodwill should be amortised over its estimated useful life, not exceeding 40 years, be reflected under Fixed Assets and written down immediately if it became irrecoverable. Currently, the position is that self-generated goodwill is not recognised as an asset because it is not an identifiable resource (see IAS 38 ‘Intangible Assets’).
Purchased goodwill is dealt with in IFRS 3.
The relevance of the accounting concept of goodwill comes into play when it is necessary to determine the market value of goodwill on valuation date under para 26(1) or (2) or when determining the proceeds on its disposal.
On the legal meaning of goodwill, in Caterham Car Sales and Coachworks Ltd v Birkin Cars (Pty) Ltd & another 5 , Harms JA (as he then was) stated the following:
‘Goodwill is the totality of attributes that lure or entice clients or potential clients to support a particular business (cf A C Becker and Co (Pty) Ltd v Becker and Others 1981 (3) SA 406 (A) at 417A). The components of goodwill are many and diverse (O'Kennedy v Smit 1948 (2) SA 63 (C) at 66; Jacobs v Minister of Agriculture 1972 (4) SA 608 (W) at 624A-625F). Well recognised are the locality and the personality of the driving force behind the business (ibid), business licences (Receiver of Revenue, Cape v Cavanagh 1912 AD 459), agreements such as restraints of trade (Botha and Another v Carapax Shadeports (Pty) Ltd 1992 (1) SA 202 (A) at 211H-I) and reputation. These components are not necessarily all present in the goodwill of any particular business.’
In the landmark Australian case of FCT v Murry 6 the court observed that there was a difference between legal and accounting goodwill. The court noted that the accounting and business concepts of goodwill emphasise the necessity for the business to have some value over and above the value of the identifiable assets. A business may have goodwill for legal purposes even though its trading losses mean that its sale value would be no greater than its ‘break-up’ value.
The court stated that the attraction of custom still remains central to the legal concept of goodwill and that courts will protect this source or element of goodwill irrespective of the profitability or value of the business.
It is considered that the legal concept of goodwill should be applied in determining whether goodwill has been held continuously throughout the period since its creation. It would be impractical to apply the accounting concept of goodwill throughout the holding period, since this would involve constantly valuing goodwill throughout the period to determine whether it has been extinguished. As stated in the Murry case:
‘The sources of the goodwill of a business may change and the part that various sources play in maintaining the goodwill may vary during the life of the business. But, as long as the business remains the "same business", the goodwill acquired or created by a taxpayer is the same asset as that which is disposed of when the goodwill of the business is sold or otherwise transferred.’
By regarding goodwill as an attractive force, there is no need to have regard to its value on a day-to-day basis.
It is also more appropriate to apply the legal concept of goodwill in determining the date when goodwill was first created. In IRC v Muller & Co's Margarine Limited Lord Macnaghten said of goodwill:
‘It is the attractive force which brings in custom. It is the one thing which distinguishes an old- established business from a new business at its first start.’
It can take several years before a business becomes profitable, but that does not mean that goodwill in the form of an attractive force has not been created. It may well be, depending on the circumstances, that goodwill can commence relatively soon after a business has begun trading because that is the point at which the ‘attractive force’ should begin to develop, even if it is initially in a small way. For example, it should be possible to determine fairly soon after a business opens its doors whether repeat custom is being generated or whether sales are on an upward trajectory.
Pitfalls of time-apportionment
The time-apportionment method contains a proceeds formula in para 30(2) which is triggered when allowable expenditure under para 20, other than selling expenses, is incurred on or after the valuation date. The effect of the formula is that the more allowable expenditure incurred on or after the valuation date, the greater is the proportion of the overall gain or loss that will comprise a capital gain or loss. If no expenditure is incurred before valuation date and only ZAR 1 of expenditure (other than selling expenses) is incurred on or after the valuation date, the entire economic gain (proceeds less the ZAR 1 expenditure) will comprise a capital gain, with the result that the market value method (if available) or 20% of proceeds method will have to be used. Selling expenses set out in para 20(1)(c)(i) to (iv) do not trigger the proceeds formula but the cost of valuing goodwill for the purpose of determining a capital gain or loss will trigger the proceeds formula. The failure to treat the cost of a CGT valuation in the same way as selling expenses is inequitable and makes little sense. The purchase of goodwill on or after the valuation date will also trigger the proceeds formula.
Finally, SARS has a useful Excel-based ‘TAB Calculator’ which can greatly speed up the complex task of determining the time-apportionment base cost of an asset.9
Self-generated goodwill is an asset for CGT purposes. When it commences to be generated before 1 October 2001, the time-apportionment method can be used to determine its valuation date value. Factors which can make its use unattractive include whether goodwill was purchased in more than one year of assessment before valuation date (‘N’ will be limited to 20) and the extent to which the proceeds formula makes more of the overall gain a capital gain (for example, because of the cost of a CGT valuation or the purchase of goodwill).
Note: References to ‘para’ or ‘paragraph’ in this article are to paragraphs of the Eighth schedule to the Income Tax Act 58 of 1962.
This article was first published in ASA December/January 2022.