How one company ended up with a five figure tax liability after the ATO became their valuer.
A few years ago, a company completed an internal restructure. The company then received an amended tax assessment from the ATO. The transaction that triggered the amended assessment was an internal one and even though no money changed hands, the restructure resulted in a capital gains tax event. The taxpayer had relied on the CGT small business concessions to overcome their tax liability.
These concessions, where available, allow SMEs to significantly reduce or eliminate their tax on certain capital gains. At the time of the restructure, an internal review of the business concluded that it was worth $1.3 million. The ATO challenged the use of the concessions on the basis that the company did not satisfy one of the eligibility requirements – the maximum net asset test which at the time was $5 million. The ATO valued the business at $4.7 million. This difference, together with other assets that needed to be counted, caused the company to fail the maximum net asset test. Without access to the CGT concessions the company was exposed to a tax liability of many hundreds of thousands of dollars.
An isolated case? No, the ATO has a large number of similar cases afoot. Would an independent valuation have made a difference? A valuation by itself does not provide a tax guarantee, however the ATO is far less likely to challenge an independent view formed at the time of the transaction. In the absence of a formal valuation, the ATO is more likely to question whether the true value has been arrived at.
Most people think about valuations when there is a dispute occurring or when an asset is being bought or sold. They often overlook other transactions where a valuation is absolutely necessary. The danger of doing this is that you may be inadvertently inviting the Tax Commissioner to determine his valuation of the transaction. And in many cases, this will produce a nasty surprise.
There is a wide range of every day SME transactions that have a potential tax consequence. Think about the simple issue of shares in a company, the transfer of shares between shareholders, the restructure of a business, assessing the distributable surplus of a company for Division 7A purposes or using the CGT small business concessions. Each of these transactions requires a value to be attributed to it. SMEs often try and do this themselves or look to their accountant to provide a quick indicator without undertaking a formal valuation. Why pay for the cost of a valuation where the purpose is purely internal, and it may never be required?
Sections 112 and 116 of the Tax Act provide what is commonly known as the market substitution rules. This allows the Commissioner to deem his own value on a transaction where the parties are not dealing at arms’ length and where a market valuation has not been applied. The Commissioner has also outlined his expectation of valuations in Practice Statement 2005/8. This requires a formal valuation process for any transaction where the parties are not dealing at arms’ length and where the value assessed will impact on the calculation of a tax liability. Following these rules is simply a smart risk management strategy.
In our example did the ATO get the value right? Almost certainly not. However, the taxpayer is now on the back foot trying to overcome an amended assessment and fighting through the appeal channels. Not only does the Tax Act at times require a valuation to be completed, the valuation properly completed will produce the best tax outcome for you.
Greg Hayes is a Director Hayes Knight (NSW) and the author of A Practical Guide to Business Valuation for SMEs published by CCH Australia.