In the process of buying a business, the purchaser should conduct a due diligence review to establish that they are buying what they believe they are buying. The review identifies areas of risk and contingent liabilities that the business may have and to factor these risks in the purchase price.
When buying a business or the company that conducts a business, there are many tax issues that the purchaser needs to consider prior to the contract being signed.
In most cases a purchaser acquires the assets of the business unless there are significant commercial reasons for buying the company (e.g. contractual obligations that cannot be assigned). This avoids the risk of assuming the company’s liabilities some of which may not be known or readily identifiable.
The taxation implications of buying either the assets of the business or the shares in the company are very complex and professional advice should be obtained.
BUYING ASSETS OF THE BUSINESS
The type of assets usually purchased include trading stock, goodwill, plant & equipment, business premises, trademarks and other intangible assets. Depending on the circumstances, other assets may be acquired and liabilities may also be assumed.
The price paid for the business should be allocated between all the business assets being acquired and the values separately allocated in the contract.
The ATO will generally accept the allocation of sale proceeds between the various classes of assets as agreed in the contract provided the vendor and the purchaser are dealing at arms length.
1. Trading stock
The valuation of trading stock can have a material effect on the sale negotiations. The purchaser prefers a higher value allocated to stock as this results in a higher cost of goods sold and therefore a lower profit, whereas the vendor prefers a lower value to reduce their assessable income.
For tax purposes the vendor is treated as selling the stock for its market value and the purchaser is treated as having bought the stock for this value.
2. Trade debtors
The purchaser doesn’t normally acquire the trade debtors of the business as a tax deduction is not allowed for any debts that subsequently go bad. Instead the purchaser should collect the debts as agent for the vendor.
3. Accrued employee leave entitlements
Where the purchaser will retain some of the employees, its important that accrued employee entitlements (e.g. annual leave and long service leave) are determined and factored in the purchase price.
There are three alternative ways of dealing with accrued employee entitlements upon the purchase of a business:
- If the relevant employee’s Award does not provide for the employee’s leave entitlements to be transferred to the purchaser, the vendor can pay out these liabilities and obtain a tax deduction.
- The vendor makes a payment to the purchaser who in turn takes over the employee’s accrued leave entitlements. The purchaser either assumes these liabilities because it is an Award requirement, or because the purchaser has agreed to do so. The vendor may be entitled to a deduction for the accrued leave transfer payment and the purchaser is assessable on the amount received.
- The purchase price is reduced in recognition of the purchaser accepting responsibility for the accrued leave entitlements. The reduction in the sale price is generally not deductible to the vendor nor is it assessable to the purchaser.
4. Plant & equipment
A value should be allocated to all the items of plant & equipment. The purchaser would prefer to allocate a greater amount to plant & equipment as either depreciation or an outright deduction can be claimed for each individual item.
5. Business premises
Where the purchaser is also acquiring the business premises, a tax deduction for the capital costs of building works carried out usually passes to the purchaser. The purchaser should ensure that that a notice is provided by the vendor outlining the construction cost details for the purposes of claiming the building write-off.
6. Work in progress
An amount paid by the purchaser to the vendor for work (WIP) in progress is generally assessable to the vendor and tax deductible to the purchaser. When the WIP has been completed it will be assessable to the purchaser either:
- When the amount becomes a recoverable debt, if the purchaser is operating on an accruals basis: or
- When the amount is collected by the purchaser, if operating on a cash basis.
7. Goodwill & statutory licences
The purchase of business goodwill and also statutory licences (e.g. liquor licence, taxi licence, fishing licence) is a capital asset and is subject to capital gains tax (CGT) upon ultimate disposal. Therefore no tax deduction is available to the purchaser.
The purchaser may be entitled to claim the CGT small business concessions upon disposal of goodwill and these statutory licences.
8. Other intangible assets
A licence relating to the use of a copyright, patent or registered design is an intangible depreciating asset and the purchaser is entitled to a deduction over its effective life. The Tax Act prescribes an effective life for certain intangible depreciating assets as follows:
| 20 years |
| 8 years |
| 15 years |
| The shorter of:
|
9. Goods & services tax
GST will normally apply when purchasing a business unless the supply is GST-free. This commonly occurs when the going concern exemption is applied and reflected in the contract of sale.
The GST going concern exemption may also apply where the purchaser is also acquiring the business premises.
10. Business structure
The purchaser will need to consult their accountant to determine the most appropriate structure for operating the business. This could either be a company, unit trust, family trust, partnership or as a sole trader.
Where the purchaser is also acquiring the business premises, it is preferable for asset protection purposes to purchase the premises in a separate entity.
The future application of the capital gains tax small business concessions needs to be considered before deciding on the appropriate structure.
BUYING SHARES IN THE COMPANY
It is assumed that the purchaser is buying shares in a single wholly owned Australian Pty Ltd company that operates a business in Australia.
There are usually no GST implications to the purchaser or buyer upon the transfer of shares as this is constitutes an exempt financial supply.
A number of additional taxation issues need to be considered when buying the shares in a company as the purchaser is automatically assuming any outstanding liabilities of the company.
Where issues are identified the risks can be mitigated by using the income tax consolidation provisions, with appropriate post-sale restructuring, although this would involve some additional costs that should be factored into the negotiations with the vendor.
Some of the issues to consider include:
1. Tax status
Under the system of self assessment, the company’s income tax returns will not have been reviewed in any detail by the Taxation Office unless the company has been the subject of a tax audit. Some of the items that require detailed examination include:
- Review tax returns for the past four years and supporting work papers, including detailed reconciliations of profit/loss as per the financial statements and taxable income/loss. Confirm that the tax returns have been lodged.
- Review certain potentially contentious expenses claimed for the past four years to confirm deductibility (e.g. repairs & maintenance, legal fees, interest paid, domestic and overseas travelling and entertainment).
- Request a copy of the ATO Integrated Tax Account from the company’s tax agent to confirm that all tax obligations are up-to-date.
- Review copies of Fringe Benefits Tax (FBT) returns and supporting work papers for the past four years. Confirm that all FBT returns have been lodged and that fringe benefits tax has been correctly classified and calculated.
- Review copies of company franking accounts for the past four years, including details of dividends paid and the extent of franking. Check whether there is any liability for franking additional tax, franking deficit tax, or deficit deferral tax.
- Review copies of both accounting and tax fixed asset registers and related fixed asset reconciliation schedules for those years.
- Review any bad debt deductions claimed for tax purposes over the last four years to ensure that the debts were genuinely bad and written off prior to the end of the relevant income year.
- Assess whether any transactions may not have been undertaken on arm’s length (market value) basis between related parties.
- Determine whether any debts owed by or to the company have been forgiven in the past four years, and if so, what tax adjustments or capital loss claims resulted.
- Where there are loans to shareholders or their associates, check that interest and principal repayments have been correctly calculated and that a properly executed loan agreement is in place.
- Review copies of any correspondence with the Tax Office for the past four years to identify if there are any disputes including:
- all private ruling requests, requests for the Commissioner’s opinion or objections lodged, and all responses received;
- requests for an amended assessment; and
- requests for information from the Tax Office, whether as part of a formal audit or otherwise and all responses provided. Otherwise confirm that the company has no knowledge of any intended audit activity.
- Review copies of internal and external advice to identify any aggressive tax positions taken in tax returns for the past four years and determine potential tax shortfall penalties.
2. Trading stock
Confirm that trading stock has not been undervalued by the company in its tax returns for the past four years. If so, there may be a substantial hidden tax liability going back for many years and this will impact on the value of the company.
3. Capital gains tax
- If acquiring a controlling interest in the company, no adjustment should be made to the purchase price for any assets acquired prior to the introduction of capital gains tax (CGT) on 20 September 1985. This is because the Tax Act deems all of the pre-CGT assets to have been acquired at their market value on the date the shares in the company are purchased. Consider obtaining a formal valuation of the relevant assets to substantiate the commencing cost base for CGT purposes.
- The current market value of any substantial post 19 September 1985 assets needs to be determined so that the purchaser can take into account and adjust the purchase price for the future CGT liability that will arise when the assets are eventually sold.
- Determine whether there have been any capital gains tax rollovers to the company since 20 September 1985. Obtain details of the assets involved, their cost base and potential market value at the time of transfer.
- If acquiring a minority interest in the company, the purchaser needs to consider the possible application of the capital gains tax small business concessions upon future sale of the shares. One of the conditions for claiming the concession is that the individual must hold at least a 20% shareholding (directly or via interposed entities such as trusts).
4. Tax losses
If the company has income tax or capital losses, obtain a schedule of these losses and review details of losses utilised during the past five years to ensure that the company has satisfied either the “continuity of ownership” or the “same business” test from the start of the loss year through to the end of the income year.
Obtain details of any changes in share ownership of the company since incorporation to assist in this review.
If acquiring a controlling interest (i.e. 50% or more), the losses can only be carried forward against future profits if the company continues to satisfy the “same business test” This means the company must continue to carry on the identical business.
When negotiating the purchase price for the company, do not allow for the future benefit of the tax losses unless it is certain that the company will obtain those benefits.
5. GST & PAYG obligations
- Review GST returns for all periods from 1 July 2000, including summary sheets, schedules and other documents used in the preparation of the BAS returns.
- Obtain and review copies of all accounts from the Tax Office (e.g. income tax and integrated client account). .
- Review copies of any Recipient Created Tax Invoice agreements, sample copies of invoices and adjustment notes issued by the company.
- Confirm that all BAS’s have been lodged for the period since 1 July 2000 and payments have been correctly made for GST and PAYG.
- Review the status of independent contractors to ensure they are properly classified. There could be hidden liabilities for PAYG withholding, superannuation guarantee contributions, Workcover and payroll tax where the contractors are working under normal employee conditions.
6. Payroll tax
- Determine whether payroll tax returns have been lodged and payroll tax paid in each jurisdiction.
- Consider whether the entity is appropriately grouped or not grouped for payroll tax purposes.
- Assess whether the amount of salary and wages shown in the accounts approximates the amount declared for payroll tax.
- Review the status of independent contractors to ensure they are properly classified.
- Determine whether there are any outstanding assessments or refund claims.
7. WorkCover
- Review copies of WorkCover premiums for the past three years.
- Review WorkCover correspondence to determine whether there are any documents advising of WorkCover premium rates or industry classifications, outstanding claims or claims history.
- Determine whether WorkCover premiums and payments are up to date.
- Review the status of independent contractors to ensure they are properly classified.
- Assess whether there are any outstanding obligations, assessments or challenges currently undertaken in relation to WorkCover.
8. Superannuation
- Review copies of all superannuation guarantee payments for the most recent financial year.
- Review the status of independent contractors to ensure they are properly classified.
- Determine whether all superannuation guarantee payments have been made.
- Determine whether there have been any shortfall penalties in the past four years.
