Allocating value to business assets
When selling/buying the assets of a business, for CGT and depreciation purposes it is necessary to allocate the consideration received/paid for each of the assets. Due to the differing taxation implications for both, the purchaser and vendor may have conflicting interests when it comes to doing this allocation.
Usually the Tax Office will accept the figures allocated in the contract between arm’s length parties. Where the contract does not allocate the sale price amongst the various assets of the business (which is not uncommon), the parties should ensure they can justify their figures.
As well, vendors and buyers should be aware there are special provisions in the income tax legislation that specify the value of certain assets on disposal (e.g. on the disposal of trading stock); and some provisions that require adjustments to be made (e.g. the operation of the Div 43 clawback in the Income Tax Assessment Act 1997 (ITAA 97)).
These are discussed below.
When sold for more than their adjustable (written down) value, the difference will be included in assessable income of the vendor. Therefore, the vendor would prefer to sell these assets for their adjustable value to avoid any balancing charges.
However, the purchaser would prefer to maximise the amount it can begin claiming as depreciation deductions in the future.
Pre-CGT assets (acquired pre-20 September 1985)
The vendor would wish to allocate as large an amount as possible to these assets as any gain on their disposal will be tax free. Any amount allocated to these assets will become their cost base for the purchaser.
However, the purchaser may prefer to forgo an increased cost base for these assets if it means larger amounts can be allocated to depreciable assets.
Post-CGT land and buildings
The vendor will want to allocate up to the cost base for the asset. Any more and there will be a capital gain upon disposal.
Any amount allocated to these assets will become their cost base for the purchaser. However, the purchaser may prefer to forgo an increased cost base for these assets if it means larger amounts can be allocated to depreciable assets.
Section 70-90 ITAA 97 deems trading stock to be sold for its market value if it is sold outside the ordinary course of business. This would be the case where the trading stock is being sold because the business is being sold.
In the case of Re Miley and FCT  AATA 73, the AAT said that to determine the market value of an asset, it is necessary to apply the established test in Spencer v The Commonwealth (1907) 5 CLR 418 – the price “willing but not anxious parties” would be prepared to buy and sell the asset for.
|It is the market value of the item on the day of disposal rather than the actual consideration received that is included in the vendor’s assessable income – s 70-90 ITAA 97.
At the same time, the purchaser is taken to have acquired it at that market value – s 70-95 ITAA 97.
Where this is a pre-CGT asset there will be no CGT consequences for the vendor on disposal. The amount allocated to the goodwill will become its cost base for the purchaser.
Where the goodwill is a post-CGT asset, any gain on its disposal may qualify for the general CGT 50% discount (except for disposals by companies) and may also qualify as an active asset for the purposes of the CGT small business concessions.
The whole of the goodwill of a business is either pre-CGT goodwill or post-GST goodwill – Taxation Ruling TR 99/16. The following is reproduced from the ruling:
- If a taxpayer who founded or purchased a business adds to that business an additional business purchased as a going concern, it is a question of fact dependent on the circumstances of each particular case whether the additional business is subsumed into and forms part of the existing business or whether the two businesses remain as separate businesses. If two post-CGT businesses are subsumed in this way, the goodwill of the businesses coalesce and the cost base of the goodwill of the business purchased as a going concern becomes part of the cost base of the goodwill of the entire business.
- If a pre-CGT business is combined with another business acquired post-CGT and they are conducted as one business without the pre-CGT business losing its essential nature or character, the goodwill of the post-CGT business is subsumed into the goodwill of the pre-CGT business and all of the goodwill of the business is taken to have been acquired before 20 September 1985. The goodwill of each of the businesses coalesce without any disposal of the goodwill of the post-CGT business. The pre-CGT business must not lose its essential nature or character in the sense that it must remain the same business and not be overwhelmed by the post-CGT business in such a way that it has become a different business. The purchase of the post-CGT business must involve merely organic growth of the pre-CGT business or an expansion or accretion to it in reasonable proportions or it gives rise to a new, different business and its goodwill is a new asset.
- If a taxpayer operating a pre-CGT supermarket acquired a bakery outlet after 19 September 1985 and – as a matter of fact – integrated it into the supermarket in one consolidated business and later sold the consolidated business, the whole of the amount received for the goodwill of the integrated business is taken to have been acquired before 20 September 1985 (subject to Division 149 – about when an asset stops being a pre-CGT asset).
- If, on the other hand, the two businesses (for example, the supermarket and the bakery outlet) are – as a matter of fact – separate and distinct businesses, the goodwill attached to the additional business is acquired after 19 September 1985.”
Restraint of trade agreements
The entering into of a restraint of trade agreement will attract the operation of CGT event D1 – section 104-35 ITAA 97. That section applies where a contractual right or other legal or equitable right is created in another entity.
A capital gain will be made where the capital proceeds from creating the right are more than the incidental costs (e.g. the legal fees) incurred that relate to the event. Therefore, any consideration allocated to the restraint of trade is generally going to be subject to CGT in full although the small business active asset 50% reduction may be available.
Therefore the vendor is likely to prefer that no part of the consideration be allocated to this item, subject to the availability of capital losses. This will particularly be the case where the consideration could otherwise be allocated to another asset which may be pre-CGT.
From the purchaser’s viewpoint, the restrictive covenant will be an asset of the purchaser for CGT purposes and a capital loss is likely to arise at the end of the covenant period. Therefore there is also generally no benefit to the purchaser in allocating consideration to a restrictive covenant.
Work in progress
A specific deduction for payments for work in progress is allowable to the purchaser in the income year in which they are paid to the extent that a recoverable debt has arisen in respect of the completion (or partial completion) of the work to which the amount relates, or where it can reasonably be expected that a recoverable debt will arise in respect of the completion (or partial completion) of that work within 12 months after the amount was paid – s 25-95(1) ITAA 97.
To the extent to which a recoverable debt for the completion or partial completion of the work in progress to which the payment relates, cannot reasonably be expected to arise within 12 months of the date of the payment, that amount will be deductible in the following income year – s 25-95(2) ITAA 97.
Receipt of a work in progress amount is assessable income to the vendor.
Subsection 25-95(3) ITAA 97 provides that work in progress is work (but not goods) that has been partially performed for another but not yet completed to the stage where a recoverable debt has arisen in respect of the completion or partial completion of the work.
Where the business premises are leased, the lessor may assign the existing lease to the purchaser or alternatively, the lessor and the purchaser may enter into a new lease.
Where the lessee pays a lease premium to the lessor, it will generally be regarded as a capital payment with CGT consequences for the lessor.
Any expenditure for the preparation, registration and stamping of the assignment or the surrender of the lease where the property is used to produce assessable income is deductible under section 25-20 ITAA 97.
Generally, the vendor’s obligations with respect to employees are transferred to the purchaser and they become the purchaser’s obligations.
The vendor will generally not be allowed a deduction for any amount allowed to the purchaser for annual or long service leave liabilities nor will the purchaser be assessed on this amount. The purchaser will be allowed a deduction at the time the leave is paid.
Section 26-10 (2) ITAA 97 provides a deduction for accrued leave transfer payments. They are payments for leave made by the vendor which are required under an industrial agreement. The purchaser will include the payment in assessable income due to section 15-5 ITAA 97.
Clawback clauses are those which provide for the refund of an amount of the sale proceeds if certain specified performance criteria are not met by the business which had been sold.
Section 116-50 ITAA 97 provides that the capital proceeds are reduced by any part of them required to be repaid. This would therefore require an amendment to the return in which the capital gain was declared.
The cost base is also reduced by the same amount – s 110-40(3) ITAA 97.
Debtors are normally not sold due to the potential for bad debts and also due to having to pay stamp duty on gross assets. The purchaser will generally collect the debts on behalf of the vendor on a commission basis.
Division 43 clawback
Division 43 ITAA 97 provides a 2.5% or 4% capital works deduction for the cost of capital works on income-producing buildings and structural improvements.
Where ownership of the building changes, the right to claim any undeducted construction expenditure passes to the new owner.
The vendor is required to pass on sufficient information to the purchaser so that the purchaser can ascertain the manner in which Division 43 will apply to the purchaser’s holding. This information must be provided within 6 months of the end of the year in which the disposal occurs.
If the vendor does not or is unable to provide the information necessary to calculate the deduction, a building cost estimate by a quantity surveyor may be used to determine the amount that may be claimed.
There are no assessable balancing adjustments arising to the vendor on the sale of property where a capital works deduction has been claimed.
However, if the asset being disposed of was acquired after 13 May 1997, the deductions allowed under Division 43 are removed from the cost base on disposal. This is referred to as the Division 43 clawback – section 110-45 ITAA 97.
|Example from Interpretative Decision TD 2004/404 (now withdrawn)|
|The taxpayer acquired a commercial property (land and buildings) for $1 million. The taxpayer then spent $250,000 on altering and improving the building.
The taxpayer sold the property this year (3 years later) for $3 million.
In respect of the ownership period, the taxpayer was entitled to deduct, under Division 43, a portion of the capital works expenditure incurred in altering and improving the building and a portion of the expenditure incurred by the previous owner in constructing the building. The total amount the taxpayer deducted was $20,000.
The taxpayer did not have a profit making intention and was not in the business of buying and selling properties.
The cost base for the taxpayer used in working out the capital gain will be the $1m + $250,000 less the $20,000 = $1,230,000.
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For other tips on capital gains tax, you can also check out our other CGT articles.