Introduction
Selling a business involves more than just transferring ownership; it includes various business assets. When determining the sale price in a sale of business agreement, it is important to consider how the total purchase price is apportioned across these assets. This apportionment is not just a procedural step but carries significant weight, especially for tax purposes for both the purchaser and vendor.
Purchase price allocation is important because different business assets, such as goodwill and plant and equipment, have different tax treatments. Appropriate apportionment, clearly documented in the sale agreement, may help business owners avoid potential disputes with the Australian Taxation Office (ATO) and manage their tax obligations effectively. This guide will explain the importance of apportioning the purchase price in a sale of business agreement.
Understanding Purchase Price Apportionment in Business Sales
What is Purchase Price Apportionment?
When a business is sold, the transaction typically involves the transfer of various assets. These assets can include:
- Tangible items such as stock and equipment
- Intangible assets like goodwill and intellectual property
Purchase price apportionment is the process of dividing the total sale price among these individual assets. This allocation is crucial because different types of assets are treated differently for tax purposes.
Why is Apportionment Important?
Apportionment of the purchase price has significant accounting and taxation consequences for both the vendor (seller) and the purchaser (buyer). The way the purchase price is allocated to different business assets can affect the tax payable by both parties.
For instance:
- Vendor’s Perspective:
- May prefer to allocate more of the purchase price to Capital Gains Tax (CGT) assets, such as goodwill
- This allocation can make the vendor eligible for CGT concessions or allow them to offset capital losses
- Purchaser’s Perspective:
- May prefer to allocate a larger portion of the purchase price to depreciable assets like plant and equipment
- Depreciable assets can be written off over time, providing tax deductions and reducing taxable income
Therefore, understanding and strategically planning the apportionment of the purchase price is essential in a sale of business agreement to manage tax implications effectively for both parties.
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Tax Implications of Purchase Price Allocation
Vendor’s Perspective on Tax
From a vendor’s viewpoint, the allocation of the purchase price can significantly impact their tax obligations in a sale of business. Vendors may find it more advantageous to allocate a larger portion of the purchase price to Capital Gains Tax (CGT) assets. This preference arises because CGT assets may be eligible for certain CGT concessions, such as the small business CGT concessions, potentially reducing the overall tax payable.
Furthermore, allocating more of the purchase price to CGT assets can be beneficial in the following ways:
- Offsetting Capital Gains: If the vendor has capital losses available, these can be used to offset capital gains.
- Pre-CGT Assets: Allocating to assets acquired before the introduction of CGT can provide additional tax benefits.
- Maximising Goodwill Value: Goodwill is considered a CGT asset, and vendors might seek to maximise its allocated value to access CGT concessions effectively.
Purchaser’s Perspective on Tax
From a purchaser’s perspective, the tax implications of purchase price allocation differ significantly. Purchasers generally prefer to allocate a greater portion of the purchase price to depreciable assets, such as plant and equipment. This preference is driven by several factors:
- Depreciation Deductions: Depreciable assets allow purchasers to claim depreciation deductions, which reduce their taxable income in the years following the business acquisition.
- Increasing Depreciation Base: By maximising the allocation to depreciable assets, purchasers can increase their depreciation base, thereby reducing their overall tax liability.
While goodwill is also a CGT asset, it is not depreciable for tax purposes. This characteristic makes it less appealing for purchasers to allocate a large portion of the purchase price to goodwill from a tax perspective.
Key Assets in a Business Sale and Purchase Price Allocation
Goodwill and Purchase Price Allocation
Goodwill is a significant asset in a business sale and is considered a Capital Gains Tax (CGT) asset. Apportioning the purchase price to goodwill is crucial because it directly affects the tax implications for both the vendor and purchaser. The valuation of goodwill for purchase price allocation can be complex and often requires the expertise of an accountant, potentially leading to disputes with the Australian Taxation Office (ATO).
The legal definition of goodwill is notoriously difficult to define. Accounting goodwill is typically determined using a ‘top down’ valuation method, calculated as the difference between the overall market value of the business as a going concern and the fair market value of its identifiable assets. Legal goodwill, however, is more nuanced and context-dependent, with its definition varying across different factual and legal situations. Despite these differing interpretations, the ability of a business to attract customers is central to the legal concept of goodwill. Sources of goodwill can include factors like:
- Location
- Service quality
- Pricing strategies
- Established customer habits
For tax purposes, a reasonable apportionment of the purchase price to goodwill should reflect its market value at the time the contract was made. Failure to accurately apportion the purchase price, particularly for goodwill, may lead to disputes with the ATO regarding the reasonableness of the allocation. To avoid lengthy disputes with the ATO, it is advisable to clearly document the purchase price allocation, including goodwill, in the sale of business agreement.
Plant and Equipment, Stock and Other Assets
Purchase price allocation significantly impacts assets like plant and equipment and trading stock, which are treated differently for tax purposes compared to goodwill. Plant and equipment are depreciable assets, and the allocated purchase price determines their depreciation cost base for the purchaser. Trading stock, on the other hand, is generally valued at market value.
Vendors typically prefer to allocate less of the purchase price to plant and equipment and stock because these assets are not taxed under the CGT regime and are ineligible for CGT concessions. Conversely, purchasers mostly prefer to allocate more to depreciable assets like plant and equipment to maximise depreciation deductions, thereby reducing their taxable income. For trading stock, purchasers usually aim for a lower allocation for commercial reasons, such as accounting for slow-moving or obsolete stock.
Other assets involved in purchase price allocation can include:
- Intellectual property
- Land and buildings
- Fixtures and fittings
- Motor vehicles
The allocation for each asset class has different tax implications and preferences for vendors and purchasers. This highlights the importance of careful consideration and, often, the guidance of an accountant when apportioning the purchase price in a sale of business. Additionally, engaging in commercial negotiations ensures that the fair market value of each asset is appropriately reflected, facilitating a smoother transaction and minimising potential disputes.
Avoiding Disputes with the ATO through Apportionment
ATO’s Acceptance of Arm’s Length Apportionment
When parties involved in the sale of a going concern deal with each other at arm’s length, it is crucial to clearly document the purchase price apportionment for each specific asset in the sale agreement. Proper allocating the purchase price ensures that the purchase price of a business is divided accurately among the various assets being transferred.
The Australian Taxation Office (ATO) generally accepts such apportionments because it recognises that each party can make their own reasonable allocations in arm’s length transactions. Therefore, when the parties are independent and negotiating in their own self-interest while buying a business, the ATO is less likely to challenge the agreed-upon allocation.
Risks of Not Apportioning or Unreasonable Apportionment
Failing to apportion the purchase price of a business in a sale agreement, or implementing an unreasonable apportionment, can lead to several issues:
- Disputes and Potential Audits: The ATO may initiate disputes and audits if the purchase price is not apportioned or if the apportionment is deemed unreasonable.
- Scrutiny of Arm’s Length Status: In transactions where parties are not dealing at arm’s length, the ATO may closely examine whether the dealings were genuinely at arm’s length during an audit.
- Questioned Reasonableness: Without a documented purchase price allocation, the ATO might question the reasonableness of the apportionment made by either party.
- Costly and Lengthy Disputes: These issues can result in prolonged and expensive disputes with the ATO.
Additionally, improper apportionment can negatively impact the tax position of both the seller and the buyer, potentially affecting their eligibility for small business concessions or other tax benefits.
To mitigate these risks, it is advisable to:
- Clearly Document the Purchase Price Allocation: Ensure that the allocation is included in the sale of a going concern agreement. This includes detailing each asset’s value, such as good will for legal purposes, plant and equipment, and trading stock.
- Engage in Commercial Negotiation: Even if it requires negotiations between the parties, documenting the allocating the purchase price can prevent future disputes and ensure compliance with ATO requirements.
- Consider Small Business Concessions: Proper apportionment can help both parties take advantage of relevant small business concessions, optimising their overall tax position.
By taking these steps, businesses can avoid potential conflicts, maintain a smooth relationship with the ATO, and ensure that their business to generate income remains compliant and financially sound.
Practical Steps for Purchase Price Apportionment
Documenting Apportionment in the Sale Agreement
When selling your business or the sale of shares, it is important for both vendors and purchasers to ensure that the agreed purchase price allocation is formally documented within the Business Sale and Purchase Agreement. Prices should be apportioned clearly in the agreement by including a specific schedule or clause that outlines the allocation. This allocation should cover goodwill and other assets, ensuring that the price in relation to goodwill is explicitly defined for legal purposes.
By documenting the purchase price allocation in the sale agreement, both parties are legally bound to reflect this allocation in their tax returns. This practice is crucial in:
- Preventing inconsistencies in financial reporting
- Avoiding potential disputes with the Australian Taxation Office (ATO) regarding the valuation of assets for tax purposes
Proper documentation ensures that the gains tax on the sale is accurately calculated, and the business is unlikely to generate issues with the ATO over asset valuations.
Seeking Professional Advice and Valuations
To add value to its business and ensure a reasonable and justifiable purchase price allocation, it is advisable for both vendors and purchasers to seek professional guidance. Engaging experienced lawyers and accountants in the sale of a business can provide valuable assistance during this process. These professionals can help navigate the complexities of purchase price apportionment in relation to various assets, including goodwill and other assets, and ensure compliance with ATO guidelines.
Furthermore, obtaining independent valuations for key assets, such as goodwill, may be beneficial. Independent valuations offer an objective assessment of the fair market value of these assets, supporting the price in relation to goodwill and minimising the risk of disputes with the ATO. This can be particularly useful in:
- Supporting the agreed apportionment
- Minimising the risk of disputes with the ATO
In situations where parties cannot agree on asset values, an application can be made to the Commissioner of Taxation for a private binding ruling to determine an acceptable market value for tax purposes. Without proper apportionment, the business is unlikely to generate accurate tax returns, potentially leading to gains tax on the sale being improperly calculated. Additionally, prices should be apportioned based on the value of assets rather than on price or habit to ensure fairness and compliance.
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Conclusion
Apportioning the purchase price in a sale of business agreement is a critical step that carries significant tax implications for both vendors and purchasers. Proper purchase price allocation across various business assets, such as goodwill, plant and equipment, and stock, ensures that each asset is treated correctly for tax purposes. This process is essential for vendors looking to leverage capital gains tax (CGT) concessions and for purchasers aiming to maximise depreciation deductions on depreciable assets. Failing to accurately apportion the purchase price or to document it clearly in the sale agreement can lead to disputes with the Australian Taxation Office (ATO) and may result in costly and lengthy audits.
To navigate the complexities of purchase price apportionment and ensure a smooth sale of business, seeking professional advice is highly recommended. Contact our experienced team at Corestone Lawyers today to explore how our expertise in sale of business agreements can assist you in strategically allocating the purchase price, managing your tax obligations, and avoiding potential disputes with the ATO, ensuring your business sale is compliant and commercially sound.
