Tax Consequences Require Utmost Care
Lawyers, Agents and clients should take the utmost care in drafting contracts for the sale and purchase of businesses as crucial tax outcomes flowed from the wording of the agreements, Barrister Denham Martin told an Auckland District Law Society seminar, Taxation: Issues Arising on the Sale and Purchase of Businesses.
"You get one chance to get it right for the client. You don't get a second chance. Tax in a business sale is the most unexpected cost if you get it wrong."
Mr Martin observed that the taxpayer bore the burden of proof. If an agreement simply provided for a global price, there could be severe tax consequences at a later time if the taxpayer was unable to demonstrate what part of the price was referable to specific aspects such as a restrictive covenant, shares or leaseholder improvements.
He warned that the Inland Revenue Department had very skilled advisers and good resources. It was accordingly no surprise to see that the types of cases which had occurred in Australia as a result of thorough tax investigations were now also being seen in New Zealand.
"It's always things flowing out of contracts and agreements - things we as lawyers are involved in."
Mr Martin said tax rules applied generically across almost every business sold. A check list could accordingly be prepared as a starting point and many issues would remain the same regardless of the type of business involved.
The first point to consider was what gains on sale were subject to income tax. New Zealand did not have a comprehensive capital gains tax, and the ability to sell a business with no or minimal tax cost was still a major concession provided by this country's tax system.
Mr Martin suggested taking the "generally no taxation on sale rule" as a starting point and then considering what exceptions might apply. The exceptions were almost all statutory creations.
They included section CD 4 of the Income Tax Act 1994, which could mean profits from shares sold in a special-purpose company set up for a one-off transaction could be taxable.
Under section CD1(2) land sales could attract tax where the vendor was a dealer, developer or builder, or the land was sold within 10 years and an associated person of the vendor was involved in the business of land sales.
Goodwill could in certain circumstances give rise to gross income. Section CE1(e) included a taxpayer's income certain rents, fines and premiums in connection with any lease, license or easement affecting the land.
Proceeds of the sale of patents or timber were taxable.
Proceeds from an absolute and outright sale of intangible property rights including software were capital, but care must be taken to ensure no user rights were retained.
Proceeds from the sale of any license agreement were capital unless it could be shown that the vendor was a dealer in those types of agreements or had acquired them for a speculative purpose. Book debts, sales of interest in a joint venture and similar rights, and compensation or restraint payments would be capital sums.
Mr Martin said business people should repeatedly test their hypothesis as to whether proceeds were capital or income. It should never be assumed that a business sale of shares was on the capital account.
Detailed knowledge of the vendor's affairs was required in order for lawyers to provide informed advice. The lawyer would need to know the vendor's tax history, whether the person had sold a number of properties, and whether the person came within the definition of a dealer.
There was a fine line in determining how many deals would put a taxpayer over the line into qualifying as a dealer.
Mr Martin said financial arrangements transferred as part of a sale of business assets would give rise to gross income if sold for more than their face value. The bad news in relation to financial arrangements was that a taxpayer could be assessed as a vendor, but might not always get a deduction as a purchaser.
All costs directly associated with the acquisition of the shares or assets of the business being sold, including legal, accounting and valuation expenses, would ordinarily be treated as capital items and non-deductible.
However, if the item was subject to tax on sale, a deduction would sometimes be allowed to the purchaser on acquisition, as in the case of patents, trading stock, revenue account property and employee restraints.
Money borrowed to acquire income-producing assets would be deductible. If the acquisition involved shares in what would become a group company, interest on that borrowing would also be deductible.
Mr Martin said that, where the sale was structured as an acquisition of shares, there were usually GST consequences.
The sale and purchase of shares was an exempt "financial service" and outside the requirements of the Goods and Services Tax Act 1985.
Where the sale involved the disposal of an operational business, the supply would be zero-rated if it constituted a going concern and both parties had agreed in writing that it was a going concern. Problems could arise in relation to issues such as the status and existence of the purchaser if a new company was set up.
Mr Martin noted that certain potential taxation recapture mechanisms might apply at the point of sale and the possibility of the loss of accrued tax benefits could also arise.
Where assets had been depreciated and sold at an amount exceeding their adjusted tax value, that gain would be gross income to the vendor. In certain circumstances, the commissioner might deem a market price to apply on the sale of depreciable property.
Transfers of assets between "associated persons" were subject to limitations. Essentially, the purchaser was entitled to no greater deduction than could have been taken by the transferor.
Where a sale involved shares in a company that had either unutilised losses or imputation credits, it would be vital to ensure that these were utilised prior to sale or that sufficient shares were held by natural persons to maintain continuity.