Capital Gains Tax - Issues to consider when selling a small to mid-sized business

Capital Gains Tax Issues to consider when selling a small to mid-sized business

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Table of Contents

Introduction ........................................................................................................................ 3 Meet our contributor ........................................................................................................................................................... 4

Chapter 1: Capital Gains Tax (CGT) issues to consider when selling your business ............... 5 As a business owner looking to exit my business, what should I consider from a Capital Gains Tax (CGT) perspective, if I sell the business on the open market? ............................................................................ 5 As a business owner looking to exit my business, what should I consider from a Capital Gains Tax (CGT) perspective, if I seek to transfer the business to a family member? ................................................... 8

Chapter 2: Apportioning asset values, earnout clauses and other sale issues .................... 10 What are the issues to be aware of when apportioning and negotiating the amounts that make up the sale price (e.g. goodwill, P&E, stock)? ................................................................................................................. 10 What opportunities do earnout clauses provide? ................................................................................................. 12 What if my company shares or assets were purchased pre-‐capital gains tax? ........................................ 13

Chapter 3: How to access the Small Business CGT Concessions .......................................... 14 Am I entitled to the Small Business CGT Concessions? ........................................................................................ 14 Do the current Small Business CGT Concessions provide me with any advantages in a sale process? What are the thresholds and considerations here? .............................................................................................. 15

Disclaimer: The information contained in this eBook is general in nature and should not be taken as personal, professional advice. Readers should make their own inquiries and

obtain independent advice before making any decisions or taking any action.



jpabusiness.com.au +61 2 6360 0360 3

Introduction

Comments by James Price JPAbusiness Pty Ltd

Some of the best business owners we work with don’t necessarily focus on the numbers first. Instead, they focus on what they’re delivering to the customer, then the positive performance and numbers flow.

The same is true for issues of business taxation.

Often if you focus too much on the amount of tax you’re paying or the fact you’re going to be paying tax, you put yourself in a negative position for making decisions about how you will grow or change the business.

Paying tax is actually a positive because it means you’ve got incrementally surplus earnings and you’re growing the business.

Having said that, tax considerations – particularly Capital Gains Tax (CGT) – are very important for any of you considering changing the structure of your business, divesting or selling part or all of your business as a result of retirement, change of career, succession planning, or some other factor.

In this situation it’s wise to seek your tax advisor’s assistance in looking at the options around capital gains tax and other implications associated with a business sale.

Often good planning up front can mean a business owner can optimise the benefits of a sale price. We’re familiar with a number of examples where addressing the impacts of various tax laws and business restructuring has helped ensure an optimum outcome for the business sale process.




Meet our contributor

In this eBook we welcome back tax expert Michael Pisani, principal at Chapman Eastway.

Chapman Eastway is a family and business advisory firm based in Sydney, and one of the highly respected service providers in the JPAbusiness network.

Michael recently shared his extensive knowledge with us in our Self-Managed Superannuation Funds eBook, and has kindly agreed to share his insights on Capital Gains Tax as well.

A chartered accountant and specialist tax advisor, Michael has more than 10 years experience providing taxation and business advisory services to a diverse group of corporate and private clients. He has a strong technical background with experience in group restructuring, retirement and succession planning, ongoing taxation planning and family wealth preservation.

http://www.chapmaneastway.com.au

http://www.chapmaneastway.com.au

http://www.chapmaneastway.com.au/firm-profile/principals-and-advisors/michael-pisani/

http://www.jpabusiness.com.au/e-book/self-managed-superannuation-funds-for-small-to-mid-sized-business

http://www.jpabusiness.com.au/e-book/self-managed-superannuation-funds-for-small-to-mid-sized-business




Chapter 1: Capital Gains Tax (CGT) issues to consider when selling your business Comments by Michael Pisani Chapman Eastway

As a business owner looking to exit my business, what should I consider from a Capital Gains Tax (CGT) perspective, if I sell the business on the open market?

The key thing to consider is:

• are you selling business assets, or • are you selling an entity?

If you conduct a business out of an entity, such as a company, the tax implications of selling the company’s shares, as opposed to selling the business’s assets out of the company, are very, very different.

As a general rule of thumb, most purchasers would prefer to buy business assets as opposed to shares or an entity, because they take on less risk associated with the history of the entity.

From a tax perspective the outcomes can be vastly different.

If you sell business assets out of an entity you have to deal with extracting profits out of the entity, whereas if you sell shares in a company, there can be easier access to CGT concessions.




Here’s an example:

XYZ Pty Limited is 100% owned by Mum. The company conducts a retail business.

The key assets in XYZ Pty Ltd are:

Stock at cost $100,000

Plant and equipment (P&E) written down value (WDV) $50,000

Internally generated goodwill $150,000

Total asset value $300,000

For our example, we’re going to assume:

• Mum is on the top marginal rate of income tax (49%); • retained earnings of the company are $150,000, and • Mum purchased shares in the company for $100, five years ago.

Scenario 1: Mum sells her shares in XYZ Pty Limited for $300,000

Share sale proceeds $300,000

Less: cost base of shares $(100)

Gross capital gain $299,900

Less: general CGT discount (50%) $(149,950)

Taxable gain $149,950

Tax payable $73,476

If Mum sold the shares in the company to an external party for $300,000, she would make a capital gain of $299,900. She would be entitled to the general CGT discount (50%), which would reduce that gain by half. So she would have a taxable gain of $149,950. Mum is on the top marginal rate of income tax, so she would pay tax of $73,476.




Scenario 2: An extraction or sale of business assets from the company, XYZ Pty Limited

Rather than selling the shares in the company, let’s say XYZ Pty Ltd sold the business assets out of the company.

In that case, XYZ would have a gain on the sale of the goodwill of $150,000. (There would be no gain on the stock or P&E because they’re sold at cost.) So the company has a profit of $150,000 and would pay company tax at 30%, which is $45,000.

The issue then is, how does Mum extract the cash from the company? Generally she would do that by paying a dividend, because otherwise the earnings and the cash are locked in the company.

XYZ would pay a cash dividend to Mum of $255,000. There would possibly be franking credits attached to that dividend, so that would place income in Mum’s hand of $364,286, which she would pay tax on.

Assuming a top marginal rate of tax and the benefit of the franking credits, she would effectively pay personally another $69,214 in tax.

Gain on sale of goodwill $150,000

Company tax payable $45,000

Cash dividend to Mum $255,000

Plus franking credits $109,286

Taxable income $364,286

Gross tax $178,500

Less franking credits $(109,286)

Personal income tax payable $69,214

Total tax payable $114,214




So total tax paid in the two examples is:

• Shares sale – $73,476 • Business assets sale – $114,214

As you can see, selling the assets out of the company can give a very different tax result than selling the shares in the company.

As we mentioned earlier, most vendors want to sell shares, but most purchasers want to purchase business assets, so there is often a conflict there.

The moral is that it requires quite a bit of planning, which should be done prior to negotiations taking place, as the structure of the sale could result in dramatically different after-tax outcomes.

This example doesn’t factor in the possibility of accessing the Small Business CGT Concessions. These concessions could reduce the tax payable in both scenarios and, again, could change the after-tax result.

For information on the concessions, see Chapter 3.

As a business owner looking to exit my business, what should I consider from a Capital Gains Tax (CGT) perspective, if I seek to transfer the business to a family member?

The key CGT issue when transferring assets in a non-arm’s length transaction (i.e. the sale price may not be at fair market value) is the market value substitution rules.

These rules basically mean when you’re selling assets and the transfer is deemed to involve parties not acting on an arm’s length basis, then the CGT rules impose what would be a fair market value on the transaction.




For example:

Mum and Dad have shares in a company with a business in it.

Mum and Dad give the shares to Junior for $Nil consideration.

The market value substitution rules then apply, which means the Tax Office would impose a deemed market value on the disposal.

Mum and Dad would then pay CGT on the deemed proceeds of the transfer of the shares to Junior.

The Office of State Revenue for NSW would also be interested to ensure the parties are dealing at fair market value, because they want to collect stamp duty on the transfer.

When transferring business assets to family members you can structure the deal to allow for progressive buyouts over a period of time, thus spreading out the tax burden.

For primary production businesses in NSW, there are also some inter-generational transfer stamp duty relief provisions, which can be helpful.




Chapter 2: Apportioning asset values, earnout clauses and other sale issues Comments by Michael Pisani Chapman Eastway

What are the issues to be aware of when apportioning and negotiating the amounts that make up the sale price (e.g. goodwill, P&E, stock)?

When you’re selling business assets out of a company as a going concern, you’re generally selling a composite of different types of assets within the business. For example, you might sell:

• stock; • plant and equipment, for example cars, service vehicles; • intellectual property, for example registered trademarks and patents,

and • goodwill.

If you were to buy a business as a going concern – if you were to buy that collection of different types of assets – you have two options:

1. You can apportion the purchase proceeds between the different types of assets and stipulate that apportionment in the purchase contract. You can say ‘I’m buying this business for $300,000. $100,000 is for the stock, $50,000 for P&E and $150,000 is for goodwill’.

2. Alternatively, the contract can be ‘silent’ on the apportionment. You can say ‘I’m buying this business, which includes all these assets, and I’m paying $300,000’. The contract itself does not stipulate the break-up of the purchase price.




What are the implications?

If you choose the first option, and apportion the purchase price, the different elements will have different tax implications for the vendor.

For example, you may stipulate a value of $100,000 for the plant and equipment, but the vendor’s tax written down value (WDV) is $50,000. The difference between the value you have stipulated in the contract and the vendor’s WDV would give rise to an assessable profit of $50,000 for the vendor on disposal of the P&E.

The purchaser and the vendor may have quite different motivations for placing different values on the various business assets.

For example, goodwill is a non-depreciable asset for tax purposes. If the purchaser wanted to increase profits they could put more of a weighting on goodwill, whereas if they were looking for more of a tax deduction they could put a higher weighting on P&E or stock.

Agree to disagree

In a commercial sense, where you’re dealing on an arm’s length basis, it can be difficult for parties to agree on the exact apportionment of the purchase price. For this reason contracts are often silent on the apportionment.

If the contract is silent on how the purchase price is apportioned, then the responsibility is on both parties to separately apportion the purchase price on a reasonable basis. ‘Reasonable’ is generally based on fair market value of the assets being sold.




What opportunities do earnout clauses provide?

The other issue when selling a business on the open market is that it’s very common, these days, to have earnout clauses.

Basically an earnout is when you sell a business and a certain purchase price is paid, but along with that purchase price is a component that is ‘at risk’ and dependent on future earnings.

Earnout clauses can be problematic from a CGT perspective and there have been significant changes in recent years in the way earnouts are taxed.

At the moment we’re relying on a 2010 press release from the Assistant Treasurer which has simplified the taxation of earnouts, but it isn’t actually law yet. This direction has been helpful for vendors and increased some of the flexibility around the way business sales are structured.

Here’s an example of how a standard earnout arrangement works:

You’re selling your business.

The purchaser says ‘I’ll pay you $1 million for your business now and then I will pay you 20% of the profits for the first two years in which I’m conducting the business’.

This de-risks the purchaser and is a sign of confidence by the vendor, who is saying ‘yes, the business is sustainable and it will continue to make profits’.

The law, as it stands, says the first consideration you receive – the $1 million – relates to the business, and the rights to 20% of the first two years’ profits are CGT assets and you will be taxed on them separately.

This law makes life very complex and is a disincentive to earnout clauses.

In October 2007 the ATO responded to this issue with a draft ruling, Capital Gains Tax consequences of Earnout Arrangements.




Despite not being enacted as law yet, the current treatment under the Assistant Treasurer’s press release basically says ‘whatever proceeds you get from the earnout will be added to the sale proceeds you received for selling the business’.

Once all those payments are lumped together you can then apply your General and Small Business CGT Concessions.

In most cases, using this ‘look-through treatment’ has preferable tax implications for the seller.

What if my company shares or assets were purchased pre-capital gains tax?

One issue we haven’t addressed is what happens when the shares of the company or assets within the company were acquired pre-capital gains tax, i.e. prior to September 1985?

This is a very complicated area, so it’s not really appropriate to go into a lot of detail here. Suffice to say that where you do have pre-CGT assets or shares, it can definitely change the tax implications when selling the shares or selling business assets out of the company and it requires specific advice and planning.

A couple of points to note are:

• The tax office has a number of restrictions and criteria which mean some pre-1985 shares or assets can be deemed to be acquired post-CGT and so are exposed to CGT;

• Many people don’t think about the goodwill associated with businesses that started trading pre-1985 – this can be the most significant asset of the business and represents a very significant tax planning opportunity.




Chapter 3: How to access the Small Business CGT Concessions Comments by Michael Pisani Chapman Eastway

Am I entitled to the Small Business CGT Concessions?

There are four Small Business CGT Concessions which may allow you to disregard or defer some or all of a capital gain from an active asset that you use in your small business. They are:

• 15-year asset exemption • 50% active asset reduction • Retirement exemption • Replacement asset rollover

Generally, to access the concessions you must:

• be a small business entity with a turnover of less than $2 million, or

• be able to satisfy a maximum net asset value test of $6 million. (The test is quite complex because you have to pull in values of connected entities and affiliates.)

The concessions are available for the sale of active assets, which generally refer to business assets or assets used in connection with the business.

To use the concessions you must first satisfy the basic conditions that apply to all four concessions, and then satisfy any conditions that apply specifically to a particular concession.




If you’re considering selling shares in a company, or an interest in a trust, you have to be a CGT concessions stakeholder, which means:

• you or your spouse must have an entitlement of 20% or more of the income and capital of a trust or,

• you or your spouse must have an entitlement of 20% or more of the income, capital and voting rights of a company.

If you’re ticking all those boxes you might start thinking about whether you can access these CGT concessions, but these are just very general, preliminary conditions.

Do the current Small Business CGT Concessions provide me with any advantages in a sale process? What are the thresholds and considerations here?

The four Small Business CGT Concessions can reduce the amount of CGT payable on a sale in a number of different ways:

1. 15 Year Asset Exemption – This is the Holy Grail as far as these exemptions go. Broadly you have to hold the asset for longer than 15 years and the asset must be sold in connection with someone’s retirement. If you can access this concession, the amount of CGT can effectively be reduced to nil.

2. 50% Active Asset Reduction – This generally applies to individuals or trusts that hold CGT assets. If you hold them for longer than a year there is a 50% CGT discount. So, in very general terms, you pay tax on half the profits. This concession reduces that taxable amount by half again, so you only pay tax on a quarter of the gain.

3. Small Business Retirement Exemption – If you make a capital gain, you’re over 55 and the gain is in connection with your retirement, you may be able to receive up to $500,000 once-in-a-lifetime tax free. If you’re under 55 the amount must go into super.




4. Replacement Asset Rollover – This is effectively a deferral of CGT that would otherwise be payable. For example, if you sell one active small business asset and within a prescribed timeframe you purchase another asset, you may be able to defer the CGT that would otherwise be payable until you sell the second asset.

CGT concessions a potential minefield for small business

The Small Business CGT Concessions, while very generous, are also very complex.

There are a lot of pitfalls around these CGT concessions and, unfortunately, a lot of cases of people claiming the concessions then finding themselves in court.

The ATO has recently made practitioners aware of a number of cases going through the tribunal and court system, in which people have claimed access to these CGT concessions but, upon review and audit, the ATO has successfully disallowed them.

Good advice before you sell is essential

An important rule here is, if you are looking at accessing these potentially very generous concessions, make sure your advisor has the appropriate level of technical ability and experience to be able to advise on these rules.

A business sale event is often coupled with a major life event, such as retirement, so it can come as a rude shock if you were banking on accessing these concessions and then find you can’t.




If your advisor is suitably experienced in this area you can have confidence in your expectations of the amount of money you’ll take home after the sale.

However, not only do you need good advice, you need to access it well before the transaction occurs – ideally when you start thinking about selling an active asset.

In some instances the way a sale is structured can mean the difference between getting access to these concessions or not.

So, my key advice is: get good advice and get it early – after the transaction is too late.

Disclaimer: The information contained in this eBook is general in nature and should not be taken as personal, professional advice. Readers should make their own inquiries and

obtain independent advice before making any decisions or taking any action.

