revenue pitfalls in entity sales
3 mins reading time
We are seeing a growing preference towards commercial deals at the shareholder/unitholder level, which makes sense in the context of:
- being able to do so without the additional burden of duty costs (unless the underlying entity is a landholder, or in Queensland, is a unit trust which holds Queensland dutiable property);
- not having to disturb third party dealings or changing the profile of the trading entity (subject of course to existing key contracts and agreements with a change of control provisions);
- the potential to form an income tax consolidated group facilitating the subsequent movement of assets within the group without income tax (or duty – usually); and
- the generous revenue concessions granted to individuals and trusts from a capital gains tax perspective – with both being able to access the 50% general discount and if applicable, the Small Business CGT Concessions.
However, these advantages can be rendered obsolete when the common revenue pitfalls of entity sales are overlooked from the outset.
In no particular order the most common traps we deal with in practice are:
1. landholder and corporate trustee duty
The concept of a landholder varies from state to state but in Queensland and New South Wales the threshold is $2m and requires an analysis of the current market (not land tax or rateable) value of the property and fixtures.
If a target is a landholder, an acquisition of 50% or more will incur duty at conveyancing rates, notwithstanding that it is a share sale. Borderline cases should have valuations to support the conclusions of a client and their adviser.
In addition, Queensland has a unique regime that attaches duty to shares in corporate trustees for non-fixed trusts that hold Queensland dutiable property. Unless those trusts are family trusts for duty purposes (nothing to do with ‘family trust elections’) and the transfer of shares is to a family member, then conveyancing rates of duty can apply.
While relatively obscure, these issues do come up in estate and succession planning engagements or where advisers get creative with ways to transfer control of non-fixed trusts between arm’s length parties.
2. pre-CGT assets and interests
While transactions involving pre-CGT assets and interests are dwindling, they are still about and care must be taken when dealing with pre-CGT interests in particular and you must first be satisfied that such interests have maintained their pre-CGT status.
Take a share sale for example – while the shares themselves may remain unchanged since September 1985, if, just before the disposal of the shares, the market value of post-CGT assets in the underlying company is more than 75% of the company’s total value, a portion of those shares (i.e that reflects – on a reasonable basis – the post-CGT property of the company) will effectively be treated as post-CGT, with some cost base modifications.
A more common issue crops up when there has been a change in the “ultimate owners” of pre-CGT interests in pre-CGT entities with pre-CGT assets. Pre-transaction changes in ultimate ownership of the underlying pre-CGT assets (in most cases, those individuals who have direct or indirect ownership interests in the asset owner) will not affect the pre-CGT status of the assets in the entity provided that at least 50% of all ultimately held interests continue to be maintained as pre-CGT.
This means that a post-CGT change of more than 50% of those ultimate interests would cause the pre-CGT assets to lose that status without any apportionment. This may be acceptable to the exiting party, but it is not ideal for the remaining party. It is worth noting though that where this does occur (i.e. where more than 50% of all ultimately held interests are held post-CGT), it does not cause the remaining pre-CGT interests to attract any post-CGT treatment as a consequence of the ‘75% rule’ noted above.
3. carry forward losses
A change of less than 50% can occur and an entity can continue to rely on having the same owners for the purposes of carrying forward losses.
If however, the change is 50% or more then the entity can no longer rely on the same owner test and must rely on the same or similar business test (depending on when the losses were incurred) which can be far more challenging to satisfy. Where the target has losses that the purchaser intends to utilise, it clearly warrants considerable upfront attention to ensure that the alternative test can be met.
4. debit loans
Particularly in the context of a seller looking to apply the small business CGT concessions, what can cause havoc with eligibility are debit loans. To the extent that the value of such loans is at least 20% of the market value of the active assets of an entity, this can cause the interests in that entity to fail the active asset test, if the loans have been in place at that value for too long. This still catches people out and is an important review point when structuring a transaction from the outset with access to the concessions in mind.
5. entity elections
One of the hardest pitfalls to rectify pre-transaction is in the context of the many companies (and to a lesser extent unit trusts) that have made (usually incorrectly) interposed entity or family trust elections as part of their involvement in broader groups.
Given that such elections cannot be revoked (except in limited circumstances), these elections often render a sale of underlying shares or units commercially impossible as despite a non-family group member paying market value for the interests, family trust distribution tax would apply to any post acquisition dividend or distribution received by that third party. Consequently, one of the first items of due diligence if contemplating the purchase of shares or units is to seek confirmation that no such elections have been made.
Revenue considerations, while important, should not unnecessarily be a blocker to the commercial objectives our clients seek to achieve. While most transactions can be structured to manage the perceived pitfalls outlined above (if caught early enough), the devil, as they say, is always in the detail.
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revenue pitfalls in entity sales
We are seeing a growing preference towards commercial deals at the shareholder/unitholder level, which makes sense in the context of:
- being able to do so without the additional burden of duty costs (unless the underlying entity is a landholder, or in Queensland, is a unit trust which holds Queensland dutiable property);
- not having to disturb third party dealings or changing the profile of the trading entity (subject of course to existing key contracts and agreements with a change of control provisions);
- the potential to form an income tax consolidated group facilitating the subsequent movement of assets within the group without income tax (or duty – usually); and
- the generous revenue concessions granted to individuals and trusts from a capital gains tax perspective – with both being able to access the 50% general discount and if applicable, the Small Business CGT Concessions.
However, these advantages can be rendered obsolete when the common revenue pitfalls of entity sales are overlooked from the outset.
In no particular order the most common traps we deal with in practice are:
1. landholder and corporate trustee duty
The concept of a landholder varies from state to state but in Queensland and New South Wales the threshold is $2m and requires an analysis of the current market (not land tax or rateable) value of the property and fixtures.
If a target is a landholder, an acquisition of 50% or more will incur duty at conveyancing rates, notwithstanding that it is a share sale. Borderline cases should have valuations to support the conclusions of a client and their adviser.
In addition, Queensland has a unique regime that attaches duty to shares in corporate trustees for non-fixed trusts that hold Queensland dutiable property. Unless those trusts are family trusts for duty purposes (nothing to do with ‘family trust elections’) and the transfer of shares is to a family member, then conveyancing rates of duty can apply.
While relatively obscure, these issues do come up in estate and succession planning engagements or where advisers get creative with ways to transfer control of non-fixed trusts between arm’s length parties.
2. pre-CGT assets and interests
While transactions involving pre-CGT assets and interests are dwindling, they are still about and care must be taken when dealing with pre-CGT interests in particular and you must first be satisfied that such interests have maintained their pre-CGT status.
Take a share sale for example – while the shares themselves may remain unchanged since September 1985, if, just before the disposal of the shares, the market value of post-CGT assets in the underlying company is more than 75% of the company’s total value, a portion of those shares (i.e that reflects – on a reasonable basis – the post-CGT property of the company) will effectively be treated as post-CGT, with some cost base modifications.
A more common issue crops up when there has been a change in the “ultimate owners” of pre-CGT interests in pre-CGT entities with pre-CGT assets. Pre-transaction changes in ultimate ownership of the underlying pre-CGT assets (in most cases, those individuals who have direct or indirect ownership interests in the asset owner) will not affect the pre-CGT status of the assets in the entity provided that at least 50% of all ultimately held interests continue to be maintained as pre-CGT.
This means that a post-CGT change of more than 50% of those ultimate interests would cause the pre-CGT assets to lose that status without any apportionment. This may be acceptable to the exiting party, but it is not ideal for the remaining party. It is worth noting though that where this does occur (i.e. where more than 50% of all ultimately held interests are held post-CGT), it does not cause the remaining pre-CGT interests to attract any post-CGT treatment as a consequence of the ‘75% rule’ noted above.
3. carry forward losses
A change of less than 50% can occur and an entity can continue to rely on having the same owners for the purposes of carrying forward losses.
If however, the change is 50% or more then the entity can no longer rely on the same owner test and must rely on the same or similar business test (depending on when the losses were incurred) which can be far more challenging to satisfy. Where the target has losses that the purchaser intends to utilise, it clearly warrants considerable upfront attention to ensure that the alternative test can be met.
4. debit loans
Particularly in the context of a seller looking to apply the small business CGT concessions, what can cause havoc with eligibility are debit loans. To the extent that the value of such loans is at least 20% of the market value of the active assets of an entity, this can cause the interests in that entity to fail the active asset test, if the loans have been in place at that value for too long. This still catches people out and is an important review point when structuring a transaction from the outset with access to the concessions in mind.
5. entity elections
One of the hardest pitfalls to rectify pre-transaction is in the context of the many companies (and to a lesser extent unit trusts) that have made (usually incorrectly) interposed entity or family trust elections as part of their involvement in broader groups.
Given that such elections cannot be revoked (except in limited circumstances), these elections often render a sale of underlying shares or units commercially impossible as despite a non-family group member paying market value for the interests, family trust distribution tax would apply to any post acquisition dividend or distribution received by that third party. Consequently, one of the first items of due diligence if contemplating the purchase of shares or units is to seek confirmation that no such elections have been made.
Revenue considerations, while important, should not unnecessarily be a blocker to the commercial objectives our clients seek to achieve. While most transactions can be structured to manage the perceived pitfalls outlined above (if caught early enough), the devil, as they say, is always in the detail.