Ascribing a value to goodwill on the sale of business – flexibility in the exercise?

INTRODUCTION

The sale of a business can give rise to a smorgasbord of CGT issues for both the vendor and purchaser of the business. From a tax perspective, a sale of a business is in fact a sale of the various assets that comprise the business. The CGT implications that arise therefore turn on the application of the CGT provisions to each individual CGT asset. Broadly, the assets (CGT and revenue) of a business might typically comprise the goodwill, trading stock, depreciable plant, lease of premises, and perhaps business names and logos, and items of intellectual property.

HOW MUCH FLEXIBILITY DOES A VENDOR HAVE IN THE ALLOCATION OF THE PURCHASE CONSIDERATION TO THE VARIOUS ASSETS THAT ARE THE SUBJECT OF THE SALE?

In particular, if there are pre-September 1985 CGT assets in the pool of CGT assets being disposed of, the vendor may be motivated to ensure that as much as possible of the sale proceeds be ascribed to the disposition of these assets as the gain on these will be tax free. A typical example is inherent goodwill of a business that is a pre-September 1985 asset.

The short answer to the above question however, is that the vendor has little flexibility in this regard. The lesson, therefore, is not about how far the allocation can, say, be manipulated for a tax effective outcome, but how to ensure that the allocation is acceptable and appropriate for tax purposes. 

Practice Note

The goodwill of a business is “acquired” when the business commences, even if the business was new at the time it commenced or there was no purchased goodwill at that time. If a business commenced pre-September 1985, the goodwill is a pre-CGT asset and it follows that no CGT consequences arise from the sale of the goodwill of the business even if the sources of the goodwill may have varied during the life of the business, or the value of the goodwill has fluctuated. The proviso however, is that the business has remained the same in its essential nature and character so that it cannot be said to have been “freshened up”.  

ASCRIBING A VALUE TO GOODWILL

When ascribing a value to the goodwill on sale, it is worth noting the following:

For tax purposes, goodwill is an asset separate from the other assets of the business (Murry v FCT 98 ATC 4585). Even if much of the “sources” of the goodwill can be attributed to, say, the use of particular assets in the business, or the location of the business, for tax purposes the value of the goodwill is still separate and distinct from the value of those assets, or the value of the premises. For income tax purposes, goodwill is not reflected in an enhancement in the value of the assets that might have played a significant role in the generation of the goodwill of the business.
 

• The Commissioner of Taxation has stated that he will accept a value ascribed to goodwill where there is arm’s-length dealing (Taxation Ruling TR 1999/16). In this regard, it is appropriate to ascribe a value to goodwill that approximates its market value as this is indicative of an arm’s-length dealing. In any case, under the income tax legislation, a market value to the goodwill will be substituted if the price ascribed in the contract has resulted from non–arm’s-length dealings between the parties (sec 116-30(2)). If the parties do not apportion the purchase price, the Commissioner considers that each party must make its own allocation on the basis of the relevant market values of the assets at the time of making the contract.

Practice Note

The concept of what amounts to an arm’s-length dealing is not necessarily clear. Hill J in Pontifex Jewellers (Wholesale) Pty Ltd v FCT (1999) 23 ATR 643 noted that the term “at arm’s length” masks an ambiguity. Does it refer to:

• the relationship between the parties to a transaction; or

• the terms on which the transaction is settled?

Hill J observed that the test is generally taken to refer to the terms of the transactions rather than the relationship between the parties. It is not material whether the parties are related in some way if the parties behaved in a manner in which independent parties acting in their own commercial interests would have behaved so that the outcome of the dealing is commercially realistic.

Accordingly, it is both possible for related parties to deal with each other at arm’s length and for unrelated parties to deal with each other at non–arm’s-length terms.

• Although open to other alternatives, the Commissioner’s preferred approach to valuing goodwill on the sale of a profitable business is to consider the difference between:

1. the present value of the predicted earnings of the business; and
2. the sum of the market values of the assets of the business.

The Commissioner notes that this calculation must take into account both “off balance sheet” assets and “on balance sheet” assets.

Practice Note

It might be appropriate to obtain a valuation from a registered valuer in some cases, as the Commissioner is less likely to challenge an independent valuation.

The effect of the above principles is that in effect, a vendor cannot artificially inflate the value ascribed to goodwill in a sale of business to achieve a tax effective outcome.

By way of illustration of some of the potential issues that may arise in a sale of a business, the following case study is provided.

CASE STUDY

Vernon Pty Ltd has been running a business distributing homewares and children’s play equipment in Australia for some 10 years. As part of a rationalisation of its business activities, a decision was made to look for a buyer for the children’s play equipment distribution part of the business.

Negotiations were entered into with representatives of Icarus Pty Ltd, another Australian company. The plan was to transfer all of the assets associated with the play equipment distribution business for $10 million.

In January 2004, the parties reached agreement, and representatives of both companies signed an agreement on 31 January whereby the assets of the play equipment distribution business were to be transferred to Icarus for $10 million. The relevant assets included:

• a license to import some of the equipment from the US. The license was acquired for nil consideration in 1999;
• a freehold distribution outlet in Caulfield acquired in 1983 for $250,000;
• a freehold distribution outlet in Richmond acquired in 2000 for $5 million; and
• furniture and fittings in those outlets (current WDV $10,000).

The allocation of the purchase price in the contract was as follows:

• Licence– nil
• Caulfield distribution outlet  – $990,000
• Richmond distribution outlet $5 million
• Furniture and fittings – $10,000
• Goodwill – $4 million

As part of the contract, Vernon agreed not to compete in any children’s play equipment products for a period of 3 years and received an additional $50,000 for this promise.

There are four “things” being sold:

• contractual rights (the licence and the restrictive covenant)
• land and buildings
• furniture and fittings
• goodwill.

Contractual rights

In Murry’s case the court concluded that a licence was property and a separate CGT asset to the goodwill of the taxi service in that case. In any event, the legal and equitable rights that the licence to import US goods gives the company are a CGT asset within the second limb of sec 108-5 of the Income Tax Assessment Act 1997 (“ITAA97”).

The licence has a nil cost base, assuming that the market value substitution rule (sec 112-20 ITAA97) does not apply. If Icarus and Vernon are dealing at arm’s length and have “arrived at” a nil allocation for the transfer of this asset, the disposal of these rights will not trigger a CGT liability.  

The contract also requires the company to enter into a covenant not to compete for 3 years in children’s play equipment for consideration of $50,000 (capital proceeds). Creation of this obligation gives rise to a CGT event D1. Vernon makes a capital gain of approximately $50,000, this being the consideration given for the covenant. The term “approximately” is used here because any costs incurred in completing this transaction (eg legal fees) can be deducted from the capital proceeds.

Land and buildings

There are two parcels of land and buildings. The Caulfield property was acquired in 1983. As this CGT asset was acquired prior to 20 September 1985, sec 104-10(5) applies and this capital gain will be disregarded. However, any post-CGT improvements to the property will be treated as separate CGT assets (sec 108-70(2)), and subject to the value of these improvements being in excess of the improvement threshold. If there are improvements, the CGT rules will apply to these improvements as separate assets to the land.

The Richmond property is a post-CGT asset. If the amount apportioned to this CGT asset is its market price, there will be no capital gain or loss from this CGT event as the market value is equivalent to its cost base. If, however, the market value of this asset is in excess of $5 million (which appears likely), then the capital gain will be the difference between the cost price of $5 million (plus each of the second to fifth elements of the cost base) and the market value at the time of disposal. As the vendor is a company, the Div 115 50% discount does not apply.

Furniture and fittings

Apart from gains calculated under CGT event K7, any capital gain arising from the disposal of a depreciating asset is disregarded because the disposal will cause a balancing adjustment pursuant to Subdiv 40-D of the 1997 Act. It is assumed that the furniture and fittings are depreciating assets in the context of Vernon’s operations. If a balancing adjustment occurs, an amount may be included in the company’s assessable income or an amount may be deductible.

If the written down value of $10,000 (at which the assets are sold) reflects the current market value of these assets, this part of the transaction is tax neutral. However, in TD 98/24 the Commissioner observes that the “written down values” of depreciating assets is not necessarily the market value of those assets.

Goodwill

As the business commenced before 1985, the goodwill is a pre-CGT asset if the business has not changed since its commencement such that that it can no longer be considered to be the same business as the one that was conducted in 1985. Given that this goodwill has been internally generated, it has a nil cost base.

Unrelated parties will usually be assumed to be acting at arm’s length; however they will not be dealing at arm’s length if they “collude to achieve a particular result, or in which one of the parties submits the exercise of its will to the dictation of the other, perhaps to promote the interests of the other” (Granby Pty Ltd v FC of T 95 ATC 4240).

Collusion may typically occur when the parties attempt to “transfer” value from

a revenue asset (eg furniture and fittings in this case) to a capital asset (eg the Richmond property) or a pre-CGT asset (eg the goodwill) to obtain the benefit of CGT concessions or accelerated depreciation.

Where there is a suggestion of this occurring, there is the risk of the Commissioner examining the allocations, and challenging them under various legislative provisions, such as sec 40-180 (Item 8 of the table); sec 116-30(2)(b)(i) and sec 112-20(1)(c) (refer also to para 46 of TR 1999/16).

CONCLUSION

Although a sale of business is a somewhat standard transaction that clients engage in, the tax issues associated with aspects of the transaction, such as the proper allocation of sale proceeds, can be a tricky exercise. The client should be aware that there is little opportunity for “manipulating” the allocation to achieve a lower tax bill.