Last week the new tax rules applying to the sale of commercial assets and the allocation of the purchase price for such assets became effective. The rules will be of particular relevance for those parties buying commercial property, businesses by way of an asset sale or other bundles of assets.
A purchase price allocation is the division of the total purchase price between the various classes of assets sold in a transaction. For agreements entered into on or after 1 July 2021, a purchaser and seller of a bundle of assets will both generally be required to make the same allocation of the total purchase price across the different assets being sold.
Transactions involving mixed asset categories
Where a transaction involves the sale of mixed categories of assets, often the tax consequences for assets in the different categories can be quite different. For example, the payment for land or goodwill may often be outside the tax base and not give rise to income tax consequences. On the other hand, the payment for trading stock would typically be deductible to the payer and taxable to the recipient. Depending on whether they are buying or selling assets, commercial parties therefore have an incentive to allocate the purchase price for assets on a basis that best suits their position. Previously there was no legislative requirement for parties to adopt the same allocation other than in relation to limited asset categories, although consistency was generally agreed as a contractual matter.
The new rules were introduced to address concerns on behalf of Inland Revenue in relation to these so-called "mixed supplies". Inland Revenue issued a discussion document in December 2019 which outlined its concerns, including the adoption of inconsistent allocations by commercial parties, the departure from an agreed valuation for tax purposes and the adoption of allocations that did not reflect market value.
New rules for when a purchase price is and is not agreed
Two separate rules have now been introduced to apply in circumstances either where the parties to a transaction have agreed an allocation of the purchase price or where no such agreement is made. If the parties agree on a purchase price allocation, there is now a specific legislative requirement for the parties to use that agreed allocation in their tax returns. There is also a requirement that the purchase price allocation reflect the respective market values of the assets. Inland Revenue has the ability to substitute a purchase price allocation if it considers that the agreed allocation does not reflect the relative market value of the assets.
The rules will be of particular interest where advisors are acting for purchasers of assets as, if no allocation of the purchase price is agreed in the sale documentation or prior to filing a tax return, the vendor will have the ability to determine the allocation. In that scenario, the vendor has three months following the change in ownership of the assets to notify the purchaser and Inland Revenue of the purchase price allocation. If no notification is made, the allocation then falls to the purchaser and, if there is again no notification, to Inland Revenue. It remains to be seen how often this rule is going to be relevant in practice as well-advised commercial parties would typically agree an allocation and not leave it to the discretion of a counterparty.
Exceptions to the rules
It should be noted that there are certain exceptions, for example, the rule whereby a vendor may notify the purchaser of the purchase price allocation does not apply where the total purchase price for the assets is less than $1 million. In addition, that rule does not apply to a sale of residential land and chattels unless the purchase price is $7.5 million or more. An allocation of the purchase price should nevertheless be considered as a matter of best practice in those cases.
Practical considerations for commercial parties and their advisors for an asset sale:
You would need to be comfortable that, for asset sale transactions with significant value, a robust market valuation has been sought and agreed.
If a transaction is being negotiated on a tight timeframe, manage the risk that a purchase price allocation may not be agreed prior to signing and will be addressed at a later date prior to taking a filing position.
Where the transacting parties are in different tax positions, such as a tax-exempt party or a party in a material tax loss position, an agreed allocation may be subject to an increased degree of scrutiny.
Address the position where there will be potential purchase price adjustments after the agreement is executed and ensure that the agreed allocation continues to reflect market value.
A final point of interest is that the Special Report on the new legislation provides that a unilateral vendor, purchaser or Inland Revenue allocation is binding on the parties "with no right for a party to contest the allocation by filing a notice of proposed adjustment or to take any other proceedings to challenge the allocation". That statement seems questionable, particularly in circumstances where a potential three-way dispute process was considered as part of the Select Committee process.
As noted above, the new rules apply to agreements entered into on or after 1 July 2021.
Please get in touch with Greg Neill or your usual Russell McVeagh contacts if you would like to discuss how the new laws may apply to your business or to a particular transaction.