Managing your tax to Maximise your value

Performing taxation due diligence reviews on behalf of purchasers provides a unique perspective on the taxation positions of privately held businesses. It provides an objective view of taxation matters and one that focuses on value, as well as risk.

In this article we rank the top 5 tax due diligence issues identified in reviews of privately held businesses. These are the common issues that have the greatest impact on value.

It should be noted that a purchaser will only be interested in taxation issues where the entity that owns the business is being purchased. For sales of businesses direct the vendor retains the taxation risks in the entity they continue to own.

All of the issues are simple matters to resolve that could help to maximise the value of business and minimise warranties in those crucial negotiations.

These things can be fixed once they are identified during the due diligence process. But if they are dealt with effectively prior to the transaction then the purchaser can have greater comfort about the value or risks associated. This will work in your favour when it comes to negotiating value or vendor warranties.

# 1 – No Deferred Tax Assets

Even the smallest of businesses have timing differences that give rise to deferred tax assets in their balance sheet. The most common arise from provisions for annual, sick and long service leave where the expense has been recognised and no tax deduction is available until the leave is taken and the leave pay is paid. The deferred tax asset represents the tax effect deduction that will arise in the future as a result of this.

Another common example giving rise to a deferred tax asset is where you are depreciating your assets in your accounts faster than you can for tax purposes.

By recognising these assets you can build your net assets and your retained profits so that you can take out extra cash as dividends prior to sale. Crucially these dividends may be able to be franked where you have excess franking credits.

The effective tax rate on the cash withdrawn by way of a franked dividend is 23.57% versus 23.25% for a capital gain subject to the general CGT discount so there is little tax difference between a dividend and a capital gain.

Alternatively where you have a purchase price that is adjusted for the value of net assets so that the value determines, at least in part, the amount of your capital gain the value of the deferred tax asset may be counted.

# 2 – Payments and Loans to shareholders

Payments to shareholders, their families or related entities can be problematic for the purchaser of a company. These can often be for services provided by or wages to family members or related entities. The tax law treats these amounts as non deductible to the extent that they are excessive when compared to the services performed.

The key is to ensure that payments to family members are documented and reasonable. Employment or service agreements should be in place with the family members or entities, which substantiates that the payments are reasonable.

# 3 – Transfer Pricing

Increasingly privately held businesses are moving into international markets and setting up operations overseas. As such overseas countries and the ATO become interested in how you are pricing transactions for services between countries, particularly where there are differentials in tax rates.

Transfer pricing is not just an issue for the big end of town. The ATO has recently begun targeting privately held businesses via their disclosures in the income tax returns. Further, if your company is being acquired by foreign purchasers then they are generally attuned to transfer pricing as it is a key tax issue in running global businesses.

As such you need put in place transfer pricing arrangements to ensure that the tax risks arising from transfer pricing do not become a negotiation point or give rise to warranties. There are often commercial benefits arising from transfer pricing studies because the functions and risks analysis undertaken provides a great analysis of the substance of a business which can be helpful in the sale process itself.

# 4 - Losses

Tax losses are a problem that no one really wants to have and are generally treated with little respect until a company reaches the point when it starts to make profits. They can only be utilised if a company meets the continuity of ownership test or same business test both of which can be problematic.

Where purchasers are making profits or are a consolidated group they may be better placed to utilise your losses than you are and may place a higher value on them than you do.

It is important to plan to ensure that you meet either of these tests and there are strategies that can be put in place to ensure that changes in ownership or your business don’t endanger your losses. Similarly, making sure that your losses are properly disclosed as ‘deferred tax assets’ or otherwise as ‘deferred tax assets not brought to account’ can appropriately bring them to the attention of a purchaser.

# 5 - No Tax Sharing Agreements

Without going into the technical details, if you have a consolidated tax group, you need a tax sharing agreement. Otherwise each company in your group is jointly liable to the ATO for all income tax debts of the entire group even though they did not relate to your profits.

This is particularly a problem where you are selling one company from your group. In the absence of a tax sharing agreement you cannot stop the ATO chasing the exiting company for the whole of the debt at some time in the future, although warranty protection can be obtained.

The tax sharing agreement only becomes effective from the date that it is executed so it needs to be in place preferably from the day that the consolidated group is formed. A consolidated group with a tax sharing agreement will be worth more and there will less for discussion if this simple matter is dealt with.

Honourable Mentions

With any list, there is conjecture about those items that missed out on inclusion. Following are a couple of these.

• Contractors, contractors, contractors and bona fide contractors almost always rate a mention because of the potential to create PAYG withholding taxes, superannuation and payroll tax liabilities if they are really employees. If you use a lot of contractors, manage these issues in advance.
• Payroll tax grouping rules and cross border payrolls catch people out regularly where they control number of businesses in different states of Australia leading to payroll tax liabilities arising in unlikely places.

Planning

Planning for the sale of your business should start as early as possible so as to maximise your value. You should plan to:

1. minimise the taxes on the sale

2. maximise the impact of taxes on your balance sheet

3. ensure that your tax affairs are in order

4. have as few discussions with the purchaser about tax as possible.



Author: Peter Berg & Scott Treatt, May 2008

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