July Tax Alert

Article

Purchase price allocation: A square peg for a round hole

Tax Alert - July 2020

By Matthew Scoltock and James Hickey
 

Legislation to enact the Government’s much-anticipated purchase price allocation (“PPA”) reform has been introduced. The Taxation (Annual Rates for 2020-21, Feasibility Expenditure, and Remedial Matters) Bill (“June Bill”) was introduced to the House in early June 2020. As discussed in our February 2020 Tax Alert, Officials published an issues paper in late 2019, outlining a number of PPA-related policy concerns (in particular, the need for vendors and purchasers to consistently allocate purchase prices for income tax purposes, and for purchase price allocations to reflect “market value”). The Officials’ issues paper also proposed what was, at that time, their proposed “fix.”

In large part, that “fix” has made its way into the draft legislation, providing a strict framework for the way in which a vendor and purchaser may allocate the “global” purchase price for property that is treated differently for income tax purposes (e.g., the sale and purchase of a combination of non-depreciable property, depreciable property and revenue account property), known as a “mixed supply”. The sale and purchase of commercial, industrial or residential real estate (comprising land, building and fit-out), or the sale and purchase of a business (or part of a business), will ordinarily comprise a mixed supply.

Several sections of the Income Tax Act 2007 explicitly require purchase prices to be allocated to “taxable property” based on “market value.” These are intended to ensure that purchase prices for mixed supplies are allocated consistently by vendors and purchasers, and at “market value.” While there is some debate as to whether or not the requirement to do so for every mixed supply currently has force in law, the Government seemingly believes that the issue is “grey” enough to warrant its own statutory regime. The Government is of the view that there is too much room for a vendor and purchaser to “game the system” by separately allocating purchase price to create either an excessive tax-free capital gain or a deductible loss on sale, thus eroding the tax base and resulting in a loss of Government revenue.

Key Features

The proposed amendments will, if enacted, apply to sale and purchase agreements for mixed supplies entered into on or after 1 April 2021, and can be summarised as follows:

  • If the vendor and purchaser agree a PPA (say, in the sale and purchase agreement, as is best practice), they must follow it for purposes of their income tax returns. The vendor and purchaser must have agreed the PPA by the earlier of the day on which the vendor or the purchaser files its income tax return for the income year in which the mixed supply takes place.
  • As a backstop, if the vendor and purchaser do not agree a PPA, the vendor has the first right to decide the PPA, and must notify both the Commissioner and the purchaser of its PPA within two months of the “change in ownership” of the property. However, if the vendor does allocate the purchase price, the price “floor” is the tax carrying value of the property.
  • If the vendor does not allocate the purchase price within the two-month timeframe, the right to decide the PPA “flips” to the purchaser.
  • If the vendor and purchaser do not, in turn, decide a PPA, the vendor will be treated as disposing of the property for “an amount that reflects its respective market value…,” and the purchaser will be treated as acquiring the property for nil consideration (such that it has no deductible or depreciable “base” for income tax purposes).
  • Under a de minimis rule, neither the vendor nor the purchaser is required to decide the PPA if (1) the “global” purchase price is less than $1M, or (2) the total purchase price allocated by the purchaser to “taxable property” is less than $100,000.
  • The Commissioner has an over-riding power to allocate the purchase price on behalf of the vendor and purchaser based on “respective market value,” subject to a de minimis for “low-value depreciable property.”
  • The Commentary on the June Bill states that “[i]t is not intended that parties have to allocate an amount to every individual item. It will be sufficient for the allocation to be made at the level of asset categories subject to particular income or deduction rules - for example, depreciable property, buildings, revenue account property, financial arrangements, land, and so on.” However, that administratively critical principle has not been captured in the drafting of the proposed amendments.

Consultation with Officials

Disappointingly, many of the criticisms/issues that were raised with Officials have not been reflected in the proposed amendments. Some have been commented on by Officials in the Regulatory Impact Assessments (“RIA”) to the June Bill. As noted in the RIA, in deciding how best to respond to their PPA-related policy concerns, Officials considered (1) the status quo (i.e., doing nothing), (2) a vendor-first “party allocation” (for which Officials have opted), (3) a “Commissioner allocation,” and (4) an operational approach.

While an operational approach has been overwhelmingly favoured by industry (on the basis that - other than the status quo - it is the most commercial, and the least likely to impact the vendor’s and purchaser’s relative bargaining strength), Officials primarily considered either a vendor-first “party allocation” or a “Commissioner allocation.” An operational approach was rejected by Officials as, in their view, the Commissioner had no “legal basis” to require consistency of PPA between the vendor and purchaser. As noted in our February 2020 Tax Alert, throughout consultation there has been a visibly strong commitment from Officials to pursue a legislative course of action, rather than publish, for example, a Revenue Alert or operational statement, or simply require vendors and purchasers to notify the Commissioner of their purchase price allocations where agreements cannot been reached. In our view, such an operational approach is likely to go a long way to “correcting” the behaviour with which Officials are troubled. And, if there is concern that there is no “legal basis” for the Commissioner to require consistency as to PPA, why not simply correct that?

Comment

As set out in our February 2020 Tax Alert, giving the vendor the first right to allocate the purchase price will, almost certainly, create an imbalance in the vendor’s and purchaser’s relative bargaining strength that might otherwise not exist. This was, we understand, a near-universal criticism/issue raised by industry throughout consultation with Officials. Unfortunately, the proposed amendments do nothing to address it. Rather, as is clear from the RIA, Officials continue to consider that “[i]f the vendor is not prepared to agree the allocation, the purchaser may either refuse to go ahead with the transaction, or lower its price.” That view is, of course, detached from commercial reality - particularly in the context of competitive M&A, where it is highly unlikely that a bidder can stay competitive and, at the same time, negotiate a lower purchase price.

Similarly, in the context of a competitive M&A deal, it is clear that a New Zealand bidder may be at an immediate disadvantage due to the fact that most intangible property is unable to be amortized/depreciated for income tax purposes. By contrast, in the United States (for instance), goodwill and “going concern value” are generally amortisable over 15 years on a straight-line basis. A foreign bidder will often be indifferent as to PPA if the property is being “taken” outside the New Zealand tax net, and is therefore likely to have a competitive advantage over a New Zealand bidder. That is, clearly, not a great policy outcome in a post-COVID-19 environment in which we are trying to support New Zealand business.

Perhaps a more fundamental question is whether or not a foreign purchaser, with no physical presence in New Zealand, that is “taking” property outside the New Zealand tax net, ought to be subject to a consistency requirement at all. Allocation of the purchase price may be meaningless to the foreign purchaser. And yet, as the proposed amendments are drafted, if the vendor does not (or is unable to) exercise its first right to allocate the purchase price, the decision will “flip” to the foreign purchaser.

In addition, the two-month timeframe for a vendor to decide the PPA and notify the Commissioner and the purchaser is far shorter than the theoretically open-ended timeframe given to a purchaser (if a PPA is not agreed by the vendor and purchaser, and the vendor does not exercise its first right to allocate). While that timeframe may, at first, seem reasonable (given the vendor will have held that power from “day dot”), many mixed supplies are not vanilla and actually have numerous complexities and “moving parts” (which may be caused by the parties themselves, or even by third parties). For non-vanilla mixed supplies, a two-month timeframe may not work practically. For example, if a vendor and purchaser both have a 31 March balance date, and a mixed supply completes on 1 April 2021 without agreement as to PPA, the vendor will have until 1 June 2021 to decide the PPA and notify the Commissioner and the purchaser. Clearly, that does not give the vendor much time to evaluate the property’s “respective market value”, particularly if market conditions have shifted materially between negotiation and completion. More significantly, however, if the vendor does not exercise its first right by that date, the purchaser will possibly have until 31 March 2023 - being the filing date for the vendor’s and purchaser’s income tax returns - to decide the PPA and notify the Commissioner and the vendor. The vendor (a New Zealand business) will therefore be left at the mercy of the (possibly non-resident) purchaser.

Last, while Government may believe that vendors and purchasers need to be motivated to comply with the proposed amendments, deeming purchasers to acquire property for nil consideration while treating vendors as disposing of the same property for its “respective market value” is asymmetrical and penal. In addition, while making the tax carrying value of the property the price “floor” (if the PPA is decided by the vendor under section GC 21) is clearly an important caveat, it does not take into account the fact that the “global” purchase price might be less than the tax carrying value of the property.

Conclusion

Clearly, a “one-size-fits-all” solution is unlikely to work in practice, and may even distort the commercial dynamic of a number of mixed supplies (particularly in the context of competitive or cross-border M&A). Given the complexity and commercial impact that the proposed amendments are likely to have, we remain firmly of the view that an operational approach is the better “fix.”

However, if enacted as currently drafted, we expect the proposed amendments to result in more vendors and purchasers agreeing purchase price allocations (or mechanisms/methods for allocating the purchase price ahead of completion). As we have said in the past, the most important takeaway will be for vendors and purchasers to make every effort to agree purchase price allocations as early as possible in the course of mixed supplies, and ensure that they are applied consistently for income tax purposes. It will be critical that vendors and purchasers engage their New Zealand tax advisors as early as possible to determine the income tax consequences of purchase price allocations, and to ensure that they are not adversely impacted in unforeseen ways.

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