Purchase price allocation: Using a sledgehammer to crack a chestnut
Tax Alert - February 2020
By Hadleigh Brock & Matthew Scoltock
In mid-December 2019, Inland Revenue released an officials’ issues paper proposing legislation in relation to allocating purchase price where multiple assets are bought and sold in a single deal. This proposal has significant commercial and tax consequences for vendors and purchasers, both now and in the future.
Citing concerns that vendors and purchasers: (1) do not always agree upon how to allocate the purchase price across the assets being bought and sold, (2) sometimes fail to follow the agreed-upon allocation (where one exists), or (3) may agree to a purchase price allocation that does not reflect “market values”, officials propose that vendors and purchasers be required to base their purchase price allocations on “relative market values” and consistently adopt the same purchase price allocations in their income tax returns to eliminate the risk of ‘tax asymmetries’ and loss of fiscal revenue.
Officials propose enacting the following rules in relation to sales and purchases that are “mixed supplies” (i.e., transactions that involve a mix of capital account
assets and revenue account assets, depreciable and non-depreciable assets, etc.):
(1) that in all cases the vendor and purchaser be required to use the same allocation of the purchase price in relation to the different assets;
(2) that this be achieved by a ‘hierarchy’ of rules. If a vendor and purchaser:
a) agree a purchase price allocation, both must file their income tax returns using that allocation;
b) do not agree a purchase price allocation, then:
i. the purchaser must use the vendor’s purchase price allocation when filing its income tax returns. In this case, it is proposed that there will be a requirement for the vendor to disclose its allocation to both the purchaser and the Commissioner of Inland Revenue (“Commissioner”) within a specified period of time (for example, within three months after the assets are treated for income tax purposes as being disposed of by the vendor);
ii. if the vendor fails to provide that allocation, the purchaser may determine its own purchase price allocation, which must be provided to the vendor and the Commissioner, and must be followed by the vendor;
(3) that, notwithstanding (1) and (2), purchase price allocations must be based on “relative market values” (except, possibly, with respect to a non-agreed allocation of the purchase price to depreciable assets, in which case it is proposed that either tax-depreciated cost or original cost may instead be available);
(4) it may be appropriate to have a de minimis exemption to protect purchasers in low-value transactions from an “unexpected consistency requirement” (the example provided in the issues paper is that the de minimis exemption could apply where the amount allocated to deductible or depreciable items is less than NZ$50,000).
The issues paper notes that the Commissioner will retain the power to adjust any agreed-upon purchase price allocation if she considers that it does not reflect the “relative market values” of the assets. In addition, it is proposed that if the rules are not followed, the Commissioner will disallow the purchaser’s income tax deductions.
Overall, we believe the proposal is a ‘sledgehammer’ reaction to a very specific and targeted concern which, we understand, relates to a relatively small amount of potentially lost revenue (noting that the issues paper does not disclose the potential tax at stake from the proposal).
It is clear from consultation to date, and from the issues paper, that a major concern of officials is the lack of ‘tax symmetry’ in a transaction that gives
rise to tax-free capital gains in the hands of the vendor and, at the same
time, generates an increased tax-depreciable cost base for the purchaser. For
example, say a depreciable asset with an original cost of NZ$100 and a tax-depreciated cost of NZ$80 is sold for NZ$120. The vendor will have NZ$20 of
depreciation recovery income and NZ$20 of capital gain. The NZ$20 capital gain
will be tax-free in the hands of the vendor (as New Zealand does not have a
comprehensive capital gains tax), but will also give rise to NZ$20 of future
income tax deductions (in the form of depreciation) in the hands of the purchaser (assuming it is not related to the vendor).
The issues paper specifically refers to software and “fixed-life intangible property” as examples of assets in relation to which market values might be greater than original cost. It also refers to the sale of commercial real estate as an area of concern (e.g., in relation the allocation of purchase price between fit-out (depreciable for income tax purposes), building (depreciable at 0%) and land (non-depreciable for income tax purposes).
This issue has been on Inland Revenue’s ‘radar’ for some time, and has more recently become a high priority, particularly given the Government’s rejection of the Tax Working Group’s proposed capital gains tax in 2019. During this time, there has been a visibly strong commitment from officials to pursue a legislative
course of action rather than issuing, for example, a Revenue Alert, operational
statement, or other form of taxpayer guidance. In our view, a non-legislative
route is likely to have gone a long way to ‘correcting’ the type of behaviour that
officials are concerned with, without also having the potential to significantly impact commercial outcomes and disadvantage purchasers (in particular, New Zealand purchasers), as discussed below.
Our experience suggests that, in many cases, vendors and purchasers are already negotiating and agreeing purchase price allocations with regard to market values within the natural dynamic of a competitive deal. Everyone would agree that this is best practice.
Legislating for the vendor to (by default) have the power to set the purchase price allocation will create an asymmetry of bargaining power that might otherwise not exist. The allocation of purchase price in the context of mixed supplies can result in materially different economic outcomes for vendors and purchasers (particularly if the purchase price is allocated to non-deductible and non-depreciable assets such as goodwill and certain other intangible assets, etc.). That asymmetry is likely to be exacerbated in the context of a competitive deal (i.e., involving multiple bidders) in which bidders have different income tax
profiles. The most obvious example is a New Zealand bidder vs. a foreign bidder, where the tax laws of its home jurisdiction allow a foreign bidder to amortize/depreciate (or otherwise claim an income tax deduction for) certain assets that a New Zealand bidder cannot amortize/depreciate (e.g., goodwill).
The issues paper dismisses that fundamental issue by stating that “taxpayers can decline to enter into an agreement”, and “any disagreement as to the allocation can easily be dealt with by an adjustment in price”. This, of course, demonstrates little regard for the way in which competitive, multi-party deals work. In our view, it is unlikely for a prospective purchaser to remain competitive and, at the same time, negotiate a lower deal value.
It is also clear that New Zealand bidders are likely to be most disadvantaged by
the proposal due to the fact that most intangible assets are unable to be amortized/depreciated for income tax purposes (by contrast, in the United States (for example), goodwill and “going concern value” are generally amortizable over 15 years on a straight-line basis). Thus, a foreign bidder for New Zealand assets will often be indifferent as to purchase price allocation (as it will be able to amortize or depreciate the purchase price for income tax purposes irrespective of how it is allocated, particularly if the intangible assets are acquired in the foreign bidder’s jurisdiction), and is therefore likely to have a competitive advantage over a New Zealand bidder as a result of the officials’ proposal.
The other obvious issue is that if a deal is competitive and the vendor and purchaser are unable to agree a purchase price allocation prior to signing (which is not uncommon in relation to cross-border deals or deals negotiated on short timeframes), enactment of the officials’ proposal will allow the vendor to - in substance - dictate terms and create uncertainty. Agreeing a purchase price allocation (or even agreeing to accept a vendor’s purchase price allocation) is not always a realistic possibility, particularly when a prospective deal is in its early stages (e.g., where a vendor is accepting initial bids from a number of possible purchasers).
Whilst the issues paper briefly notes that concern, the officials’ suggestion as to
how it ought to be addressed is relatively weak. Officials note that it may be
appropriate for the legislation to include an implied term requiring vendors to
“act reasonably”. However, the real impact of that suggestion is likely to be
minimal given that, in practice, purchasers would likely need to prove loss and
seek damages, which would involve considerable time and costs.
Officials have been clear that the proposal is a response to positions that they have seen taken in relation to mixed supplies, and that there is a genuine issue that ‘needs to be fixed’.
However, we believe it is misguided to propose a legislative change that will impact every mixed supply - and potentially have a detrimental impact on New Zealand bidders - rather than seeking to identify a fair solution that will address truly mischievous behaviour giving rise to tax asymmetries. A more commercially-minded solution might involve requiring greater disclosure; for example, requiring New Zealand taxpayers to disclose with their annual income tax returns the key facts of a deal (e.g., vendor, purchaser, nature of the business/assets, deal value, purchase price allocation, etc.), with penalties for non-disclosure. This would give the Commissioner the information needed to identify mischief in the market, would not impact the commercial balance of every mixed supply, and would give Inland Revenue the ammunition needed to remedy such mischief - particularly given that officials believe “in all cases allocations should be based on relative market values, and the Commissioner must have the power to adjust an allocation (whether or not agreed) that is not so based. Officials believe that this is already the law…” (emphasis added).
Whilst in large part detached from the commercial reality, the officials’ issues paper is clearly a high priority for Inland Revenue, and is likely to become the ‘world’ in which all vendors and purchasers will unfortunately have to live. It is also clear that purchase price allocations will become an even more significant focus for Inland Revenue (irrespective of if/when the proposal is enacted,
given the officials’ view that it simply clarifies existing tax laws). Our only hope is that through public submissions the proposal develops greater regard for commercial impact and practical application (e.g., through an increased (and more sensible) de minimis threshold).
We expect the proposal to result in more vendors and purchasers agreeing to
purchase price allocations (or mechanisms/methods for allocating the purchase
price post-signing), noting that, in our experience, this is already regular practice. Sale and purchase agreements might also more commonly include purchase price allocations that are determined by third-party valuations.
The most important takeaway from the proposal, however, is that a vendor and
purchaser must make every effort to agree a purchase price allocation as early
as possible in the course of a deal, and ensure that it is applied consistently
for income tax purposes. Vendors and purchasers need to 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.
Public submissions on the officials’ issues paper close on 14 February 2020. We expect that the proposal will be included in a taxation bill in mid-2020, with likely implementation in early-to-mid-2021.
February 2020 Tax Alert contents
- Purchase price allocation: Using a sledgehammer to crack a chestnut
- R&D tax credits – an ever evolving regime, even before first returns are filed
- Are you aware of changes to the taxation of telecommunication and travel allowances?
- Happy New Year – a taxpayer (pyrrhic) victory, and a refresher on Parliamentary sovereignty
- Snapshot of Recent Developments