The Australian Taxation Office (ATO) has recently increased its focus on succession planning, particularly concerning asset transfers between generations. Succession planning has been nominated on its website as a key area of focus. This is driven by the significant wealth transfer occurring as businesses established in the 1960s, 70s, and 80s are being passed on to the next generation. Accountants play a crucial role in ensuring these transfers comply with tax laws and valuation requirements.
When assets are transferred between living related parties, such as parents and their children, they must generally be valued at market rates for tax purposes. This prevents underreporting of asset values, which could otherwise reduce tax liabilities. However, determining the true market value of an asset is not always straightforward, particularly in cases where there is no active market, such as private company shares or trust units.
Valuation involves assessing goodwill, future earnings potential, and asset composition, competition, the life cycle of a business and other issues which means estimates can vary significantly. The ATO has made it clear that it will challenge valuations that do not align with its view of market value, leading to potential disputes and unexpected tax liabilities. When related parties are involved, these tax liabilities are frequently unfunded as no external party is putting money on the table.
A recent case before the Administrative Appeals Tribunal (AAT), Moloney and the Commissioner of Taxation, highlights the risks associated with disputed valuations. The Moloney family, operating a business in Western Victoria, sought to restructure their business. As part of this process, they engaged the corporate advisory arm of their usual accounting firm, Crowe Horwath, to provide a valuation. The firm valued the business at $3.5 million, which allowed the transaction to qualify for small business capital gains tax (CGT) concessions that apply to businesses valued at less than $6 million.
However, the ATO challenged this valuation and engaged its own valuer, Korda Mentha, who assessed the business at $7 million. This meant, according to the ATO, that the Moloney family no longer qualified for the CGT concessions, resulting in a significant taxable capital gain of $3.5 million.
To support their case, the Moloneys engaged another independent firm, PKF, which valued the business at around $3 million. This wide disparity in valuations illustrates the inherent subjectivity in assessing private business assets.
The Moloneys won the case because the AAT preferred the valuation by PKF.
A critical consideration in succession planning is the management of related party debt, often requiring an assessment of Division 7A risks. This provision can trigger deemed unfranked dividends when a private company extends a loan to a shareholder or an associate, potentially resulting in unexpected tax consequences.
A key valuation issue under Division 7A is the calculation of the company’s distributable surplus—a crucial factor, as a deemed dividend can only arise if a surplus exists.
A lesser-known but significant aspect of Division 7A is the Australian Taxation Office’s (ATO) discretionary power to adjust the value of assets recorded in a company’s balance sheet. This authority extends to assets not explicitly listed, enabling the ATO to determine what it considers an ‘appropriate’ valuation.
Notably, the ATO has clarified in a ruling that it generally will not adjust the value of internally generated goodwill. However, there is an important caveat: if the company or its shareholders have treated goodwill as having a higher value than what is reflected in the accounts—such as when presenting financials to lenders or investors—the ATO may intervene and apply an alternative valuation.
Given the likelihood of ATO scrutiny, accountants advising clients on succession planning should consider obtaining multiple valuations or stress-testing existing ones. This can help identify any potential red flags that may prompt an ATO challenge.
To mitigate risk, it may be beneficial to obtain a second opinion from an independent valuer. This can serve as a safeguard if the ATO disputes an initial valuation.
Proper documentation of valuation methodologies, assumptions, and supporting financial data is critical. In the event of a dispute, detailed records can strengthen the case for a particular valuation.
As succession planning remains a key focus area for the ATO, more legal cases are likely to emerge. Accountants should stay informed about evolving interpretations and rulings on valuation disputes.
Given the complexities surrounding business valuations and the substantial tax implications involved, succession planning will likely remain a contentious issue in Australian taxation. Accountants must help their clients to manage valuation risks to protect them from unexpected tax liabilities and potential penalties.