When the COVID-19 pandemic first struck in early 2020, mergers and acquisitions (M&A) ground to a halt. However, after a short pause, M&A activity rebounded stronger than ever (You can read more about the deal-making resurgence in our M&A and VC Report 2021). In the private business space, the last 18 months has seen very significant levels of sales, mergers and acquisitions. Here, we consider some of the tax issues that need to managed when purchasing a private business.
Private businesses present particular opportunities and challenges in M&A transactions. The Australian tax system creates a bias towards the sale of shares in a private company, rather than the sale of the underlying assets. For purchasers, this often means acquiring the entity and having to manage exposures to historical liabilities, tax being a prominent one. Adequate due diligence processes are key before buying someone else’s entity.
In our experience, there are some common areas where purchasers of private businesses find material tax issues. As a purchaser, your due diligence should cover these areas, and for a vendor, your pre-sale planning process should aim to identify and address any risks in these areas as this will help take friction out of the sale transaction process.
Whilst PAYG Withholding obligations tend to be routine, issues regularly arise in relation to payroll tax and superannuation.
For payroll tax the issues tend to centre around:
- Having workers based interstate and failing to identify registration obligations triggered by the location of employees, or the different registration thresholds in different states.
- Non-cash benefits and other non-standard items (e.g., employee shares and options) included in the definition of wages.
- Grouping with other related businesses, particularly where discretionary trusts are involved, and
- Payments to contractors, and the employee/contractor distinction.
Superannuation is another area where care needs to be taken when performing due diligence reviews. This is because failure to meet superannuation obligations can have ramifications for directors.
Warranties are a good way to manage the financial exposure to these risks but are rarely adequate. The preferred approach is to rectify the issues by lodging the outstanding filings and paying the outstanding tax or superannuation. The ATO and State Revenue Offices are much more amenable to reducing penalties where issues are voluntarily disclosed.
The nature of private businesses means that the distinction between the owners and the business is often blurred. There are numerous tax provisions in place to try and deal with this issue.
Not all private businesses pay private expenses on behalf of the owners. Many are very diligent in distinguishing between personal and business affairs, but some are not.
Private expenditure can cause a range of different tax issues, some arising for the beneficiary of the expenditures, others for the business. Examples include:
- Division 7A: This can deem certain loans, payments, use of assets and forgiveness of loans to be dividends. The main tax impact is for the shareholder or their associate who is taxed on the dividend. The risk for the business entity is a loss of tax deductions for the expenditure.
- Section 109: This is an old provision but enables excessive remuneration to an associate to be deemed to be a dividend and hence non-deductible. Particular care needs to be exercised where large remuneration packages are provided to family members.
- FBT: This applies where benefits are provided in connection with employment. The real issue with FBT is the open-ended nature of the amendment period where FBT returns have not been lodged or where the returns are clearly incomplete.
Temporary full expensing
One of the main stimulus measures during the COVID-19 pandemic has been (and still is) the ability to claim a tax deduction for 100% of the purchase price of some depreciating assets. A broader range of private businesses have utilised this measure to achieve a much needed tax benefit.
For a purchaser, the issue arises where an entity conducting a private business is acquired and then joins the tax consolidated group of the purchaser. As part of joining the tax consolidated group, the tax cost bases of the assets of the acquired entity are reset. Conceptually this process aligns the tax cost bases with those that would have been achieved in an asset acquisition transaction. Where an asset has been subject to the temporary full expensing, it is allocated a cost base under this tax consolidation process, but no depreciation deductions are available to the tax consolidated group of the purchaser. This can produce a materially different outcome for a share acquisition compared to an asset acquisition.
Irrespective of the above, it is important to examine the vendor’s eligibility for temporary full expensing as part of the due diligence process as there are complex rules surrounding eligibility, the types of assets purchased, etc.
Pre-sale dividend and loan transactions
Where an entity is being acquired, the usual approach is to acquire it on a “cash free – debt free” basis. To achieve this position the private business may declare dividends, forgive loans and otherwise ‘clean up’ their balance sheet prior to sale.
The issues with pre-sale dividends is well known, in particular the need to accurately calculate the franking account balance at the time of completion to ensure that the benchmark franking rate is appropriate, as well as ensure that the franking account will not be in deficit as a result of the pre-sale dividends.
For loan transactions the issues are broader and can be harder to identify. The forgiveness, waiver, assignment, release, non-cash repayment and set-off of loans, amongst other types of transactions, can all trigger tax implications. The tax implications include assessable income, capital gains, FBT, deemed Division 7A dividends, reduction of tax losses, adjustment of tax cost bases and loss future deductible expenditure. These tax implications can arise for the vendor, the target entity and/or the purchaser.
We recommend a cooperative and transparent approach to pre-sale transactions. The reality is that getting these transactions right is in the mutual interests of all the parties. As a vendor, if you are undertaking these transactions prior to entering into sale negotiations, accurately documenting the transactions and the tax treatment will be key.
Acquiring a private business can provide some significant benefits for the purchaser, but the unique nature of private businesses both generates some of these benefits and creates a range of tax issues that need to be identified and managed.
Approached correctly and addressed prior to entering into the transactions, most of these tax issues should not become ‘deal breakers’. However, if they are left unaddressed, the post-completion liabilities can be large.
William Buck are mid-market specialists with extensive experience advising private businesses. We act on both the sell side and buy side of transactions, and can assist is many areas including corporate advisory, tax advisory, tax and financial due diligence and valuations. For assistance with an upcoming transaction, please contact your local William Buck Tax Advisor.