There are a range of potential tax issues that a purchaser can inherit when acquiring the shares in a private company, which is why the purchaser needs to undertake thorough tax due diligence and the vendor needs to be prepared. Due to the Australian tax system’s tendency to favour the sale of shares in a private company rather than the sale of its underlying assets, purchasers often acquire shares and find themselves managing exposures to historical liabilities, including tax liabilities.
Many tax risks identified through a due diligence process can be managed through appropriate warranties and indemnities in a share purchase agreement. However, it is important to be aware of these issues prior to purchase and factor them into pricing, warranty and indemnity insurance and amounts held in escrow.
Vendors should also address any risks within these areas in the pre-sale planning process, preferably with the help of a professional advisor.
Below are some of the common issues we are currently identifying when undertaking tax due diligence work.
Temporary full expensing
Temporary Full Expensing (TFE) was introduced as a stimulus measure during the COVID-19 pandemic and allowed eligible entities to claim an immediate tax deduction for 100% of the purchase price of some of their depreciating assets. TFE is still in operation and applies until 30 June 2023.
Although there are requirements around the eligibility for TFE that must be considered in a tax due diligence, the main issue that arises relates to the purchaser’s acquisition structure for the company – in particular, whether they intend for the target company to join a tax consolidated group.
Tax consolidation allows wholly owned corporate groups to be treated as a single entity for tax purposes. The interaction between TFE and tax consolidation occurs in the tax cost setting process. Upon acquiring a new entity to join a tax consolidated group, the ‘head company’ of the tax consolidated group must calculate the tax cost of the assets of the joining entity (being the target company). Previously, where a company was acquired by a tax consolidated group, the full purchase price of the company would be allocated across the assets of the company. This could lead to ‘step up’ in the tax cost bases of certain assets (such as depreciating assets), which could allow for greater depreciation deductions to be claimed in future by the tax consolidated group.
However, where an underlying asset’s purchase price has been fully deducted under the TFE measures, a portion of the purchaser’s cost is still allocated to the asset in the tax cost setting process, but no further depreciation deductions are available to the tax consolidated group in respect of the asset. Therefore, this cost to the purchaser is effectively lost.
The interaction between TFE and tax consolidation means that there can be materially different outcomes for a purchaser of a share acquisition as compared to an asset acquisition.
During the COVID-19 pandemic, there were a number of other support measures available to businesses such as JobKeeper, the cashflow boost, and various State/Territory grants.
Many of these measures had complex eligibility rules, so it is important for a purchaser to assess the vendor’s eligibility for these measures where they were utilised. Where a company falsely claimed or received JobKeeper or the Cashflow Boost for example, where a company was ineligible to receive support, the company may be required to repay the support. Purchasers should ensure that this is either appropriately dealt with prior to sale completion, or adequately covered in the purchase agreement.
Further, the various measures have varying treatments for income tax purposes (i.e., the Cashflow Boost is non-assessable and non-exempt, whereas JobKeeper payments are assessable income). It is not uncommon for private companies to incorrectly categorise the support measures for income tax purposes, which can give rise to historical tax issues for a purchaser.
Base rate entity
A company’s tax rate is ordinarily 30%, unless the company is considered a ‘base rate entity’. Base rate entities are subject to a lower tax rate (being 25% from FY22 onwards).
The broad factors relevant to determining whether the company is a base rate entity are:
- the company’s aggregated turnover (turnover including that of its connected entities and affiliates) is less than $50M, and
- the percentage of the company’s income that is ‘base rate entity passive income’ (BREPI) is no more than 80%.
Often, private companies will consider their standalone turnover in assessing their base rate entity status and fail to include the turnover of their connected entities and affiliates. The definition of connected entities and affiliates is relatively broad and extends beyond just a parent company and its subsidiaries. For example, connected entities can include entities which have common control. For example, a controlling shareholder of Company A may hold 40% of shares in Company B (being a completed unrelated business). The turnover of Company A will need to be taken into account in calculating the aggregated turnover of Company B, and vice versa.
Where the connected entities and affiliates of companies are not appropriately identified, this can expose a company to historical tax liabilities.
Often in private businesses, the line between business and private expenditure can become blurred.
When acquiring a private company, a purchaser should consider any tax exposures that could exist from business owners incurring private expenditure through their company.
Division 7A impacts should be considered where private companies have incurred expenditure on behalf of their shareholders or associates. However, tax risks from Division 7A issues generally sit with the shareholders and their associates, with limited risk to the company itself.
Fringe benefits tax (FBT) can present greater issues, with unpaid fringe benefits tax liabilities being a concern. However, a greater risk can apply where no FBT returns have been lodged with the ATO at all as an indefinite amendment period may exist. This can make it particularly difficult for a purchaser to quantify any tax risks that could arise from FBT.
There are a number of common issues arising around payroll tax for private businesses.
A frequent issue is the employee / contractor distinction in respect of payments to contractors. However, a more commonly identified risk in tax due diligences is where private businesses fail to correctly calculate payroll tax thresholds where they pay wages to employees in various states and territories of Australia. Private businesses will often claim the full payroll tax threshold in each state and territory, even where they have employees across the country. In such instances, the thresholds in each state and territory must be adjusted for interstate wages.
Significant penalties can arise from issues relating to superannuation payments, so it’s important that this area is thoroughly examined during the due diligence process.
A common problem businesses face is the late payment of superannuation. Where super is paid late, it is non-deductible to the business, even following payment. In other words, this can sometimes give rise to a permanent tax reconciliation adjustment, not just a timing one.
Further, the entity has an obligation to lodge superannuation guarantee charge statements with the ATO, along with payments of interest and penalties.
Warranties may be used to manage financial exposure to risks. However, the preferred way is for these issues to be appropriately addressed with the ATO prior to completion.
As we’ve highlighted, there are a range of potential tax issues that a purchaser can inherit when acquiring the shares in a private company. These could be associated with government stimulus measures the company may have accessed, particularly throughout COVID, historical payroll tax liabilities, FBT liabilities unpaid superannuation, and other areas. This is why it’s critical that purchasers undertake thorough tax due diligence and vendors are prepared.
For assistance with either the preparation of your business for sale or the due diligence process as a potential purchaser, contact your local William Buck advisor.