Capital gains concessions: Avoid valuation traps

The small business capital gains tax (CGT) exemptions are an important but unfortunately complex part of the tax system.

They can provide significant benefits to small businesses and can reduce or eliminate a capital gain made on a CGT asset that has been used in a small business. The four exemptions or concessions available are the 15-year exemption, the 50% reduction, the retirement exemption and the rollover concession. They are valuable concessions but complicated for SMEs to deal with.

One of the two basic conditions that must be met for a capital gain to qualify for the concessions is that the taxpayer must satisfy a maximum net asset value test. In basic terms, under this test, the net value of all the CGT assets of the taxpayer, the taxpayer’s affiliates and entities connected with the taxpayer must not exceed $6 million.

The Tax Office has been concerned for some time that taxpayers are making mistakes in meeting this test. According to the Tax Office, taxpayers often incorrectly use the historical value or cost of the asset for the test, rather than the asset’s market value. Assets most likely to be undervalued are property and shares.

The maximum net asset value test is required to be met “just before the CGT event” (eg. sale of a business or asset) that gives rise to any gain. So, the valuation of the asset in question just before the CGT event is important.

Under the tax law, the “net value” of the relevant CGT assets means the amount by which the market value of each of the assets exceeds both the liabilities that are related to the asset and various specified provisions.

The ATO says taxpayers should check they are correctly valuing the assets in question by:

using the asset’s market value, not the historical value or cost of the asset; and
including all assets held by the entity, including any asset that was sold and any goodwill of the business.

Two recent cases before the Administrative Appeals Tribunal (AAT) have highlighted the asset valuation difficulties that can be encountered when applying the net asset value test.

In one case, the AAT confirmed that a business was not entitled to the CGT small business concession with respect to the sale of a marina for $8.9 million as the then $5 million maximum net asset value test was not satisfied. The $5 million threshold was increased to $6 million for CGT events that occurred from July 1, 2007.

The business acquired a marina in June 1996 for $1.675 million and after a series of unprofitable years, entered into a contract to sell the marina as a going concern for $8.9 million on July 4, 2006. The contract was completed on August 14, 2006. The business sought a private ruling from the Commissioner to determine the market value of the marina to be between $4 million and $4.5 million – this would have enabled it to pass the $5 million test. The Commissioner disagreed saying value should be the sale price of the marina and issued an assessment accordingly.

The AAT had evidence from two expert valuers engaged by the business and the Commissioner respectively. The valuer engaged by the business came up with a market value for the marina of $4.5 million and the Commissioner’s valuer had the market value of the marina at $5.3 million on July 4, 2006 (meaning the $5 million test would be failed).

The AAT did not agree with the valuation method used by the valuer engaged by the business. The Tribunal thought it “somewhat curious” to adopt a market value by reference to offers made and the sum at which a vendor was prepared to sell (ie. $4.5 million).

The AAT was of the view that the valuation performed by the Commissioner’s valuer using two conventional approaches of capitalisation of operating profit and of direct comparison had more merit. The AAT accepted the reasoning of the Commissioner’s valuer and his conclusions that the marina had a market value of $5.3 million in July 2006. The AAT said it was also satisfied that the market value of the marina was at least that amount.

The result was that the business failed the $5 million net asset value test and could not take advantage of the small business concessions on the sale of the business.

In the other case, the AAT also rejected the valuations supplied by the taxpayer concerning his sale of two $1 shares in a company for some $4.93 million. At that time, the only shareholder in the company was another company that was associated with the taxpayer.

The issue to be determined by the AAT was whether the market value of a motel and caravan park that the company held through a chain of unit trusts exceeded the then $5 million threshold for the maximum net asset value test.

The taxpayer had claimed the small business CGT concessions in his tax return for the year ended June 30, 2006, but the ATO later reviewed the claims and disallowed them.

The valuations by the ATO came in at $11.9 million.

The AAT rejected the valuations obtained by the taxpayer on the basis that:

although one of the taxpayer’s valuations was said to have been made on a “going concern basis”, there was no attempt to estimate future profits and the AAT said that a valuer choosing to undertake a valuation by reference to the “income generating potential” of a business must ascertain the income stream which the business may be expected to generate. As a result, the AAT said the valuation was worthless as it made no attempt to consider this matter;
the valuations were not made “just before the CGT event” (ie. the sale of the shares) as required – but in one case some 17 months after time, while another valuation was not produced until years after the relevant event.

The AAT also considered that it seemed the sale of the shares was undertaken with one end in mind, and that was to obtain the CGT concession. The AAT also noted that the taxpayer’s accountant admitted that the sale price was calculated so as to obtain the small business concession.

The AAT noted that the taxpayer had probably incorrectly taken into account only half the value of the motel and caravan held by the final unit trust in the chain in view of the 50% holding in that unit trust. In this regard, the AAT said the effect of the legislation was that the full value of the unit trust’s net assets must be taken into account in these circumstances.

These cases graphically illustrate the importance of obtaining correct and valid valuations of assets if the CGT small business concessions are to be used. The concessions are valuable, but the path to get there can be tricky. As always, good professional advice should be sought.

Terry Hayes is the senior tax writer at Thomson Reuters, a leading Australian provider of tax, accounting and legal information solutions .