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Too Friendly vs. Too Aggressive – Preferably Neither

Tax Telegraph, September 2013

Too Friendly vs. Too Aggressive – Preferably NeitherThe idea of “market value” comes up in tax legislation multiple times, yet is defined very broadly. Market value impacts the treatment of trading stock, the acquisition cost or proceeds from a sale, the value of intangible assets, restructuring, access to the small business capital gains tax (CGT) concessions and many other areas.

So what goes into determining market value?

Back in 1944, Mr Abrahams took the Federal Commissioner of Tax to the High Court over duties relating to his brother’s estate. What came out of that case, in relation to market value, which is still important now is the idea that market value is “the price which a willing but not anxious vendor could reasonably expect to obtain and a hypothetical willing but not anxious purchaser could reasonably expect to have to pay … if the vendor and purchaser had got together and agreed on a price in friendly negotiation”.

This raises more questions such as, “what exactly is reasonable?” and “what is friendly negotiation?”

Be Reasonable

A key aspect in using a market value is ensuring the valuation has been calculated on a reasonable basis. For example, it is unlikely that a taxpayer will get away with trying to value an original Picasso painting at $50 and then trying to argue with Tax Office that this was the market value of the painting based on the cost of canvas and oil paints.

With assets such as property, the taxpayer is expected to take into account the “highest and best use” in determining the market value. The taxpayer should take into account “the most probable use of a property which is physically possible, appropriately justified, legally permissible, financially feasible, and which results in the highest value of the property being valued.” For example, a taxpayer owns a one bedroom beach shack in a prime position in Bondi with approval to build multiple apartments. If the taxpayer claims that the market value of the property is the market price of any one bedroom house in the area, their valuation may be challenged by the ATO as the highest and best use would clearly result in a higher value.

This can be an easier process with some things and a much more difficult process with others. For example, publically traded shares and in some cases property have active markets which can quickly give you a market value. Other things such as private company shares, goodwill, intellectual property and other intangibles or art can be much harder to value as often, no active market exists.

However, this does not mean that a taxpayer must spend a small fortune in acquiring multiple valuations from numerous experts in the field. Though it is naturally preferable for the valuation to be completed by a qualified professional with appropriate expertise in the specific area, it is in many cases, not a formal requirement. However, this being said, the valuation should be replicable. That is, the methods used to arrive at the valuation are explained so that another person can easily understand how the value was determined. If the process is not adequately explained, the valuation may not be accepted by the ATO.

So, now you might be thinking, “fine then, I’ll just call a professional.” Sure, this could give you a stronger case, however, simply obtaining a professional valuation, does not mean the ATO is obligated to accept this as the market value, especially if they do not see it as reasonable. There have been cases, where a taxpayer has obtained a formal valuation and this has been challenged by the ATO and subsequently the ATO’s challenge has been upheld by the Federal Court.

Luckily for all taxpayers, the ATO has a lengthy document outlining its view of various methods and principles regarding the methods of determining market value in a variety of situations. What is clearly evident is that many of these scenarios have multiple permissible methods which can result in a reasonable result. A business, for example, can be valued based on the market value of the business, the value of the business’s assets or even based on business income through discounted cash flows or capitalisation of earnings.

How friendly is too friendly?

Another fundamental aspect governing market value is the concept of dealing at arm’s length. This means that a buyer and seller negotiate and deal with each other in a manner that would be expected of unrelated parties. If parties do not deal at arm’s length the ATO may adjust the dealings to reflect and arm’s length outcome.

Though more often than not, dealing at arm’s length is an issue when a buyer and seller are related parties. However this does not mean that unrelated parties are automatically assumed to be dealing at arm’s length. Agreements which have an element of “I’ll scratch your back, if you scratch mine,” can equally find themselves face ATO scrutiny. This is because arm’s length is determined by the actual dealings between parties not just the overall relationship as demonstrated in Granby Pty Ltd v Federal Commissioner of Taxation 95 ATC 4240.

This does not necessarily mean that transactions that take place above or below market value are automatically not at arm’s length. What is more important is the nature of the dealings. Any dealings that are deemed to not be at arm’s length by the ATO can be challenged and the outcomes adjusted.

Why should I care?

Getting a valuation of your assets to work in your advantage (without being overly aggressive of course) can often help you save a small fortune in tax liabilities.

In areas such as CGT, the market value could directly impact your tax liability in the current year or in the future. If you give away an asset or are given an asset by a related party, your capital proceeds or cost base respectively will often be substituted with the market value of the asset. Therefore, the effective use of market value could result in a substantial benefit or cost.

Another example of the impact of market valuations arises during the sale of a business. Often the sale agreement will identify a lump sum price for the purchase of a number of assets – some being intangible (e.g. goodwill) and some tangible. Often you may find purchaser and vendor allocate different amounts to different assets. Allocating the purchase price to an asset such as copyright, patents or depreciable assets gives ongoing tax benefit to the purchaser.   By way of contrast, allocating price to goodwill may give rise to a tax benefit to the vendor (e.g. the CGT discount and/or small business CGT concessions).

Eligibility to access the small business CGT concession in many people’s cases hinges on satisfying the maximum net asset value ($6 million) test. Sometimes a simple change in the value of the assets can result in tax savings (or liabilities) of hundreds of thousands of dollars.

Alternatively, if a taxpayer gets it wrong or does not take the appropriate steps to justify their position, this could not only result in the ATO challenging the valuation but subsequently reassessing the tax liability. This could carry the risk of penalties for having an unsupportable position in addition to being charged interest.

It clearly is of benefit to try and get everything right the first time and have peace of mind knowing that your tax affairs are sound. Especially with market value and its broad applications, it may be helpful to get some advice or a second opinion and your local Deloitte Private tax advisor is here to help.

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Spyros Kotsopoulos
Editor – Tax Telegraph
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