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Don’t shoot yourself in the foot: Business sale contracts

Experience can be a great teacher.  But it’s also desirable to not learn some things the hard way.  That certainly applies when it comes to selling your business.  Nobody knows your business better than you, but your Nexia advisor knows many businesses (including our own).

Apparent zero-sum game that’s anything but

The unfortunate story of a recent business sale serves as a reminder that selling your business involves so much more than negotiating a sale price.  We know about this particular case because it was laid out in an application to the ATO for a private ruling, which are published without names.  Both seller and buyer had legal representation in the preparation of the sale contract, as they well should.

The crux of the issue was the allocation of the sale price amongst the various business assets, in particular to goodwill and plant & equipment.  If more of the sale price is allocated to one asset, less will be allocated to others.  That might appear to be a zero-sum game, but it is anything but.  The reason is that the tax impost on gains from goodwill and plant & equipment can be very different.

Gains on plant & equipment are usually fully taxable – there are essentially no concessions available.  However, due to various available concessions, the tax impost on a goodwill gain is usually lower, even nil.  So, change the allocation between these two assets, change your tax bill.  Definitely not a zero-sum game.

Too bad, so sad

Back to that business sale.  The sale contract set out the allocation of the sale price between plant & equipment, goodwill and other assets.  But it was the tax advisors when subsequently preparing the tax return who pointed out that the plant & equipment was actually worth a lot less than the amount of the sale price allocated to them.  This didn’t mean the business overall was worth less.  Rather, it simply meant that, when negotiating the finer details of the sale contract, it would have been quite reasonable for more of the sale price to be allocated to goodwill, and less to plant & equipment.

That would have shifted gains away from fully taxable plant & equipment, and over to concessionally taxed goodwill.  But it was too late, and the seller’s tax bill was higher than it otherwise would have been.

You might be asking yourself – how does this happen?

Wool, eyes and contracts

When it comes to negotiating the allocation of a business’s sale price between goodwill and plant & equipment, a buyer and a seller have diametrically opposed interests.  The seller wants more allocated to goodwill, and less to plant & equipment, because the goodwill gain is often concessionally taxed.  Conversely, the buyer wants more allocated to plant & equipment, because it means more of their outlay will be tax deductible through depreciation deductions.

When selling a business, the buyer typically prepares the initial draft contract, and the negotiation of the details goes back and forth from there.  It’s possible in this case that the buyer slipped into the initial draft the self-serving allocation of the sale price just to see if they’d get away with it.  The seller conceded in their private ruling application that, incredibly, they weren’t aware of the allocation in the contract.

No one on the seller’s side involved in the negotiation and contract preparation process understood the above issues around allocation or the tax consequences.  And it’s apparent that the seller did not get their tax advisors involved.

That’s how it happens.

Arm’s length

After discovering their higher tax bill, the seller tried to change the outcome by submitting that private ruling application to ATO.  They asked if they could ignore the sale price allocation in the sale contract, and calculate their tax outcomes based on allocating less to plant & equipment (to match its market value), and more to goodwill.

The result

The relevant tax laws do not permit what the seller asked permission to do.  The reason is that the seller and buyer were dealing with each other at arm’s length.  That is, they were independent and each seeking the best outcome for themselves.  The result was the seller being stuck with the allocation as per the contract.
Taxation laws generally do not interfere with whatever outcomes arise when parties are dealing with each other at arm’s length.  That means the tax outcomes will be whatever they turn out to be – even where someone gets a bargain, or shoots themselves in the foot.

The lesson

The lesson is, when it comes to selling your business, get your tax advisor involved early.  There are also many other value-added services Nexia Edwards Marshall NT can provide, like grooming your business, value negotiation, pre-sale restructuring, negotiating warranties, etc.  Extracting the maximum value into your hands from exiting your business requires so much more than merely brokering a sale.

If even the mere thought has popped into your head that exiting your business is on the horizon, talk to your trusted Nexia Edwards Marshall NT advisor.

The material contained in this publication is for general information purposes only and does not constitute professional advice or recommendation from Nexia Edwards Marshall NT. Regarding any situation or circumstance, specific professional advice should be sought on any particular matter by contacting your Nexia Edwards Marshall NT Adviser.

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