Chapter 5 – The proposed solutions

• Policy framework
• Outline of proposals
• Agreed allocation
• No agreed allocation
• Contest rights
• De minimis

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5.1 This chapter sets out the proposed solutions.

Policy framework

5.2 Officials’ policy framework is that in all cases:

• allocations should be based on relative market values, and the Commissioner should have the power to adjust an allocation that is not so based; and
• the parties to a mixed supply should adopt the same allocation in their returns, and the Commissioner should be able to readily determine whether or not they have done so.

5.3 This framework is designed to both protect the revenue base and to be fair on the parties to the transaction. As noted in the previous chapters, these outcomes will not necessarily arise in the absence of specific legislative requirements.

Outline of proposals

5.4 Officials do not see any need to change the existing substantive rule for trading stock. This rule requires consistency between the vendor and purchaser and allows the vendor to determine the allocation. Obviously, the transaction documents can specify an agreed allocation. This rule covers all assets held on revenue account other than depreciable property and financial arrangements.

5.5 However, discussions with advisors suggest that it may well be necessary to provide some encouragement to purchasers to comply with the existing law in this respect. Many advisors seem unaware of the existence of section EB 24, and current practice in many cases appears to be that purchasers adopt their own allocations of a global price to trading stock with no regard to those adopted by the vendor.

5.6 To increase taxpayer certainty, prevent vendors and purchasers from engaging in allocation practices that adversely impact tax revenue, and minimise administrative costs, we propose to:

• extend this consistency requirement to depreciable property and financial arrangements;
• provide that purchasers are not entitled to claim any deduction for items acquired in a mixed supply unless they have either followed an agreed allocation or requested the vendor’s allocation. If the vendor has not provided its allocation on a timely basis, then the purchaser may use its allocation, which must also be provided to and adopted by the vendor.

5.7 Prima facie, the vendor would use relative market values to determine the allocation to depreciable property and financial arrangements as with the trading stock rules. Possible alternatives for depreciable property are to use the vendor’s depreciated cost or original cost.

5.8 In all cases, the allocation should be able to be challenged by the Commissioner on the basis that it does not reflect relative market values. There is no need for a challenge by a taxpayer, since taxpayers can decline to enter into an agreement unless and until they are prepared to accept the outcome of the application of the proposed allocation rules to their transaction.

5.9 In the remainder of this chapter, we provide more detail about this proposal and how it might work. We also seek feedback on whether there is a better way to achieve consistency.

Agreed allocation

5.10 Agreed allocations are commonly adopted in asset sale agreements. The allocation may be specified in the agreement, either in specific figures or by way of a formula. Alternatively, the agreement may contain some mechanism for an allocation to be determined (for example, the use of a particular valuer, or some form of arbitration), either before or after the transaction has been agreed to or settled. Whatever mechanism is chosen, if parties agree on an allocation, we propose that the legislation specifically provide that they must follow that allocation in filing their tax returns. This will ensure consistent filing positions.

No agreed allocation

5.11 If there is no agreed allocation, the Income Tax Act 2007 already provides that the allocation to trading stock and depreciable property must be determined by the vendor on the basis of relative market values, and in the case of trading stock that it must be adopted by the purchaser.

5.12 We propose that this law be amended in a number of respects, in order to ensure that the consistency clearly envisaged in relation to trading stock is actually achieved, in relation to all of the taxable assets sold.

Allocation to depreciable property

5.13 For depreciable property, if there is no agreement as to market value, the treatment of trading stock suggests that the vendor should determine the market value, which the purchaser would be required to follow. However, it may be that the degree of uncertainty as to the market value of depreciable property is greater than it is with most forms of trading stock, and that as a result, leaving the valuation to the determination of the vendor is less acceptable.

5.14 In a situation where the parties are in fact negotiating the allocation, this concern does not seem to stand scrutiny. At the end of the day the allocation is about the post-tax value of the transaction, and any disagreement can be dealt with by an adjustment to price (for example, if the purchaser is concerned that the value allocated to trading stock or depreciable property is too low, it may reduce the price it is prepared to pay). However, in a situation where the parties have agreed the transaction without negotiating the allocation (which is likely to be less common than it is now if there is an explicit consistency requirement), it is more likely that giving the allocation power to the vendor would put the vendor in a much better tax position than the purchaser.

5.15 If this is a concern, a possible alternative for depreciable property where the allocation is not agreed would be to treat it as sold for either its cost to the vendor, or its depreciated value to the vendor.

5.16 Treating the property as sold for original cost would give rise to full depreciation recapture income to the vendor, and depreciation for the purchaser based on the original cost of the depreciable property. It would thus be relatively vendor unfriendly but would ensure that there is no revenue loss from the transaction.

5.17 Treating the property as sold for its depreciated value would give rise to no depreciation recapture adjustment for the vendor. The transaction would have little or no effect on the depreciation claimed on the transacted assets – that is, the amount of depreciation claimed by the purchaser would be the same or similar to the amount the vendor would have claimed if the transaction had not occurred. This is a similar approach to that taken to a sale of depreciable assets between associated parties (section EE 40). The depreciated value would in most cases be a more accurate measure of the value of the assets than original cost, so might be seen as striking a more appropriate balance between the parties, particularly where they did not turn their minds to the allocation before agreeing on the transaction.

5.18 It is not intended that these three alternatives (vendor determination subject to a market value requirement, original cost or depreciated cost) should be optional in any way. Because they are intended to apply if the parties cannot agree, it would not be sensible for some choice to be able to be made between them. We propose that if the parties do not agree an allocation, there would be only one method for allocating the consideration to depreciable property.

5.19 Whichever method is chosen, the Commissioner would retain the ability to challenge a valuation on the basis that it does not reflect relative market values. The purpose of having a single method is to ensure consistent reporting positions, not to provide a safe harbour.

Allocation to financial arrangements

5.20 For financial arrangements, the value is likely to be within a relatively narrow range. It may therefore be appropriate to adopt the same approach as is taken for trading stock, that is, relative market value as determined by the vendor. It would not be appropriate to treat financial arrangements as sold for the amount outstanding, as this would not take into account the risk of default by the debtor.

Valuer appointed by Commissioner?

5.21 Some submitters suggested that the problem of vendor bias in transactions with no agreed allocation could be addressed by having the Commissioner appoint a valuer to determine the allocation. The cost of this would need to be borne by the parties.

5.22 Issues with this suggestion include:

• the potential difficulty in finding a qualified valuer prepared to provide a valuation. For some assets there is not a wide choice of valuers, and many may see a commercial conflict in acting in such cases;
• the risk of judicial review or other forms of litigation by a dissatisfied party;
• the need to create a legislative and administrative framework to deal with such a process; and
• the cost involved, in cases which may not merit a valuation.

5.23 Official’s judgement is that in cases where the issue is sufficiently material for a valuation by the Commissioner to be justified, it is likely that the parties will have agreed their allocation.

Ensuring consistent allocations

5.24 As discussed above, a simple legislative requirement for consistent allocations does not seem to have been entirely effective in the case of trading stock. In order to ensure consistent allocations are actually adopted where there is no agreement between the parties, we propose the following process.

5.25 First, there should be a legislative requirement on the vendor to provide its allocation to the purchaser, with a copy to Inland Revenue. This allocation should have to be provided within a specified period, for example, within three months of the time when the assets are treated for tax purposes as disposed of by the vendor. This will give the vendor time to complete the allocation, and also give the purchaser time to use the allocation to complete its tax return for the year of the transaction.

5.26 It is necessary to make some provision for what happens if no allocation is provided. In that case, we suggest that the purchaser should first be required to request an allocation from the vendor. If no allocation is provided within a defined period from when the request is made, for example, one month, the purchaser would be entitled to make its own allocation on the basis of relative market values, and to provide that allocation to the vendor with a copy to the Commissioner. The purchaser and the vendor would then both be required to use that allocation. The purchaser would not be entitled to a deduction for any element of the purchase price unless and until it first requested an allocation from the vendor, and then (if no vendor allocation was provided) provided its allocation to the vendor and the Commissioner.

Contest rights

Contest by the Commissioner

5.27 If the Commissioner believes that an allocation does not reflect market values, the Commissioner may decide to issue a NOPA to whichever of the parties has an increased tax obligation as a result of the NOPA. No change is proposed with respect to this process. Suppose that the NOPA is issued to the vendor. If the result of the dispute were an increase in the amount allocated to depreciable property, trading stock or financial instruments, the purchaser should be entitled to request an amended return reflecting that increased amount. Similarly, if the dispute were with the purchaser, the vendor would be entitled to request an amended assessment reflecting the benefit of any decrease in the amount allocated to taxable items. This should all be possible under existing law.

Contest by a party

5.28 There will be no need for contest rights if the parties have agreed to an allocation. Where there is no agreement, and the vendor makes the allocation, it is possible that the purchaser may believe that the allocation does not reflect market value. The question that arises is whether it is necessary to provide the purchaser with any right to contest that value, if the Commissioner does not wish to do so.

5.29 There is a strong argument that no such right is needed or appropriate. If the purchaser was concerned about the allocation, it would have ensured that it was agreed. By failing to require agreement, the purchaser has accepted that the vendor is entitled to make the allocation.

5.30 If some contest right is appropriate, there does not seem to be any need for it to involve the Commissioner. The Commissioner is, in this scenario, content to accept the vendor’s allocation. However, she is not well placed to defend that allocation in a dispute process and will often be largely indifferent as to whether the purchaser’s or the vendor’s allocation is adopted, so long as one allocation only is adopted by both parties. Accordingly, officials propose that the parties to a mixed supply would not have the right to issue a NOPA challenging the allocation which is required to be adopted in their returns.

5.31 However, it may be appropriate for the legislation to provide for an implied term, which would give the non-allocating party a contractual right against the allocating party. For example, the allocating party could be under a duty to act reasonably in making its allocation. That would give the other party a right to claim damages against the allocating party for any additional tax payable by it as a result of an unreasonable allocation.

5.32 There is precedent for such an implied term in section LP 6 of the Income Tax Act 2007. When a company or unit trust pays a supplementary dividend, it is making a non-pro rata payment as between its foreign and its resident shareholders (or unitholders). Ordinarily, this might be a breach of company law, the terms of the shares or the terms of the trust. Section LP 6 approves the payment regardless of these obstacles, unless in the case of a company the constitution specifically over-rides the section.

5.33 In this case, the legislation would effectively give a non-allocating party who wished to dispute an allocation the right to do so directly with the allocating party, rather than with the Commissioner. The outcome if the non-allocating party is successful would not be a change to the tax positions, but a payment for damages.

5.34 If such a term were implied, thought would need to be given as to whether or not it could be over-ridden by agreement. If the objective of implying such a term is to give purchasers (in the usual case of a vendor allocation) some protection from unreasonable vendors, allowing an over-ride would allow that objective to be defeated by vendors who insist on an over-ride. However, not allowing an over-ride would interfere more significantly with parties’ freedom of contract.

De minimis

5.35 A concern that has been raised with requiring the purchaser to follow the vendor’s allocation is that some purchasers may not be aware of this requirement at the time they enter into a transaction and assume instead that they will be able to determine the allocation themselves. This might be a concern if the purchaser paid more for the relevant assets than it would have were it aware of the consistency requirement. Ignorance of the proposed statutory consistency requirement would be more likely in lower value transactions.

5.36 On one view, whether or not the purchaser is aware of the rule is unimportant. The loss of tax revenue created by inconsistent allocations is the key issue. While low value transactions may give rise to a lower loss of revenue, there will be more of them. The vendor will need to make an allocation in any case, and there should be little additional cost in providing it to the purchaser. The current rule requiring the purchaser to follow the vendor’s allocation in relation to trading stock does not have a de minimis.

5.37 Officials are of the view that it is unlikely that a purchaser sophisticated enough to factor the tax effect of an allocation into its determination of the purchase price would be unaware of a consistency requirement if one were introduced. Potentially relatively low value sale transactions are already subject to numerous special tax related requirements which vendors and purchasers are required to be aware of, such as:

• for residential property, the requirement on the vendor’s agent to pay residential land withholding tax if the vendor is a non-resident and the land is not a main home (subpart RL of the Income Tax Act 2007); and
• for commercial property, the compulsory land zero rating rule in section 11(1)(mb) of the Goods and Services Tax Act 1985.

5.38 However, if there is a view that purchasers in low value transactions should be protected from an unexpected consistency requirement, the most obvious response is to adopt a de minimis. For example, mixed supplies where the total amount allocated by the purchaser to deductible or depreciable items is less than $50,000 could be excluded from the consistency requirement. This would not affect the obligation to allocate using relative market values.