Chapter 6 – Issues to consider

• Effect of the proposal on commercial behaviour
• Sales for a bargain price
• Auctions and tenders
• Sales involving dealers or other revenue account holders
• Degree of consistency
• Denial of a deduction for purchasers who disregard the law

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6.1 This chapter discusses a number of issues to consider alongside this proposal:

• The effect of the proposal on commercial behaviour.
• How the allocation should work in the case of a sale for a bargain price.
• How the allocation would work in the case of sales by way of auction or tender.
• The degree of consistency that should be required.
• Denial of a deduction for purchasers with no valid allocation.

Effect of the proposal on commercial behaviour

6.2 An issue raised by the proposal is whether it places an unacceptable amount of discretion in the hands of a vendor. A vendor might, for example, allocate an unduly high amount to land and goodwill, and unduly low amounts to trading stock and depreciable property (though as suggested above, it would be possible to require use of depreciated cost for depreciable property).

6.3 The obvious response is that purchasers who are concerned about this possibility can insist on an agreed allocation. An objection that may be made to this response is that it makes the allocation a point of potential disagreement, and that it is not appropriate for a requirement that exists purely for income tax purposes to potentially impede commercial transactions. In a competitive process, purchasers may not want to raise the allocation issue, for fear that it will make their bid less competitive.

6.4 Officials do not believe that this concern stands up to scrutiny. It is true that as compared to the current position, the proposal will make it much more likely that the parties to a mixed supply will want to discuss the allocation, though this will depend on the materiality of the issue. However, any disagreement as to the allocation can easily be dealt with by an adjustment to the price. Suppose for example that a potential purchaser takes the view that a vendor’s allocation to depreciable property is too low. If the purchaser insists that the allocation be increased, the vendor can do so at no after-tax cost, by simply increasing its asking price, assuming that the allocation was material to the determination of that price.

6.5 The real problem is that under the current system where consistency is not required, the allocation issue is not dealt with. This allows the parties to a mixed supply to take inconsistent positions, to the benefit of themselves but the detriment of taxpayers as a whole. Requiring consistency will remove the tax subsidy that parties adopting inconsistent allocations currently enjoy. In marginal cases, this may mean that a transaction does not go ahead, because the seller and buyer cannot agree on a price in the absence of this tax subsidy. For example, a purchaser may be prepared to pay a certain price for a commercial building on the basis that it will be able to claim depreciation based on a figure for fit-out which is 50% higher than the amount that will be returned by the vendor. If there is a requirement for consistency, the purchaser may reduce the price it is willing to pay, and the vendor may not accept that price. That does not seem an inappropriate outcome. The parties should not be able to use the tax system as a way to bridge the gap between the lowest price the vendor will accept and the highest price the buyer will pay.

Sales for a bargain price

6.6 It has sometimes been suggested that adopting an allocation based on relative market values is not appropriate in a situation where there is a fire sale. It is possible for goods to be sold between arm’s length parties at a price that is below a normal market price.

6.7 Officials recognise that a straitened seller may agree to a price below arm’s length. However, they do not agree that a test based on relative market values fails to recognise this possibility. For example, suppose a business is sold in fire sale circumstances for $400,000, where a more orderly sale of the individual components would have yielded $500,000. In that case, depending on the facts it may make sense for the relative market values to be determined by applying a twenty percent discount to all of the values taken into account in arriving at the $500,000 figure. Alternatively, there may be some items that are more liquid, and for which a lower or no discount is appropriate, with a higher discount on others.

6.8 Edge is a good example of such a case, where there was no difficulty in discounting the value of the trading stock to recognise the fact that it was sold in a mortgagee sale.

Auctions and tenders

6.9 Not all mixed supplies are a result of a negotiation process. For example, commercial property may be sold by way of auction or tender. It is important that any proposal can be integrated into these common methods of sale. Officials do not anticipate that this will present any significant difficulty.

6.10 Under current law, purchasers of a commercial property at auction or tender will usually not know, at the time they make a bid, precisely what the allocation to fit-out will be, as they will not have had the opportunity to undertake a sufficiently detailed inspection of the property. This lack of knowledge does not prevent transactions taking place – uncertainty as to the allocation to fit-out is just one of many uncertainties that any purchaser of property inevitably faces. There is no reason to think that if the allocation is determined by the vendor in accordance with relative market values, or in accordance with the vendor’s depreciated cost, that the purchaser will be in a significantly worse position than it is in currently.

6.11 Nevertheless, if purchasers want more certainty about the allocation, it is likely that vendors seeking to maximise the price they can achieve will volunteer the necessary information as part of the selling materials. For example, they may specify that fit-out is estimated to constitute a certain percentage of the value of the property or may disclose the fit-out’s depreciated value. Alternatively, the terms of the auction or tender could provide for an allocation mechanism, for example, for the allocation to be undertaken by an agreed valuer after the winning bidder has been determined.

6.12 Submissions are sought as to whether the proposal is likely to cause any difficulties for commercial transactions, and if so, how it might be modified to address these.

Sales involving dealers or other revenue account holders

6.13 When the purchaser in a mixed supply is a dealer, acquiring the property with a dominant purpose[5] of resale, or otherwise holds the property on revenue account, prima facie there is no commercial tension in relation to the allocation. The revenue account purchaser is entitled to a deduction for the entire purchase price, so the consistency requirement is not relevant.

6.14 However, an issue arises when a revenue account purchaser acts as a conduit in a transaction that is, in reality, between two non-dealers. A specific anti-abuse rule may be required to ensure that the interposing of the revenue account purchaser is disregarded.

Degree of consistency

6.15 There is a question as to the degree of consistency required between the parties. For example, in a sale of a commercial building, would it be adequate to agree an allocation between land, building and fitout, without specifying the allocation between the specific different items of fit-out?

6.16 While agreement of this kind would be better than no agreement, it can still leave substantial scope for discrepancies. In particular, the vendor may allocate the price so that some depreciable items are sold for more than their cost so as to reduce depreciation recapture on other items. The purchaser may allocate the price in a different way, to items that depreciate at a faster rate. So long as the allocations are within a market value range, the discrepancy would not be able to be challenged.

6.17 Accordingly, officials suggest that to the extent that the vendor treats an item of property as a separate item for taxation purposes (mostly obviously, in a depreciation schedule, or in an IT system for recording financial arrangement income) the parties should be required to agree on the amount allocated to that item. This will not require any additional work for the vendor, since the vendor is separately identifying the item in any case and will have to allocate a portion of the consideration to it. It also should not require any additional work for the purchaser, who will have to set up its own records, or take over those of the vendor.

6.18 This approach should not preclude the purchaser taking a different approach from the vendor to the classification of depreciable items. The issue is not the classification of the items, but the amount of the purchase price allocated to them.

6.19 For example, suppose that a vendor of a commercial building has made no distinction for depreciation purposes between items A, B and C, treating them as a single asset depreciated at a single rate. However, the purchaser intends to split out item C, and depreciate it at a higher rate than items A and B. That should not be problematic in any way, so long as the total amount allocated by the purchaser to the three items is the same as the amount the vendor has allocated to them.

Denial of a deduction for purchasers who disregard the law

6.20 It appears that many advisors were not aware of the existence of section EB 24 and the requirement for a consistent allocation of trading stock between the vendor and purchaser in a mixed supply. Even where there is an existing legislative requirement for a consistent allocation, purchaser tax returns have in many cases been prepared simply on the basis of the purchaser’s own allocation. This suggests a need to develop rules which not only require consistency as a matter of law but encourage voluntary compliance so far as possible.

6.21 We therefore consider there is a need for an explicit legislative rule that denies a purchaser in a mixed supply a deduction for any amount paid, unless that amount has been determined on the basis of the rules set out in this proposal. This means there would be no right to a deduction unless it was based on:

• an agreed allocation;
• in the absence of agreement, the allocation provided by the vendor, based either on the vendor’s assessment of market value, or the vendor’s original cost or depreciated value;
• only if the purchaser has requested the vendor’s allocation and not received it, the purchaser’s allocation – in which case the vendor would also be required to use the purchaser’s allocation.

6.22 Such a rule would make it clear to those preparing tax returns that they need to actually obtain an allocation that ensures consistency and would enable them to make this requirement clear to their clients. It would also make it easier for the Commissioner to deal with situations where taxpayers have not attempted to comply with the law.

6.23 Such a rule would need to allow for the purchaser to claim a deduction in a later year once it has the vendor’s allocation or has properly provided its own, and subject to continuity of ownership requirements.

[5] Or, in the case of land, a purpose of resale.