29/03/2021·4 mins to read
Important changes to tax rules on purchase price allocation
Some important changes to income tax rules concerning “purchase price allocation” (PPA) come into effect on 1 July 2021, for transactions entered into on or after that date. Parties to affected transactions - and in particular purchasers - will need to proceed very carefully in order to make sure the new rules do not distort their anticipated (after-tax) economic position.
PPA is an issue in all transactions involving the sale of a mix of asset types which have different tax treatments. It arises, for example, in business and asset sales, commercial property sales and forestry and farm sales.
IRD has become increasingly concerned at market practices, in various mixed asset sale situations, resulting in vendors and purchasers not entering into a binding agreement on PPA and taking different positions on PPA in their tax returns. This typically causes revenue loss as each party will adopt a PPA that optimises its after-tax position.
In a commercial property sale and purchase, for example, the vendor will often want to allocate more of the total price to the land and less to the building and fit-out. The land allocation will usually be non-taxable but the allocation to the building and fit-out will give rise to depreciation recovery income if it exceeds the vendor’s depreciated tax book value in those assets.
The purchaser will typically be inversely motivated. They will want to allocate more of the total price to the building and fitout to maximise available depreciation deductions going forward.
Similar inverse motivations play out in other mixed asset sale situations, particularly those involving the transfer of tax depreciable or certain revenue account assets together with non-taxable assets.
Provided both parties have a valuation of key assets supporting their position, it can be difficult (and time consuming and costly) for IRD to intervene and require consistency of PPA. Current tax rules are also of doubtful application in requiring consistency as a technical matter in any event.
The new tax rules are designed to induce parties to agree on PPA and adopt consistent positions for tax purposes. In a nutshell, under the new rules:
- If the parties agree a PPA in writing, at any time before either party files an income tax return for the period including the transaction, the agreed PPA is statutorily binding and they must follow it in their tax returns.
- However, if the parties have not agreed a PPA before settlement/closing of the transaction and the transaction is a mixed asset transaction for the vendor, the vendor may unilaterally determine a PPA. The vendor’s unilateral PPA will bind the purchaser if it is notified to the purchaser and IRD within three months after settlement/closing. In making this unilateral PPA, the vendor cannot allocate less than their tax book value to taxable assets. (In theory the parties could subsequently agree a PPA, under 1, which would override the vendor’s unilateral PPA, but it is difficult to see why a vendor in this position would ever agree to this.)
- If the vendor does not notify a unilateral PPA within the 3-month timeframe, the purchaser may unilaterally determine a PPA within a further 3 months, and the purchaser’s unilateral PPA will bind the vendor if it is notified to both the vendor and IRD within that period.
- If neither party notifies a unilateral PPA within the prescribed timeframes (and there is no agreed PPA before the first tax return filing date in 1) then IRD will be entitled to determine the allocation, based either on the PPA adopted by one of the parties or IRD’s own view of market value.
In the case of either an agreed or unilateral PPA, IRD will retain an overriding right to reset the allocation if it considers that it does not reflect the relative market value of the assets. We expect this override will be very rarely exercised, given that the key tax policy objective of the new rules is achieved purely by incentivising the agreement and adoption of a PPA by the transaction parties.
The transactional and contractual response to the new rules will vary depending on the transaction type, the mix of assets and the vendor’s tax book values. Suffice it to say that, in many cases, potentially being exposed to a binding unilateral PPA determined by the other party will be extremely unpalatable.
In competitive transactions there is no question the new rules will stack the PPA cards in the vendor’s favour. The vendor will be able to proceed with the comfort of knowing they will have the first right to unilaterally determine PPA (subject only to the tax book value ‘floor’ noted above) in the absence of agreement.
Those prospective purchasers, in particular, who determine their offer price based on a modelled after-tax position that assumes a cost base in depreciable or revenue account assets greater than the vendor’s tax book value, will need to:
- raise the question of PPA, and the purchaser’s expectations on PPA, at an early stage in negotiations;
- wherever possible, seek to leverage their position so that PPA is agreed at signing;
- if PPA cannot be agreed at signing, seek to include in the agreement:
- a binding process for agreeing PPA before settlement, with the matter to be referred to an expert valuer (whose determination would be deemed to be an agreed PPA) if required; and/or
- if there is a risk of PPA not being agreed at settlement, a covenant by both parties not to do a unilateral PPA, and to follow a process for agreeing PPA (including expert determination if required) in a timely fashion after settlement.
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