For the purposes of Key Person [Keyman] Insurance - Part 4

In our last of a four-part series on valuation issues for small and medium businesses, we look at tax issues requiring a valuation.

Last year, a company that completed an internal restructure received an amended assessment from the Australian Taxation Office.  The transaction was an internal one and, even though no money changed hands, the restructure resulted in a capital gains tax event.

The taxpayer had relied on the CGT small business concessions to overcome tax liability.

These concessions, where available, allow small and medium enterprises to significantly reduce or eliminate the tax on certain capital gains.  An internal review of the business concluded that it was worth $1.3 million.

The ATO challenged the use of the concessions on the basis that the company did not satisfy one of the eligibility requirements – the maximum net asset test, at the time $ 5 million.  The ATO valued the business at $4.7 million.

This difference, together with other assets that needed to be counted, caused the company to fail the maximum net asset test.  Without access to the concessions the company was exposed to a tax liability of many hundreds of thousands of dollars.

An isolated case?  No, the ATO has a large number of similar cases afoot.

Would an independent valuation have made a difference?  A valuation by itself does not provide a tax guarantee, but the ATO is far less likely to challenge an independent view formed at the time of the transaction.

In the absence of a formal valuation, the ATO is more likely to question whether the true value has been arrived at.

Most people think about valuations when there is a dispute occurring or when an asset is being bought or sold.  They often overlook other transactions where a valuation is absolutely necessary. 

The danger of doing this is that you may be inadvertently inviting the tax commissioner to determine his valuation of the transaction.  In many cases, this will produce a nasty surprise.

There is a wide range of everyday SME transactions that have a potential tax consequence.

Think about the simple issue of shares in a company, the transfer of shares between shareholders, the restructure of a business, assessing the distributable surplus of a company for Division 7A purposes or using the CGT small business concessions.  Each of these transactions requires a value to be attributed to it.

SME’s often try and do this themselves or look to their accountant to provide a quick indicator, without undertaking a formal valuation.  Why pay for the cost of a valuation where the purpose is purely internal, and it may never be required?

Sections 112 and 116 of the Tax Act provide what is commonly known as the market substitution rules.  This allows the commissioner to deem his own value on a transaction where the parties are not dealing at arms’ length and where a market valuation has not been applied.

The commissioner has also outlined his expectation of valuations in practice statement 2005/8.  This requires a formal valuation process for any transaction where the parties are not dealing at arms’ length and where the value assessed will impact on the calculation of a tax liability.  Following these rules is simply a smart risk-management strategy.

In our example, did the ATO get the value right?  Almost certainly not.  But the taxpayer is now on the back foot, trying to overcome an amended assessment and fighting through the appeal channels.

Back to part 1 The Virtue Of Valuing A Small Business

Back to part 2 How To Find The True Worth Of Your Busness

Back to part 3 Valuation Method Hinges On Purpose

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• analysing your ‘Key Person insurance requirements;
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• liaising with your accountant to get the figures right;
• helping to establish a value on the business/practice;
• helping to formulate Buy/Sell agreements for succession planning;
• negotiating with underwriters to tailor the best insurance cover at the most affordable premium;
• obtaining insurance premium funding;
• helping manage the ongoing Key Person insurance program – annual level reviews as well as at a time of claim to help ensure that the money goes to the right people at the right time.

It’s imperative to have an insurance broker such as RGIB arrange your Key Person insurance so as avoid any unnecessary complications at benefit payment time.

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