A gesture of goodwill from the ATO - No goodwill, no consideration, no worries?
Think again - Herding professionals down a narrow path!
On 16 March 2011, the Commissioner released a draft tax determination TD 2011/D3 – Market value of nil for shares in a 'no goodwill' incorporated professional practice ("IPP") [sic].
This ruling extends on the Commissioner's existing ruling IT 2540 (released in 1989) that accepted that the so-called "market value substitution rule" should not apply in relation to the disposal of partnership interest (held by natural persons) where the interest is disposed of for no consideration and the parties were acting at arms length.
In our view this determination (if finalised as it is) will have little to no beneficial application to practitioners looking to move in or out of a IPP and arguably puts the industry on notice for those that have disposed of interests in IPP's shares and have not declared a capital gain.
Background
The market value substitution rule is an integrity measure that is part of the CGT provisions in Australia's tax laws. Where it applies the consideration that is received for the purpose of working out the taxable gain will be deemed to be the market value of the asset subject to the CGT event (e.g. a disposal of a share in an IPP), rather than the actual consideration provided.
This rule would not apply to a sale of shares where two parties are dealing at arm's length and the consideration for the sale is greater than nil. However, if the sale of shares is for nil consideration the market value substitution rule will automatically apply regardless of whether the parties are dealing at arms length.
As such, the issue at the crux of this determination (and the concern for the ATO) is: should the entry and exit of principals (equity owners) in no goodwill IPPs for no consideration give rise to an adverse tax consequence for the transferor? In other words, if share transactions are ascribed an actual transfer consideration of nil, do those shares have an inherent value. In this respect, the ruling is as much about demonstrating market value as it is about anything else.
The nuts and bolts
This contemporary "addendum" to IT 2540 has been released following the ATO's timely recognition that the relevant laws that apply to professional practises (e.g. the Legal Profession Act 2004) now allow such practices to be operated via an incorporated entity.
Continuing the overall theme of IT 2540, this draft determination provides taxpayers with certainty in relation to the capital gains tax consequences of exiting and therefore disposing of shares in an incorporated professional practise ("IPP") that has "no goodwill" for nil consideration. Basically, where a "no goodwill" IPP meets certain conditions (these are explained below) the Commissioner will accept that the market value of the shares will have a market value of nil in the context of the market value substitution rule. This will mean that a disposal of such a share for no consideration will have no adverse CGT consequences for the transferor.
Specifically, at paragraphs 18 and 2 of the draft tax determination the Commissioner explains that the ATO will accept a market value of 'nil' to be applied to the goodwill, irrespective of its actual inherent value, on the disposal of a share in the 'no goodwill' IPP. This is provided that all shareholders agree to apply it and subject to the satisfaction of the following conditions:
- the original shareholders in the company are all natural person practitioners who previously held a fractional interest in the "no goodwill" partnership prior to the restructure;
- the provision of a share at the time of incorporation and in the post-incorporated environment reflects that person's status as an active practitioner in the practice;
- the company holds no other assets and has a paid up capital which reflects an immaterial value for goodwill;
- the company adopts a constitution or shareholder agreement or both that regulate the basis for admission to shareholding and surrender or transfer of shares in the company and the amount that is paid for it; and
- the constitution or shareholder agreement provides that no or an immaterial payment is made for the acquisition, disposal or change to profit distribution entitlements attached to a share in the company.
Here's the Rub
The draft determination provides the required benchmarks for "no goodwill" IPP for which the ATO will not challenge the contention that the market value of the underlying shares have a nil value. This leaves open the inference that the ATO will challenge a nil market value in respect of transfer of IPP shares where the relevant benchmark is not met. This is a concern as on a closer inspection of the criteria set by the Commissioner it may be very difficult for some firms that have incorporated to gain access to this administrative protection given:
- the requirement for the company to hold no other assets – what about debtors and prepayments?; and
- the shareholder in the IPP must be a natural person and must be an active practitioner in the partnership - shares held in family trusts would seem to be a breach of this requirement?
It is worth pointing out that at this stage the determination is only in draft form so the position of the Commissioner is potentially subject to change.
The determination will apply retrospectively once finalised. Submissions on this draft determination close on 15 April 2011. For further information on the above please contact one of the authors or your Moore Stephens relationship partner.
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