Market valuations for tax purposes

Institute of Public Accountants National Congress

November 2017

Presented by: Fiona Hansen, Partner, PPB Advisory

Topics

• Introduction

• Market Value general principles

• Valuation approaches

• Capital Gains Tax

• GST

• Income Tax

• Tax Consolidation

• Employee Share Schemes

• Thin Capitalisation

• ATO market value rulings

• Tips and tricks

• Concluding comments

Introduction

Concept of value

Concept of Market Value is important for the determination of:

• Capital Gains Tax

• GST

• Income tax

- Tax consolidation

- Employee share schemes

- Thin capitalisation

To determine the amount of tax payable

Effective tax planning

Why are tax valuations needed ?

Market Value

Value

shifting rules

Tax

consolidation

Thin

capitalisation

Asset valuation

Employee

share schemes

Valuation of

shares / options

Debt

forgiveness

Purchase price

allocations

(eg depreciable

assets)

Trading

stockOther

FBT, PAYG and non-cash benefits

Transfer pricing – eg Guidelines re

intangibles

Self managed superannuation funds

– fund assets

Off-market share buybacks

Research and development

Cultural gifts programme / donations

Stamp duty

GST – eg margin scheme partly

completed developments; pre 2000

property

Market Value general principles

ATO Market Value Guidelines

Part Summary

A Provides guidance about determining the Market Value for tax purposes.

B

Sets out the 3 valuation processes for real property, plant and equipment that the

ATO will accept. These methods are:

• a direct, sales or market comparison approach

• a depreciated replacement cost approach

• income-based approaches

C

Sets out several valuation approaches and methods for deriving Market Value for

a business, securities and intangible assets including:

• market ▪ asset ▪ income ▪ cost ▪ probabilistic

D Provides guidance on the content required in a market valuation report

E Provides guidance on how to reasonably allocate value to underlying assets

FSets out, among other things, the ATO’s compliance activities and its approach to

ruling requests involving Market Value

Market Value General Principles

• Not specifically defined for general tax purposes

• A knowledgeable, willing but not anxious purchaser/a knowledgeable, willing but not anxious vendor?

• Highest and best use

• Both parties fully informed and aware of current market conditions

• Is the sale price of an asset always equal to its market value?

9

Value versus Price

Price

is what you pay

Demand and supply

Mood / trend

Value

is what you get

Cash flows

Risk

Replication

OR

Concepts of value

The price that would be

negotiated in an open and

unrestricted market

between a knowledgeable,

willing, but not anxious

purchaser and a

knowledgeable, willing, but

not anxious vendor, acting

at arm’s length (Spencer

v Commonwealth)

Value

The amount asked, or

offered, for goods or

services (IVS)

Price

Is the estimated price for

the transfer of an asset or

liability between identified

knowledgeable and willing

parties that reflects the

respective interests of

those parties. (IVS)

The price that would be

received to sell an asset

or paid to transfer a

liability in an orderly

transaction between

market participants at the

measurement date.

Accounting concept.

(AASB 13)

Fair value

Additional value created

by combination of two or

more assets

Synergistic valueSpecial

value

Refers to the result of a

historic transaction, set in

time and amount and is

the “... the price that is

paid for goods or a

service, or the amount

paid to produce the goods

or services” (IVS)

Cost

Fair value

Some attribute of the

asset that has value to a

special purchaser

Special value

An economic concept

referring to the monetary

relationship between

goods and services

available for purchase and

those who buy and sell

them (IVS)

Market value

Value

Definition of Market Value – case law

Leading case authority

Spencer v The Commonwealth of Australia (1907) 5 CLR 418 per Griffith CJ:

...the test of value of land is to be determined, not by inquiring what price a man desiring to sell could have obtained for it on a given day, i.e. whether there was, in fact, on that day a willing buyer, but by inquiring: what would a man desiring to buy the land have had to pay for it on that day to a vendor willing to sell it for a fair price but not desirous to sell?

Key principles recognised by the High Court

willing but not anxious vendor and purchaser

hypothetical market

(may be defined

according to geographical

area, product, distribution

level eg wholesale)

unforced, arm’s length

transaction

parties being aware of current market conditions

parties being fully informed of pros and cons associated with the asset

being valued

market value is value to

3rd party, not specific to

an acquirer Cmr State Rev (Vic) v

Pioneer Concrete (Vic) Pty

Ltd [2002] HCA 43

Meaning of Market Value –important concepts

Account for potential

use

Potential use may be

higher than current

use, which may not

reflect asset’s

optimal valueATO Market

Value Guidelines

Market value should

reflect asset’s ‘highest

and best use’

recognised in the

market

Highest

and best

use

Arm’s

length

considerationTransfer pricing

purposesNot always

arm’s lengthMarket value is not

always same as arm’s

length consideration

required for transfer

pricing purposes

Foreign

related partiesTransfer pricing rules

use expected

consideration

assuming arm’s length

independent parties

dealing in similar

circumstances

Business senseMarket value is only

used this way for

transfer pricing

purposes if it makes

business / commercial

sense in taxpayer’s

circumstances

Inter-related

assets should be

valued on same

use Not some on

alternative use

and others on

existing use

Timing of a valuation

Timing

ConsolidationJoining

Formation

Exit

CGT Time of CGT event

(table in s104-5

ITAA97)

Thin capitalisation Aligned with

relevant accounting

standards

Non-cash benefits (FBT or PAYG)

Broadly when benefit

provided

Timing may be more

or less frequent than

would have

otherwise been

required

For PAYG, withholding

must be before benefit

provided

Debt

forgivenessFace value

assuming debtor

solvent when debt

incurred / forgiven

Exception: Use market

value of debt at time of

forgiveness for non arm's

length, non money lending

debt where creditor subject

to CGTEmployee

share schemeTime of acquisition

of share/option

Valuation approaches

Key valuation approaches and methods

Select the most appropriate methodology,

based on valuation industry standards for

that particular type of asset and available

data

Income approachEarnings based___________________________________________________________________________________________________________________________________________________________________

Discounted cash flow (DCF)

Future maintainable earnings

(CFME)

Dividend yield

Binomial / Black Scholes

Relief from royalty

Cost approachCost to re-create that asset (use

where little/no goodwill)_________________________________________________________

Net assets (NA)

Depreciated replacement cost

Choose

cross-check method

Comparable

transaction

and trading

multiples

Capitalisation

of earnings

Industry rule of

thumb

Discounted

cash flow

Net assets

Market approachWhat third party would pay for

that asset or similar asset________________________________________________________

Comparable transactions and

trading multiples

Cost approachCost to re-create that asset (use

where little/no goodwill)_________________________________________________________

Net assets (NA)

Depreciated replacement cost

Select valuation approach

cross-check methods

Comparable

transaction

and trading

multiples

Industry rule of

thumb

Net assets

Know What is to be valued

The Enterprise Value (EV) is the Market Value of the economic assets

The Equity Value is the Market Value of the shareholders’ equity, i.e. the Market Value of the

Enterprise Value, once the debt has been reimbursed

Current

Assets

Intangible

Assets

Financial Debt

less Cash

Shareholders’

Equity

Current

Liabilities

Equity Value

Enterprise

Value

Tangible Assets

In some circumstances individual tangible (e.g., capital equipment) and/or intangible (e.g. trademarks,

patents, contracts) assets need to be valued

Or certain liabilities need to be valued

Discounted cash flow (DCF) method

Most appropriate if:

Start up companies

Projects with finite life eg mining project

Cash flows can be predicted with

reasonable degree of certainty

Cash flows not yet stabilised

Future cash flows are expected to be

unlike past

Less appropriate if:

Company is a holding company or not

sufficiently profitable

Impractical to try and predict future cash

flows

The DCF method has regard to the expected

future economic benefits discounted to present

value terms.

Time Value of Money

A dollar today is worth more than a dollar in the

future taking into account inflation and risk /

opportunity.

Risk v Reward

A certain dollar is worth more than a risky dollar

Discount rate

CAPM (Capital Asset Pricing Model)

WACC (Weighted Average Cost of Capital)

DCF - Components

The DCF method requires:

• future cash-flows

• discount rate

Time

Valuation Date

CF 1 CF 2 CF 3 CF 4 CF 5 CF 6

Discounting Process

DCF method

• Ideally forecasts for at least 5 years for a business (preferably over a full business cycle) or the life of the asset

• Understand financial projections:

– Assumptions

– Profile of projections

– Key drivers

– Sensitivities

Terminal value

• Value of cash flows beyond the explicit forecast period for the business or an asset with an indefinite life

• Be aware of issues regarding:

– Reliability of last period cash flows

– Subjectivity of growth into perpetuity

Cash flows for explicit

forecast period

Free Cash Flows Comprise

+ EBIT

- Corporate Tax

= Net Operating Profit after Tax (NOPAT)

+ Depreciation & Amortisation

- Capex

- (+) Increase / (decrease) in Net Working Capital

= Free Cash Flow (Firm or unlevered)

Free Cash Flow Computation

Discount rate

The WACC measures a company’s cost of capital based on:

• Its after tax cost of equity and debt

• The respective proportion of equity and debt in its financial structure

Net Financial Debt

Shareholders’

Equity

Capital

Employed

Weighted Average

Cost of Capital

(WACC)

Cost of Debt (After

Tax)

Cost of Equity

Low Risk

Low reward

High Risk

High reward

Listed

Company

(12-14%)

Development

Capital

(20-30%)

Start-ups

(40% +)

Risk

premium

Risk-free

Rate

Rate of

return

Government

Bonds

Cost of Equity

E(R) = Rf + β(Rm- Rf)

Cost of Debt and Gearing

• Based on the subject company’s expected credit rating

• Market driven (yields) and not based on coupons

• After-tax

• Gearing based on target gearing using potentially comparable companies or other market data

WACC Computation

WACC is generally computed as follows:

WACC = Ke X ( E/(D + E) ) + Kd X (D/(D + E) )

With :

WACC Weighted Average Cost of Capital

E company’s equity market value

D company’s net financial debt

ke cost of equity

kd cost of debt after normative corporate tax

Capitalisation of future maintainable earningsUnder this method, the Market Value of a company is derived by capitalising the estimated future maintainable earnings using an appropriate multiple. The multiple is selected from a portfolio of comparable listed companies, based on comparability of the subject company to the comparable companies.

Most appropriate if:

Company is a going concern

Company is a reasonable

size to make comparison

meaningful

Stable future earnings

Not practical to try and

predict future cash flows

Less appropriate if:

Company is a holding

company or a start-up

company

Historical earnings are not

indicative of future earnings

Company not large enough

or not sufficiently profitable

+Company’s

market value of equity

Estimated future

maintainable earnings

Earnings multiple=

Surplus assetsX – Debt

Business / enterprise value

Some more sophisticated concepts

• Earnings can be at various levels:• earnings before interest, tax, depreciation and amortisation

(EBITDA)

• earnings before interest and tax (EBIT)

• profit after tax (PAT)

• The selected earnings stream must be capitalised with an appropriate multiple (EBITDA, EBIT or PE multiple)

CFME – example

Company A

Net assets $800,000

Net debt $500,000

FME (normalised EBIT) $400,000

EBIT multiple 5.0x

Enterprise value $2.0 million

Equity value $1.5 million

Cost approach

The cost approach includes:

orderly realisation of assets method

liquidation of assets method

net assets on a going concern basis.

These methods ignore the possibility that the company’s value could exceed the realisable value of its assets.

Asset based methods are appropriate when companies are not profitable or a significant proportion of a company’s assets are liquid.

Most appropriate if:

Holding company

Investment company

Heavy asset-based company,

eg land-rich

Not profitable or low profit

company

Company facing liquidation

Less appropriate if:

Operating company

Company with intangible assets

Liquidation not contemplated

Minority interest values

Minority interest discounts

The reduction, from the pro-rata share of the value of the entire business, to reflect the absence of control

Example – ABC Limited (1,000 shares on issue)

Net Profit After Tax $100PE Multiple 10xEquity Value $1,000

Pro-rata value per share $1.00

Value of a holding of 10 shares (1%) $6.00 ($0.60 each) (discount – 40%)Value of a holding of 300 shares (30%) $240 ($0.80 each) (discount – 20%)Value of a holding of 600 shares (60%) $570 ($0.95 each) (discount – 5%)

Liquidity discounts

• ‘The ability to convert the business ownership interest to cash quickly, with minimal transaction and administrative costs, and with a high degree of certainty of realising the expected amount of net proceeds’

• Where a share is not publicly listed, the market for that asset is less clear, and this impacts on the price which can be achieved.

Information required to perform valuations

• Financial statements for at least 3 years (preferably audited)

• Detailed monthly management accounts

• Current budgets/forecasts

• Major customers/suppliers

• Business plans

• Industry commentary

• Brokers reports

• Board reports

• Previous valuations

Common problems

Generally, failure to:• understand what it is that is being valued

• identify purpose of valuation

• clarify date of valuation

• recognise unusual/abnormal variations in earnings stream

• use appropriate comparables in selection of multiple

• apply correct discount rate/multiple to the cash flows/CFME

• adjust for related party transactions/loans

• identify surplus assets/liabilities

• inadequate or incomplete financial data provided

• valuation conclusions not supported by report

Capital Gains Tax

Market Value and CGT

• $6 million net asset value test for the small business CGT concession

• Market Value substitution rule

• Post-CGT improvements on pre-CGT land

• Various rollovers

• Apportionment of proceeds

• Value of non-cash proceeds

• Apportionment of cost base for split assets

35

Market Value and CGT

Example

A taxpayer has a pharmacy business listed for sale.

The taxpayer expects a sale price based on recent sales of similar sized pharmacies in similar locations to be about $4 million.

Out of the blue the taxpayer receives an offer of $8 million from an entity that owns a pharmacy in a neighbouring suburb.

• Satisfying the $6 million net asset value test is important

• Is the final sale price reflective of the business’ Market Value?

• How would you determine the Market Value ?

Market Value and CGT

Syttadel Holdings Pty Ltd v FC of T

• The taxpayer sold a marina in August 2006 for $8.9 million. It claimed entitlement to concessional CGT treatment, contending that the then $5 million maximum net asset value test was satisfied as the Market Value of the marina was $4.5 million.

• Both parties placed valuation evidence before the Tribunal that proceeded on the basis of highest and best use. The taxpayer's valuer determined the Market Value of the marina to be $4.5 million, and the Commissioner's valuer determined it to be $5.3 million.

• The Tribunal accepted $5.3 million was the Market Value.

Market Value and CGT

38

Excellar Pty Ltd v FC of T

• The Tribunal held that the appropriate Market Value of the asset sold, a boarding house, was the actual sale price of the asset.

• The taxpayer argued that the Market Value of the property was $3.72 million based on an expert valuer’s evidence of comparable sales in the area, rather than the actual sale price of $5.5 million.

• However, the Tribunal found that the buyer and seller were a willing but not anxious seller and purchaser of the property and, therefore, the selling price was the most relevant information that reflected the Market Value of the property.

GST

Market Value and GST

Definitions:

• ‘GST inclusive Market Value’ means the Market Value of the consideration or thing, without any discount for any amount of GST or luxury car tax payable on the supply

• ‘GST exclusive Market Value’ generally means 10/11 of the Price of the supply

40

Income Tax

Market Value and Income Tax

• Value shifting (Transfer pricing)

• Non-cash business benefits

• Employee Share Schemes

• Dividend access shares

• Property development – trading stock

42

Market Value and Income Tax

43

Property development

Example

A taxpayer has owned a large area of land acquired in the mid-1970s that they have used as a hobby farm. The land borders the outskirts of a designated urban growth area and the land is now prime for development.

With the assistance of expert consultants the taxpayer receives planning permission to develop the land into 200 residential lots.

The development is of such a scale that a business of land development has commenced.

• How do you determine the ‘cost’ of the land for trading stock purposes?

Market Value and Income Tax

44

Property Development

Section 70-30 ITAA 1997 – Starting to hold an item as trading stock

• Deemed disposal and immediate reacquisition for either:

i. cost; or

ii. Market Value

whichever the taxpayer chooses.

• Choosing Market Value results in CGT Event K4 arising. This choice is

preferable in this example as the land is a pre-CGT asset and therefore

any gain that arises is disregarded.

Tax Consolidation

Market Value and Tax Consolidation• Retained cost base assets always hold to their historical tax cost

• Reset cost base assets usually change tax cost base

This includes:

• Trading stock

• Depreciable assets

• Goodwill

• Copyright and other intangibles

Relative Market Values determine outcome. Therefore require a valuation of

the business to determine the values of the above assets

46

Tax Consolidation - example

Tax cost resetting

Head Co Ltd will be required to reset tax cost of

Operating Co’s underlying assets when Operating Co

joins Head Co Ltd’s income tax consolidated group.

Allocation of allocable cost amount (ACA) to

Operating Co’s reset cost base assets under Division

705 will be based on each asset’s relative Market

Value.

Valuation will be used to allocate ACA granularly to

each asset.

Identify internally generated intangible assets

Operating Co has incentive to identify as many

assets as possible and to maximise their valuations

(even if not recognisable for accounting purposes).

Meaning of asset for tax consolidation is broader than

meaning of accounting assets.

Allocate value to depreciable intangible assets to

generate future tax depreciation deductions.

Valuation – principles: going concern basis vs single

asset basis

Head Co LtdHead Company

Operating CoMember

Business assets

100%

Overseas Co

100%

Australia

Hong Kong

Tangible

Cash and debtors Trading stock P&E / land Other CGT assets

Non-depreciable Trademarks

over wine label

Goodwill

Intangible

Tax consolidated group

Depreciable assets Copyright Patents Registered

designs Software

Impairment

Safe harbour rules and impairment

• From accounting view, intangible assets should be carried at their recoverable amount or less once

recognised.

• If carrying value more than recoverable amount, AASB 136 requires asset to be written down and

impairment recognised as a reduction in the asset valuation amount. When impairment is recognised, need

to check whether any breaches of safe harbour ratio for thin capitalisation.

AASB 136 Impairment of Assets

• An asset is impaired when its carrying amount or cash generating unit (CGU) exceeds its recoverable

amount.

• Taxpayer must test for asset impairment annually.

• Five basic situations where AASB 136 requires an asset to be tested for impairment:

1. Asset is goodwill.

2. Asset is intangible asset with indefinite useful life.

3. Asset is intangible asset not yet available for use.

4. External indicators that an impairment trigger has occurred (eg market value significantly declined,

adverse technological / economic / legal / market changes, carrying amount of net assets exceeds

market cap).

5. Internal indicators that an impairment trigger has occurred (eg obsolescence, physical damage,

economic performance worse than expected, other significant adverse changes).

Employee Share Schemes

Employee share schemes

• Where a discount exists, that discount may be subject to upfront or

deferred taxation under Division 83-A

• Valuation of the share options:

- Conventional method

- Predetermined tax tables

Thin capitalisation

Thin Capitalisation

Maximum allowable debt

• A debt deduction is disallowed if taxpayer’s adjusted average debt exceeds its maximum

allowable debt, which is the greater of the:

- safe harbour debt amount;

- arm's length debt amount;

- worldwide gearing debt amount

Safe harbour debt amount

• Safe harbour debt amount is most common method for calculating maximum allowable debt.

• Balance sheet focused.

• Can revalue certain assets upwards that could not otherwise be revalued under accounting

standards.

• Method statement for an inward investment vehicle (general) is set out in section 820-195.

Step 1 of method statement requires average value of all assets for the income year to be

ascertained.

• Valuation and averaging rules in subdivision 820-G.

Internally generated intangible assets

Valuation rules (s820-680 – s820-690)

Market value timing aligned with accounting standards.

Values of assets, liabilities and equity capital used for thin cap

must comply with accounting standards, unless modified by

ITAA36 / ITAA97.

AASB 138 Intangibles / AASB 3 Business Combinations

Intangible assets must be recognised separately from goodwill if

meet definition of an identifiable non-monetary asset without

physical substance and fair value can be reliably measured.

Revaluations for thin cap purposes

May elect to recognise / revalue internally generated intangible

asset other than goodwill, even if accounting standards prevent

recognition / revaluation, including because no active sale /

exchange market (s820-684).

Entity must, to the fullest extent possible when recognising and

valuing assets, comply with accounting standards as if recognition

allowed by standards (s820-683).

Head Co Ltd

Operating Co

Business assets

100%

Cash and debtors Trading stock Plant and

equipment Other CGT assets

Tangibles

Loan

Revaluation Trademar

ks Copyright Patent

Intangibles

No revaluation Goodwill Staff knowledge Customer

r’ships Know-how Management

skill

Overseas Co

100%

Australia

Hong Kong

ATO Market Value Rulings

ATO Market Value rulings

• Taxpayers can either:

i. ask the ATO to provide a valuation (they will be required to pay for the

work of the valuer), or

ii. provide the ATO with a valuation and ask them to confirm it.

• Private rulings and valuations fact sheet:

https://www.ato.gov.au/general/ato-advice-and-guidance/in-detail/private-

rulings/private-rulings-and-valuations-fact-sheet/

Tips and tricks

Briefing a valuer

1

2

3

4

5

6

Two valuers if complex

One valuer can act as independent

valuer and provide expert evidence

Other valuer can act as expert to

guide taxpayer on appropriate

methodology

ATO Valuers Panel

Strategically useful

Some panel members specialise in

particular asset types

Manage valuation dispute

Maintain appropriate records showing

how market valuations obtained

ADR may be preferable to litigation

Valuer’s independence

Instructions should set out:

scope/purpose

valuer’s right to refuse opinion

fee not contingent on outcome

Give access to premises/records

Engage with ATO

Private binding ruling

Advance Market Valuation

Agreement

Early engagement mitigates risk

Elements of a good valuation

Frame precise question for valuer

Set out facts, assumptions, etc

Clear methodology and reasoning

Cross-check against other valuation

methods

ATO market valuation processes

Value of the asset/s

Type of asset/s involved

Materiality of any potential tax adjustment

Complexity of the valuation process undertaken

Documentary evidence supporting the valuation

ATO’s

considerations

Analyse taxpayer valuations

Support ATO

Provide ATO valuations

ATO Panel of

expert valuers

Broadly, the ATO’s valuers will consider:

how adequately the valuation process was documented

which market value definition has been used

how appropriate the method was (remember: not a science)

what assumptions and information have been relied on

Specialist ATO

Internal Valuation

Gatekeeper Unit

The ATO may review a market valuation as part of its compliance / risk assessment processes.

Concluding comments

• Valuation is an art (craft), rather than a science

• Selection and application of the valuation methodology is key

• The devil is in the detail – a little knowledge is dangerous

• Know what you are valuing

• It is important to clearly define the role at the outset

• Work with a tax adviser

• Follow the ATO valuation guidelines and the case law

• Accounting standards can provide helpful guidance

• Documentation, documentation, documentation

Any questions?

© PPB Advisory 2017

Disclaimer: The material and opinions in this paper are those of the authors and not those of Institute of Public Accountants. The Institute of Public Accountants did not review the contents of this presentation and does not have any view as to its accuracy. The material and opinions in the paper should not be used or treated as professional advice and readers should rely on their own enquiries in making any decisions concerning their own interests.