|
Incorporating your no goodwill practice? Watch out for CGT!
|
Andrew O’Bryan, Partner |
In recent times, some high profile firms, such as Slater & Gordon Limited, have chosen to incorporate their businesses. In response to the ATO's 21st century update on service trust arrangements, many professionals have looked at the benefits of incorporation specifically where the shares can be owned by someone other than the original partners. Over the last 18 months the ATO has been asked to consider the implications particularly for "no goodwill" practices. On 6 July 2007, the Commissioner released a guidance note titled “Tax aspects of incorporating your business”.
Goodwill irrelevant for CGT purposes when practices incorporate
Where partners in a practice recognise goodwill and that goodwill is transferred to a company, the note correctly concludes that any capital gains or losses must be recognised on transfer, subject to various concessions and discounts applying.
In no goodwill situations though, the Commissioner argues that “the market value of the partnership interests, and whether goodwill should be recognised in this market value for incorporation purposes, are questions of fact in each case.” Even though partners in a no goodwill practice do not recognise goodwill and new partners are not required to purchase goodwill from existing partners, the Commissioner is effectively saying that when a practice incorporates, goodwill may still be recognised and taxed.
This position is in contrast to the Commissioner’s position that no CGT will be payable where a partner in a no goodwill practice enters or exits as a partner. The Commissioner justifies his conclusion by arguing that where a practice incorporates, the entire business is being transferred to a company and an ongoing interest in the company is acquired by the former partners and that this is different to the situation where a partner enters or exits the partnership.
Even with this explanation, it is difficult to see the Commissioner’s reasoning: if a partner swaps his or her interest in a no goodwill partnership for a share in a no goodwill company, the value is unchanged. It is not as if the interest is suddenly worth more because it is a share rather than a partnership interest. On the basis the incorporated practice adopts the same rules i.e. no goodwill on transfers of shares, you could end up with the situation where a partnership practice is incorporated (not under rollover) and a partner sells his interest for the nominal non goodwill value of say $50,000 is assessed on a deemed market value of say $1M but ends up with a share in the incorporated practice still worth $50,000. It’s still worth only $50,000 because that is all it can be transferred for under the shareholder's agreement, which has the same entry/exit rules as the old partnership agreement.
The note only suggests that the goodwill may be recognised, but it will depend on the facts. But the Commissioner has not outlined in the note what facts will be relevant. This leaves professional practices in the dark. Will they be taxed or not?
What is the solution?
For many, the immediate impact of incorporation will not result in a substantial CGT liability, even if goodwill is recognised and taxed. This is because any CGT can be sheltered via the use of CGT rollovers (in particular, the partnership to company rollover), the CGT discount and the small business CGT concessions.
However, there will be a future CGT issue when those former partners sell their shares in the company. In any event, incorporating by rolling over doesn't really achieve much. If the partner remains the shareholder, the profits are still ultimately taxable to that partner. Incorporation also creates cash flow, payroll tax, Division 7A and franking timing issues. The transfer of work in progress creates tax timing issues too. Even under the CGT rollover, the transfer of WIP is not covered.
What is worrying is that the Commissioner’s view on what is substantially the same issue – whether goodwill in a no goodwill partnership should be recognised for CGT purposes – differs depending on the transaction. Without a clear understanding of why this is the case and no good reason for the Commissioner to have opposing views, there are no assurances that the Commissioner will continue to say that no CGT will be payable where a partner in a no goodwill practice enters or exits as a partner.
FURTHER ENQUIRIES
