Martin: Welcome to the business owners podcast where we throw aside taboos and share strategies for growing, protecting and exiting your business. My name is Martin Checketts and I represent Mills Oakley’s Private Advisory team.
Well, I’m here now at Episode 2 of Season 5 of our podcast, with tax guru John Storey. Welcome John.
John: Thanks again Martin.
Martin: Hey John I really enjoyed the previous episode which is all around selling your business and the tax consequences of that. This time we are going to talk about another topic which I know will be close to the heart of many of our listeners which is property tax issues for business owners.
Now John I know that you do a lot of work in this space with business owners and as you know entrepreneurial people often like to do things like, buy the factory in which their business operates or do some property developments on the side, or whatever it may be and we see some clients that are structured very well in that regard and some who are structured less well. So what I’d really like to do in this episode is to throw a few scenarios at you and get your views as to the good, the bad and the ugly.
John: No problem.
Martin: Well look I might on that note throw it open with a starter for 10. One thing that I see too commonly with my clients is that they have a good idea to buy the land, they own the freeholder from which they conduct the business, the office, the factory, the agricultural land, whatever it may be, but they own that real property in the same entity often a company from which they run the trading business. So of course what they’ve done is they’ve exposed that valuable land asset to the trading risk of the business which is an absolute no, no. You know, you’ve got to separate assets from trading risk. But of course, then the big question is, how they get the property out of the structure, so it’s going to cost them tax and probably stamp duty. So John over to you. (Martin and John laugh)
I’m sure you’ve got a quick two minute answer that can resolve all of those problems?
John: Yep no problem Martin. Well that is a recurring problem and it actually generates a fair bit of work for tax lawyers like me, at unscrambling an egg like that, an omelette like that, to sort of separate out the parts. There can be solutions, it depends on the structure you start with. If it’s a company for example, there are possibilities of forming a corporate group and transferring the land into a subsidiary, or transferring the business into a subsidiary so that they’re in separate boxes, if you like. There are stamp duty exemptions for forming a group and transferring land between a group and there are tax concessions called consolidation for moving assets within a group. Sometimes it might be best to get the land out of the group all together, there can be stamp duty exemptions for that, for example, if it’s a family trust, what land can be transferred to beneficiaries of the trust without stamp duty.
Martin: That’s agricultural land, right?
John: No, any land that’s owned by a family trust it can be transferred to an individual beneficiary of the trust.
Martin: Wow, ok.
John: You can… sorry I should mention in Victoria, under Victorian stamp duty. Different rules in different states. Say for example, rather than leave it in a family trust which might be carrying on a business, might be a non-working spouse who would be safer at home, transfer it to the spouse, there’s a stamp duty exemption. CGT will apply in that situation and that’s where often you need to look at the CGT small business concessions they might be able to manage the tax. So it’s not ideal but sometimes there can be solutions to fix it up later.
Martin: That’s great John thank you and as you say these can often be very complex scenarios involving not only the capital gains tax but the stamp duty, which as you say is different in each and every state of this country. But if you can do it, if you can get some good advice and separate out that asset from risk it can be really, really powerful in terms of protecting your valuable assets going forward. And also, frankly, it can make the business a lot more saleable because no big company is going to come along and buy your little company that’s got a miscellany of land and other assets in it, you know, they just won’t want to do that and they will expect that you will separate out those aspects before they come along and acquire.
John: You are going to have to do that anyway sometimes if there is going to be a little stamp duty or maybe the CGT concessions don’t reduce the tax completely sometimes doing it earlier, if you’re going to have to do it anyway, do it early, get asset protection benefits and it might minimise the tax because land generally goes up in value over time.
Martin: That’s it isn’t it, and it’s often a very difficult conundrum that we see business owners wrestle with you know, do they kind of rip the band-aid off now, feel a bit of pain but it’s done. Or, do they kind of put their head in a metaphorical bucket of sand and keep going cross their fingers that the assets aren’t exposed and also potentially expose themselves to a much, much bigger cast of affecting the same solution later down the track.
John: On a similar theme, you know the perfect structure from a lawyer’s perspective is to have separate companies for all these assets, particularly a business in start-up phase, cash flow is tight, you know they might be thinking, oh well that is an extra tax return, that’s an extra ASIC fee and the desire is to limit those costs, it’s a real balancing act between obviously minimising your costs but actually creating a bigger problem down the track.
Martin: Yeah and again the view that I have which I’m sure any professional adviser listening to this would echo and share is that, you are much, much better to spend a little bit of money up front to set it up right than to pay not only the advisory fees but the tax and stamp duty to resolve these things later down the track. Just one little thing I wanted to mention John, when you are setting up the acquisition of some land, so we might have listeners out there who are thinking of buying the factory, or thinking of buying the office. What would be a good way to structure that acquisition of the freehold land?
John: Yes there’s a couple of considerations, beyond just the asset protection one we’ve discussed. One is, in the scenario where you are buying land to be used as the business premises, presumably it’s going to be kept long term the purpose isn’t a short term sale, so generally the land will be on capital account. The law as it currently stands there is a 50% discount for the sale of capital assets but only if the land is owned in either a family trust or in individual names. So often the best structure is a family trust to own the land but the business might be run in a company for example. That’s one consideration.
The other consideration is that business real property is an exception from the usual pretty tight rules regarding self-managed super funds and what assets you can use of a self-managed super fund. So you can buy business real property in a self-managed super fund and it can be leased to the business, the business operator, and that creates a number of advantages, sometimes if people have money in super it’s a source of finance to buy that property, super funds pay a lower tax 15% in accumulation phase, zero in pension phase. So if you pay rent to the super fund, you’re reducing your income in the business and it’s taxable at lower rates than the super fund and a future capital gain is even more concessional in a super fund. So it’s quite a common strategy for people to buy a business real property in their super fund.
Martin: That’s great John, that’s very valuable advice.
Talk to me about property developments, because again this is something I think that business owners commonly look at, they might have bought the factory 30 years ago in North Melbourne, for example, and they’ve seen the asset value go up and up and up, and they’ve seen other factories in the area knocked down and up go the apartments and, you know, everyone makes a lot of money. Tell us about some of the tax tricks and traps for somebody looking to develop their commercial property.
John: Yeah. Once you become a developer, the key issue is that it may no longer be on capital account and that can sometimes trip people up a little bit. So effectively once you’ve decided to develop a property for the purpose of sub-dividing, building and sale, or strata titling and you building a tower and sale, the profit you make from that venture will be ordinary income, so it will be fully taxable and that needs to be factored into this viability of doing that. Some people then think, “oh but you know I’ve had it for 15 years surely it’s on capital account”. Well it’s basically a proportion, so you look at the market value when you started to develop it and that component is going to be on capital account and then you look at ok what value is added because of the development, that’s fully taxable. People are probably aware that you know, professional property developers, everything is fully taxable on revenue account, you don’t get any 50% discount but they might not be as aware that a one off development can be subject to the same issues. However, it really depends on the scale of the development. Sometimes smaller developments, particularly where it only results in a sub-division and sale of the vacant land as opposed to fully developed buildings, that’s in a grey area where it may, or may not be on revenue account and normally advice is needed in that situation.
Martin: That’s fascinating John and it really, to me that just really shows the importance of some good tax advice at that kind of financial modelling stage. At the stage of thinking about the economic viability of this, or thinking about different options for yourself, because the high level of what I’m hearing is you might do that analysis and think well its actually not worth me developing it myself, I might as well just sell the land and let somebody else have all of the headache of doing the development, the planning permission, the subdivision, because yes I’m going to sell it for less but I won’t have any of that headaches and I can concentrate on my business and it will absolutely be on capital account.
John. Yeah. A factor there is a lot of businesses have been owned for a long time that the land can be pre-CGT land and you know, if you factor in that, you could probably obtain some permits for the land and sell it as one vacant, as one title, that would still probably be pre-CGT, and you know, that would allow you to maximise the value of that land from a tax perspective. Another consideration in developing property is if it is in a super-fund. Super funds they’re not prohibited from developing property but they’re not allowed to borrow to develop property. I have been in the situation where someone has bought land in a super fund thinking it was the best structure for tax and they were able to access their super money to fund it and they had the plan to develop it. And then we’ve had to tell them “well sorry you actually can’t develop it because you were planning to take bank borrowings to do that” and they’re now in the wrong entity, they’re in the wrong structure and you know, getting it out of the super fund can involve legal issues, stamp duty. So yeah if you are planning to develop a property and this isn’t just developing for a future sale, it could be upgrade the warehouse or something like that. Just be mindful that super funds can’t borrow to develop property like that. They can only borrow to repair and maintain a property.
Martin: That’s so interesting John and boy I think to me it illustrates really well unfortunately and I wish it was otherwise, but unfortunately there are rarely easy answers or package solutions in tax. Everything is necessarily a fine tuned solution based upon your current situation and what you want to do in the future. There is no one ideal structure that’s the best and we should all tick that box and do it.
John: Yeah well the client I was referring to who wanted to develop land in a super fund, you know, quite sophisticated advice had been obtained about being able to borrow to buy that land and being compliant with super and cash flow and all that, but one simple question “are you intending to develop this land?” would have made it abundantly clear that super fund was just not the right structure. You know, just getting fulsome proper advice in advance could have avoided a headache.
Martin: Yeah, and the other thing that really struck me from what you’ve just said would be for those who have pre-CGT land, ‘because we would all assume and that would certainly again as a non-tax lawyer be my default assumption that, “you beauty it’s pre-’85 I will never have a tax liability in relation to this land”, but when I hear that in fact even if it’s pre-CGT and you’re developing it you might have some tax on revenue account, that’s scary.
John: Yeah that’s absolutely right. So if you sell undeveloped pre-CGT land yep it’s completely tax free. Once you start to develop it then a component of it is either going to be on taxable on capital account as a post CGT asset or if it’s a proper development for the purpose of sale, on revenue account, so you won’t, just to be clear, you won’t lose the entire concession you generally lock it in at the point in time when you make that change. But if you’re not expecting it, that can be a problem, probably the other scenario like that maybe not that relevant for business owners but most business owners will have their own house and some people get the idea of sub-dividing their suburban block into two or three or four apartments, and think “you beauty it’s a main residence you don’t pay tax on your main residence”. Well in fact once you carve off a part of your block it will be subject to tax, there can be a few ways to assist to get around that but I often have people quite surprised that they might have to pay tax on the sale of a part of their main residence.
Martin: Yes as I think most people would be, that’s a great insight. Thank you.
So just finally, say that we have properly separated the land from the operating business. So we’ve got the land in a family trust, we’ve got the land in a unit trust or a self-managed superannuation fund and the like, and we are leasing that land therefore to the business, any kind of hints and tips or things to avoid in relation to those leasing arrangements ‘because often what I see is that people don’t document them formally it’s very kind of fast and loose. Any issues with that?
John: Certainly in the context of superannuation. You need a commercial lease and the rent has to be a commercial rate. If not the fund might be non-compliant, or in breach of some other rule governing superannuation funds. It’s probably not quite as crucial outside of the superannuation context but I think it’s still best practise that you pay market rent for a variety of reasons, for asset protection reasons, uncommercial transactions can sort of undermine some of the asset protection you’re looking for and sometimes it can trip you up in other ways. So for example, there might be some bank borrowings on the property and you’re claiming deductions for that, but you’re not paying, but the company or the entity that owns the land is not being paid a market rent. Well the ATO could review that and say, “well you’re not borrowing for an income producing purpose therefore we are going to deny the deductions on the bank borrowings”. So it won’t be an issue every time, sometimes sort of peppercorn rent can do the job. But once you get these multiple entities you do have to be careful, that you know for legal purpose, tax purpose, other purposes they are different entities and not charging an appropriate rent can cause a problem, either a tax problem or a commercial problem for the directors.
Martin: Yeah thank you John and just to unpack that a bit. I think that this is a point that people like us are very well attuned to, most of our clients aren’t because they think well “I just own everything and I can carve it out how I want, sure it’s held in different entities but it’s all me”. That’s not how the law sees it and that’s not how the ATO sees it. So as I say just to kind of unpack that point a bit, say if I’m a director of the operating business and I am leasing the land from the family trust, well as a director I owe some duties to the company of which I am a director to enter into transactions in good faith for the best interest of the company, etc. So if I’m over paying rent dramatically because I think there’s going to be a tax benefit on the other side, well, if that company does go under, or it goes into liquidation or the like, and some clever person starts picking over all of the transactions it’s at that point when you are going to have a problem and some bright spark is going to say, “well no actually you breached your duties there and that was an uncommercial transaction”. So we are going to put the money back in the company and therefore it’s going to be available to your creditors etc.
John: Yeah and there can be some tax issues in not having sort of proper arm’s length arrangements between entities. As businesses grow and they get more sophisticated if you like, you can have multiple entities, you can have land in some, you can have you know, plant and equipment, multiple business lines in different entities, what can happen is, you can find that one entity might have a tax loss, while another entity in the group is making profit. Now what is tempting at the end of the financial year is to just charge a management fee between the two and from personal experience in the sense of I’ve had clients that had been audited, the ATO don’t just accept management fees at face value, there’s got to be something behind them for them to legitimately accept that, yep there’s income that’s gone over that’s deductible. And often if you actually plan it in advance there are arm’s length things they could have charged for, or whatever to match them up, so it is a relevant issue.
Martin: Wow that’s a great point thank you John.
Well look we have come to the end of this episode, I’ve certainly learned a lot, so I thank you for that. I’m sure our listeners will have done so as well. If people want to get in touch with you John, what’s the next step?
John: Yeah they can give me a call my number is 03 9605 0825 or my email, firstname.lastname@example.org. I’m happy to take any queries and would love to have a little chat and chew over a little tax issue (Martin laughs) and if I can help you and go forward great, if not it’s good to hear what people are up to.
Martin: Yeah don’t hold back John likes nothing more than to chew the fat over a complex tax problem, he loves it. (Martin laughs)
John: You’re saying that as if it’s not normal Martin. (both Martin and John laugh)
Martin: Oh boy look I think I should end it right there. (both Martin and John laugh)
Thank you John and I look forward to speaking with you in episode 3.
John: Thanks Martin.