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, hello everybody welcome to Episode 5 of our Podcast, or should I say Season 5 Episode 1 of our Podcast. I’m very excited about this season because we’ve got one of Australia’s pre-eminent tax experts in the room with me, my colleague and business partner John Storey. Welcome John.
John: Thank you Martin. I’m very pleased to be here.
Martin: Thank you John. A brief introduction about John. He’s had many years in the tax game, he trained in a large law firm in Melbourne, here and also spent some time as a tax trainer before joining Mills Oakley some 6 or 7 years ago and that I think is a really great feature of John and why his clients love him in that kind of teaching and training background that he has enables him to present some of these complex tax issues in a very simple and understandable way and certainly I’ve always found that to be a wonderful benefit of working with John Storey.
John: Thanks Martin. Tax can seem very technical and impenetrable so I think the goal of an adviser is to try to break it down to a level that the client understands and can get some value out of.
Martin: That’s fantastic. Have you got any stories for us from your tax training days, any particular highlights?
John: Is that a pun at my name Martin? (Martin laughs)
Martin: You noticed – I got that one in early. (Martin and John laugh)
John: No no, it was good fun being a tax trainer. You had to learn to speak on your feet.
Martin: Very good. Well great practise for today.
John: Hopefully you will be more forgiving than some of…
Martin: …your rowdy accountants.
John: Exactly, be kind, be kind.
Martin: I’ll try my very best. Ok. So the first episode of this season is going to be in relation to the tax treatment of your business exit and it was something I was really, really keen to discuss with John on this show because it was something that I see business owners often get wrong or don’t think about it. Or they do think about it but it’s too late to make material structural changes to their business in order to help. And it’s funny a lot of business owners spend a lot of time planning for the sale of their business and they obsess about the price and the multiple that they might receive but in my experience they often don’t take that further important additional step of quantifying what their after tax return is going to be. Which sounds so obvious, you know, you should be interested not in the headline sale figure but in the number that you get in your pocket at the end of the process. And business sellers who haven’t thought about that or haven’t got some good advice are often surprised and disappointed at that time. John any comments on that?
John: Yeah thanks Martin. Yeah it certainly is a bit of a bug bear for a tax lawyer to have someone deep into a transaction where they might have well and truly progressed past the due diligence, maybe there’s a Heads of Agreement, there’s been financial modelling, and what not, before they seek tax advice and sometimes it’s actually too late. There might have been strategies that could have been put in place, changes that could have been made that unfortunately it’s too late to fix so getting the tax adviser in early as possible is part of good planning for a business exit.
Martin: Oh that’s great advice John and I must say as a corporate lawyer who’s kind of running hard on these transactions and doing the deals, I see that all the time. So the classic that I see is that the seller comes to us with a binding Term Sheet and they signed the Term Sheet to sell their business and that Term Sheet has been put together by the sophisticated or institutional buyer on the other side and so we pedal hard and we run hard to transact the Business Sale Agreement and do all of that stuff and then some bright spark towards the end of the process says do you realise, you know, you could have saved hundreds of thousands of dollars if you had of sold the share capital of the company not the business. How often do you see that John?
John: I see it really regularly. The problem with the sort of scenario you’ve just described is two-fold. There’s recent case law and it’s been an issue for a number of years, is that Term Sheets, even if they say they’re non-binding that can actually represent the relevant taxing point for tax. So sometimes you know, it might be, oh yeah we’ll fix things up before we sell, it can actually be too late, because that’s the relevant timing point and that can have consequences, for example in what financial year you are going to pay the tax. It can also have consequences with things like small business concessions where you need to assess your net assets at a certain point in time. The other problem with this scenario you just sort of described, of the transaction is up and running we’ve already got a Term Sheet is sometimes it can be, you need to change it, you need to change the structure, you need to shift from an asset sale to a share sale or you need to do some tricky manoeuvring like a re-structure or a corporate consolidation or something like that. It might achieve a fantastic tax outcome. If you do that kind of structuring immediately before a transaction and the only real reason for doing it is tax, the ATO can review your transaction and say well I think the anti-avoidance rules are going to apply here. And it looks really bad if there was a Term Sheet signed on strategy one results in really bad tax and insert the tax adviser, suddenly it’s done as strategy two with these great tax savings. It’s not the ideal picture. Ideally you want to be approaching it from your ideal structure from the beginning so that it is a consistent story, a point of review by the ATO later.
Martin: And that’s such a big point isn’t it. So for those listening out there I’m sure many, many of us have done it. We’ve knocked up a deal with our commercial counterpart the person who we know and trust who is going to buy the business or they might be a corporate buyer, whoever. But we have tried to save a penny frankly in terms of the professional advisory fees and taken it to that point ourselves without the tax advice, without the legal advice and a small amount spent at that time before you sign the Term Sheet, you know, that is probably the best kind of professional advisory spend you’ll ever make.
John: Yeah and it can start really early a lot of, as your book suggests Martin people should be planning an exit well in advance and some of the concessions for sales of businesses, particularly the small business concessions, some of them require years of planning in advance because, for example, if you have a family trust that owns the business who that family trust distributes to over a period 4 years, prior to the transaction, can influence the availability of concessions. So sometimes it’s not uncommon for people to plan years in advance to get their structure in order, get their business in order, get their legals in order for a really successful sale. At the same time have a look at the tax as well and see how it can be maximised.
Martin: We had one client who did that really, really well and we worked with him and his accountant for many years before the sale, many years before there was even a buyer on the horizon. But he knew that one day he’d like to exit as of course we all have to. And we ascertained very early in that process that he had to sell the share capital of his company that was going to get him the best outcome. If he were to sell the business and assets it would have been sub-optimal for tax. So armed with that really important piece of information, yeah, he was ready and we just continued to prepare, he continued to run the business and one day an opportunistic buyer knocked on the door and he was able to say straight off the bat yes I’m interested in receiving an offer for the purchase of the shares in my company. That was the first line that came out of his mouth and he set that up beautifully, that was what we put in the Term Sheet, that was what we negotiated and he got a fantastic tax outcome.
John: Yeah Martin contrast that to, you know, a generic “my business is available for sale” and it progresses as an asset sale and then the tax adviser says “geez you’ll save a lot of tax if it’s a share sale” and then going back to the purchaser and saying “oh by the way we want to do it as a share sale”. Well suddenly they’ve got a bit of leverage to chisel away at the price because of the perceived increase risk and what not. So, yeah, absolutely having your preferred strategy in advance will reap dividends.
Martin: That’s great John. Now you mentioned the small business tax concessions earlier and I’m not keen to go into a very depth analysis of the concessions because I know that they are highly complex but equally I know that these concessions can be very, very valuable for a business owner when it comes time to sell. Could you, I guess I set you up for this earlier on when I said you’re good at explaining complex things in a simple way (Martin and John laugh). Could you give us a two minute overview of the small business tax concessions and some of the benefits of those concessions?
John: Well the small business CGT concessions are one of the more generous concessions in the tax legislation. They’re available for business owners if the business turnover is either less than $2 million per year, or if the owners net assets are less than $6 million. You’ve got to sort of group in connected entities which is where it gets a little more technical but if you can satisfy one of those two you have potentially got these concessions. There’s then a variety of concessions. There’s five in total that can result in either completely no tax at all. So, for example, the 15 year exemption if you’ve owned a business for 15 years and you meet certain other criteria, its only for people over 55 and retiring. There’s another concession called 50% reduction now people might have heard of the 50% discount which is when you sell a capital asset and you reduce it by 50% if you’ve owned it for more than a year. Well this is on top of that. So effectively it reduces by 75%. Then there’s a concession called a retirement exemption which allows you to carve off another $500,000 from the capital gain and then there are various concessions called roll-overs which allow you to defer the remaining tax if you buy a new business for example. So quite often the outcome of these concessions is a dramatic reduction of tax compared to them not applying or no tax at all. So they are really quite beneficial.
Martin: Well that’s great John thank you and certainly as a non-tax lawyer I understood all of that. Just thinking about the benefit of those concessions it can also be really useful for business owners to model the type of money that they might take off the table through selling and using the concessions versus keeping the business and taking the money out over the long term via dividends and I think when sometimes sellers see and the penny drops that it might actually take, after you take into account the tax effect, 10 plus years or whatever the number is to kind of extract that money over the long term, it can make selling and using the concessions quite an attractive option.
Now there’s one final aspect of selling your business that I wanted to discuss with you today John and that’s the question of earn outs. In my experience it is very, very common these days if you’re a seller to agree to an earn out. So in other words you are going to receive a portion of the sale price upfront it might be 60, 70, 80% and a portion of the sale price deferred and to be paid over one, two, three, whatever years after you’ve sold the business and with that deferred amount to go up or down depending on the performance of the business after you’ve sold it. So, very common and a very good way if you are a buyer to mitigate the risk. Now, I know that the tax treatment of these earn outs is devilishly complex John and I know that this is one area that’s been dynamic and its changed over the years. Could you explain to us the tax treatment of earn outs?
John: Yeah, this is really going to test my ability to explain tax in a simple to understand way. (Martin and John laugh)
Martin: Come on John, you can do it, I’ve got every faith, you can do it. (Martin and John laugh)
John: It’s a real example over the last five or six years it’s a real example of how not to enact tax law (Martin and John laugh), that both sides of politics have been guilty of completely making a mess of this area. It probably starts I think it was in 2010 where they started agitating for change in this area. Prior to then the tax treatment of earn outs was really unacceptable it produced some really complex and unfortunate tax circumstances. The gist of the problem was that under an earn out by definition you don’t know exactly what you’re going to get with the subsequent earn out payment or whether you are going to get it at all. But the tax system tried to bring to account the value of that earn out and tax you wanted at the same time you are selling the business. So that produced heaps of really quirky outcomes, for example, how do you value what an earn out is worth? Well that was what as you said devilishly difficult. It also created these strange outcomes what if the outcome earn out was more or less than what you paid tax on initially and that would create strange scenarios where you might have a second capital gain and that second capital gain because the earn out has been really successful might have different tax treatment to the original capital gain, for example you might not get small business concessions, so it was a really bad system, complicated, and didn’t really work at all. The government, going back to the Rudd/ Gillard government in one of their budget announcements said we are going to fix this and any subsequent payments are just going to be treated as the consideration for the original sale of the business and tax consequences will follow. That seemed like a really good strategy that to me seemed like a really good improvement on this and they announced that it would be effective from budget night and people said you beauty. For whatever reasons some people in Treasury said we think this could result in some avoidance or loss of revenue, or something and then later changed to Liberal government they modified it again. So there were people who had sold their business in the meantime and it was like well what rules apply. So there is a real issue, so if you’ve sold a business in the last six years with an earn out different rules could apply for different times, so just be wary of that. After a couple of starts of, you know, revised proposals we now finally have some new rules governing earn outs that basically say if you’ve got an earn out you don’t pay tax on the earn out yet and if you get a payment in the future you amend your tax return to include it. It’s not quite as good as the original proposal because it means amending tax returns years later, it’s a little bit clumsy but it generally will produce sensible tax outcomes and not as weird, quirky tax outcomes as the old rules. My advice is if you are contemplating buying or selling a business with earn outs get tax advice, they can be tricky.
Martin: Thank you John. Because there are also rules around how you draft the earn out too right, because for example, if the earn out were for five, six or seven years that tax treatment might not apply. Is that correct?
John: Yeah that’s right the earn out, those rules that allow you to just amend your return later are subject to certain requirements. One is that the earn out is no more than five years, the other is that it has to be based purely on economic performance and that one can be a little bit confusing as well because what represents economic performance? Yeah well a multiple of either ebitda sure that is. But sometimes there are other sort of criteria on which an earn out could be paid, you know, a retention of staff or something like that, that makes that a little trickier. And if you are outside of these new earn out rules you go back to those old rules that really quirky weird one where you have to value the earn out. So those old rules still sit there behind the scenes but trying to get within the new rules is definitely valuable and you do have to be aware of things like the timing of the earn out.
Martin: Yeah and just a cautionary note for the legal profession and ultimately for our clients, this is where things go wrong, isn’t it. You’ve got a good corporate lawyer who is good at drafting the transaction documents and drafting the earn out in a tight way to protect their vendor client but if they’re not working hand in glove with a tax person who understands these things, well through the drafting of that clause they might stray outside these rules and inadvertently give their client a big tax problem.
John: Yeah you really have to work hand in glove with the tax lawyer and the accounting advisor because sometimes the terminology used on calculating the earn out is a little foreign to us lawyers and then the tax treatment is a little foreign to the accountant or the corporate adviser. We really have to work together to make sure it works for tax purposes and its achieving the outcome that the parties want and that it doesn’t, Martin I’m sure you’ve seen examples of earn outs that have resulted in either a bonanza or a disappointment because it has been drafted to loose or too tight when the contract was signed.
Martin: Look all the time. It is such a fertile ground for dispute this earn out area. So absolutely John and I think that is another really wonderful example of the benefit of collaborative advice and how if you are selling to business you really need the right advisory team, accountant, lawyer, lead advisor, around you and for those professionals to be working together and talking to each other.
Just one final comment on earn outs and I don’t want to get too technical but I think this is an important point. You mentioned that the earn out needs to be linked to the economic performance of the business in some way. But another way that it is not uncommonly structured is simply what I would call a terms contract. In other words you pay part of the sale price now upfront and then say, I’m just going to pick a number, say its $10 million, and then you pay $1 million each six months for the next two years, on the drip feed. Now that isn’t an earn out, that is simply a deferred payment of the purchase price for the business. Tell us about the tax treatment of that situation?
John: Yeah in that situation you have to pay tax on what you receive and what you will receive if there is no economic conditions attached upfront. By upfront it doesn’t mean literally, you know, the date of settlement, obviously you don’t lodge a tax return until the next financial year and you might have 12 or 18 months to actually pay the tax. But if that drip feed of payments could be, one, two, three or five years you have to factor in that you will be expected to pay tax on it when you lodge a tax return for that financial year. And that’s where getting back to the issue of timing and term sheets, some people think well we entered into the term sheet in June we will sign the contract 1 July and that means I will get a whole year and then I’ll lodge my tax return the following May so we’ve got 18 months, so 18 months of payments and no problem and then the ATO looks at it and says no no, you signed a term sheet in June you should have paid that tax in the prior tax return and you don’t even have the money yet. So again the issue of timing comes up. There’s really no exceptions other than earn out. It’s not based on what you receive upfront it’s what you receive upfront and will receive, as long as there is no economic conditions.
Martin: That’s great John, thank you. So if anyone hearing this would like to engage with you on these issues maybe somebody thinking of selling their business, how do they get in touch with you?
John: Give me a call the details will be on the website and I’m more than happy to take a call and have a chat about an issue and if I can help great, if not, I’m still happy to have a chat or send me an email if you’ve got a question and happy to help.
Martin: That’s brilliant, firstname.lastname@example.org and also John just very quickly if I can plug your blog, The Tax Storey, which certainly I’m a big fan of, tell us about that.
John: Yeah yeah, I try to do it as often as I can. It’s my attempt to get some relevant information out there on tax and do it in a way that I think is a sort of approachable and readable to the audience, I’ve also got some video blogs on there, one of them on earn outs if you want to have a look, they’re all on the Mills Oakley website and hopefully I’ll have another one out soon.
Martin: That’s brilliant. Well thank you very much John. Next time we will be talking about property tax issues for business owners. So I look forward to re-joining with you then.
John: Thanks Martin.