Purchase Price Allocation Rules
Mark Withers runs through this new legislation which affects commercial and residential property transactions over $1 million and $7.5 million respectively.
1 September 2021
The Government has recently passed new tax legislation known as the purchase price allocation rules. These rules are set to impact commercial property transactions in excess of $1 million and residential transactions in excess of $7.5 million.
The new rules are designed to ensure that the allocations given to component parts of a transaction are the same for both buyer and seller to ensure there is symmetry in the tax treatments of both parties. To date, there has been no requirement for alignment in positions between buyer and seller and the Government believes this has created a tax slippage that it seeks to close with the new rules.
An Example ...
John, has owned a commercial building for some time. He has split his purchase between land, building and fitout items. He has some accumulated depreciation on the building and a lot on the fitout.
He agrees to sell the building property to Fred and the contract simply states an overall price.
When John does his tax return he takes a position that the market value of the fitout items is the same as his book value so pays no depreciation recovery tax on this. Fred though goes to a fitout valuer and gets a breakdown of fitout that is far greater than what John allocated in his tax return. Fred uses the valuation as a basis to depreciate the fitout items despite there being no alignment with what John has done in his return.
The purchase price allocation rules set out to encourage parties to reach agreement on the allocation of value.
The allocations must be made between land, building and other depreciable property like chattels and fitout. The rules require only that allocation is made to each asset category, not individual items within that category. Whilst best practice will be to agree allocations in the sale and purchase agreement, parties have until the date to file their respective returns to reach agreement together. Once this occurs, section GC20 binds them to apply this when filing returns.
Failure To Agree
If the parties fail to reach agreement, section GC21 gives “unilateral allocation rights” to the vendor. He has three months in which to advise the purchaser and the IRD of the allocation of price across the asset classes. If he fails to make an allocation the unilateral allocation rights then fall to the purchaser for a further three months.
If neither party makes an allocation the IRD then determines the allocation and the purchaser is denied any deductions until this has occurred. This is designed to incentivise the parties to resolve the allocation between themselves.
Currently, REINZ are working on updating the standard form sale and purchase agreement to incorporate purchase price allocation. In the meantime though, they have adopted an addendum to the agreement. This addendum is interesting as it actually seeks to contractually remove the vendors’ unilateral allocation rights provided in GC21.
Vendors therefore need to seek legal advice before signing away these rights in a contract that contains the REINZ addendum.
It’s also important to understand that whilst the rules only compulsorily apply to residential sales over $7.5 million where parties do agree an allocation with contracts under this threshold section GC20 does bind them to apply this when filing their tax return.
This legislation is to encourage parties to allocate based on the market value of each class of asset but the reality is vendors will want low allocations to depreciated property to avoid recoveries and purchasers will want high allocations to maximise their depreciation deductions.
This natural pull where both parties want the opposite outcomes should ultimately mean market value is achieved but arguably, the vendors have the upper hand as they write sale terms and conditions and have unilateral allocation right if agreement isn't reached.
Another twist with the rules is that a vendor can only allocate values that are below the tax book value by agreement rather than by unilateral allocation. If agreement has not been reached and the vendor makes a unilateral allocation under GC21 the tax book value of an asset class is the minimum that can be allocated to it. This means no deductions for loss on disposal of fitout items unless agreement is reached on allocation.
The rules will complicate the marketing process given the need to negotiate more than just the overall price for the property. Care must also be taken to determine who owns the commercial fitout as much of it may be the property of the tenant not the vendor. Take advice from your accountant prior to marketing the property or committing to a purchase; the new rules are complex.
Mark and his team specialise in advising on property-related transactions, valuation and restructure services, and tax planning. Withers Tsang & Co Phone 09 376 8860, www.wt.co.nz