Structuring for acquisition or start up - Fox Thomas · 2. Partnership A partnership exists where...

Structuring for acquisition or start up

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2479064 Structuring for acquisition or start-up

Contents

1. Sole Trader ................................................................................................................. 1

2. Partnership ................................................................................................................. 2

3. Unincorporated Joint Ventures .................................................................................... 2

4. Unit Trust .................................................................................................................... 4

5. Hybrid Unit Trust ......................................................................................................... 4

6. Class Trusts ................................................................................................................ 5

7. Discretionary Trusts .................................................................................................... 5

8. Company .................................................................................................................... 5

2479064 Structuring for acquisition or start up 1

Structuring for acquisition or start up

Whether purchasing an existing business or doing a "start up", it is important to determine the most appropriate vehicle for doing so before entering into any binding contract.

The most likely structures are:

(1) sole trader;

(2) partnership;

(3) unincorporated joint venture;

(4) trusts (discretionary/unit/class/hybrid); or

(5) company.

The major considerations in making this decision usually include:

(1) tax consequences;

(2) simplicity and cost of creating the vehicle;

(3) potential risk of failure of the business;

(4) nature and size of the business;

(5) potential for growth and the need for additional capital;

(6) nature and extent of control and management required for the business;

(7) the cost and complexity of retaining the business and the vehicle; and

(8) the new tax consolidation regime.

A summary of the taxation advantages and disadvantages of each type of vehicle is set out in Annexure A.

1. Sole Trader

The acquisition of a business as a sole trader usually requires little or no formal documentation other than that required to register a business name and of course all necessary tax registrations; namely, TFN, ABN, GST and payroll (if appropriate). A separate bank account through which the transactions of the business will occur is also necessary of course.

The sole trader is personally liable for all of the debts of the business and the ability to raise capital is largely dependent upon the credit rating of the individual or other assets which may be available for use as security for loans.

As a sole trader, the business is usually easier and less expensive to run from an administration and accounting viewpoint.


2. Partnership

A partnership exists where there is a relationship between persons carrying on business in common with a view to a profit (see section 5 of the Partnership Act 1891 (Qld)).

Typically, the individuals operating a business as partners will enter into a partnership agreement which sets out their respective rights and obligations. If no agreement is signed, the relationship is governed by the Partnership Act.

Liabilities for debts and obligations of the business are borne by the partners jointly. The liability rests with the persons who are or appear to be members of the partnership at the time the liability was incurred.

Unless otherwise agreed by the partners, the death or bankruptcy of a partner will dissolve the partnership however, in the absence of any agreement to the contrary, the partnership is not automatically terminated upon a partner becoming insane.

A partnership is characterised by a relationship of mutual trust and confidence. A fiduciary relationship exists between the partners. Even after dissolution, there are positive duties upon the former partners not to benefit themselves from partnership opportunities.

The major deterrent to the establishment of a partnership is the unlimited liability of each partner for the partnership debts.

It should also be borne in mind that a "partnership" for taxation purposes is given a broader meaning than the general law definition. Section 995-1 ITAA97 defines a "partnership" as an association of persons carrying on business as partners or in receipt of ordinary or statutory income jointly, but does not include a company.

Whilst "partnership" is a legal term to define a contractual relationship rather than a separate legal entity, partnerships are required to prepare and lodge income tax returns. However, the partnership does not pay tax.

The net income of the partnership is included in each partner’s taxable income according to their respective interests. In a similar fashion, partnership losses flow through to partners.

3. Unincorporated Joint Ventures

In practice, it is common for unincorporated joint ventures to be drafted in a way which attempts to avoid treatment as a partnership at both general law and for taxation purposes. This is usually motivated by the desire to avoid joint liability for the debts of the enterprise and to obtain the taxation benefits that can flow from the separate tax treatment of each venturer.

From a taxation point of view, a "partnership" is distinguished from an "unincorporated joint venture" by the following main aspects:

(1) a partnership is required to lodge an income tax return but does not pay tax on the partnership’s net income;

(2) various tax elections and choices which can be made under the ITAA (e.g. tax depreciation method) are made by the partnership since this is the "notional taxpayer" for the purposes of the elections. Accordingly, partners are not able to make elections to suit their individual circumstances;


(3) where there is a partial change in the interests of partners, the continuing partners in the partnership may be deemed to have disposed of certain assets resulting in assessable recapture of, for example, depreciation and balancing charges under the capital allowance provisions. However, there are elections to prevent these provisions applying in specific circumstances;

(4) where there is a partial change in the interests of partners, section 70-100 ITAA97 deems all partners to have sold all the trading stock of the partnership at market value. This applies even though the interests of some partners may not have altered. If the continuing partners hold at least 25% interest following the change, the partners can elect that the deemed disposal does not apply.

The important thing to understand is that for an unincorporated joint venture a joint venturer is not treated as a separate entity from the joint venture. This means therefore that a joint venturer may directly depreciate its interest in the joint venture and take its income and capital gains and losses from the joint venture’s activities.

The typical joint venture is governed by a joint venture agreement which endeavours to set up contractual arrangements between the parties in lieu of fiduciary obligations. Matters covered in the joint venture agreement are:

▪ define the project;

▪ confirm the parties hold joint venture assets as tenants in common and that they will be dealt with only as provided in the agreement;

▪ provide for payment of project expenses proportionately by the joint venturers;

▪ appoint a manager/operator to run the project;

▪ provide a decision making process;

▪ set out the rights of joint venturers on default.

An essential feature of a joint venture agreement is that expenses are shared but revenues are not. In practice, when project expenses are incurred, the manager of the joint venture makes a cash call to the joint venturers requiring them to pay the cash call in their agreed proportions. There is however no sharing of revenue from the project; rather, each joint venturer takes the product of the joint venture in kind and is obligated to sell it to its own account.

To ascertain if a "true" unincorporated joint venture exists regard needs to be had to the following matters:

(a) the parties take their share of profit separately i.e. there is no joint receipt of profit;

(b) separate accounting;

(c) separate tax treatment;

(d) the fact that joint venturers cannot bind each other under the terms of the joint venture agreement;


(e) the fact that each of the venturers have severally and separately appointed the manager as its agent;

(f) the several liability of venturers to third parties;

(g) the separate taking of product of the joint venture.

Normally therefore a joint venture will be an arrangement where there exists expense sharing and product sharing. However, it is important that there be no joint profit motive and no joint profit.

4. Unit Trust

Under a unit trust structure, participants acquire units in the trust representing a proportional interest in the trust property.

A trustee can recover liabilities incurred in operating the trust from the trust assets. The trustee has a personal right of indemnity against the trust assets and may have a right against each unit holder personally in the proportion of their share in the unit trust for trust liabilities.

Where a trustee is personally liable to a third person, that third person has a right of subrogation against the trust property (and potentially the beneficiaries). However, a third party can only have the rights the trustee has. Therefore, if the trustee has a limited right of recourse against the trust fund and the beneficiaries, third parties cannot have any greater rights of recourse.

To protect investors, it is usual to limit their liability in the trust deed. One way of doing this is to draft the trust deed to limit the liability of the unit holders to the amount of their subscription. In McLean v Burns Philp Trustee Co Pty Ltd, it was held that a trustee which purported to deny the trustee’s right of indemnity against the beneficiaries was effective provided it was not contrary to public policy. It has been left open for a court to find that such a clause is not effective where the unit holders are actively involved in the trust’s management.

5. Hybrid Unit Trust

The hybrid unit trust is effectively a normal unit trust in which some of the beneficiaries hold units which have special income rights attaching to them. These rights entitle the trustee of the unit trust to distribute as much of the net income of the trust to the holders of the special units as the trustee determines in its absolute discretion.

This form of trust is not favoured if there is any prospect of losses for taxation purposes in any year because under the current "trust loss" provisions of the ITAA, they have to satisfy the non-fixed trust tests in addition to the income injection test.


6. Class Trusts

A class trust is similar to a discretionary trust except that the income and capital is required to be distributed to broad classes of beneficiaries (families) in pre-determined proportions. The distribution among individual families within each class would be on a discretionary basis. The class trust achieves some of the advantages of a partnership of discretionary trusts without joint liability of the partners.

The difficulty with such a structure is the ability (or more correctly, the inability) for the "interests" of each family to be dealt with and transferred. The divisibility and portability of the structure is often a limiting factor in the adoption of a class trust as the appropriate business structure.

If there is any prospect of losses for taxation purposes in any year, the class trust is not favoured as it will be almost impossible for it to make a family trust election for the purposes of the trust loss provisions of the ITAA.

7. Discretionary Trusts

Where more than one "family" is involved in the purchase of a business, a partnership of discretionary trusts tends to be preferred because they overcome the disadvantages of hybrid trusts and unit trusts while retaining the following advantages:

(1) the generation of pre tax income stream;

(2) the ability for the discretionary trust partners to access losses of the partnership;

(3) the ability of the discretionary trust to deal with income, including utilising corporate beneficiaries; and

(4) the availability of the CGT discount capital gain (Division 115).

8. Company

A business may, naturally enough, be purchased by a private company. This has the advantages of limited liability and the ability to issue shares to the persons who contribute capital to the business and who may be seeking proprietorship by way of a directorship in that company. The liability of each member is limited to the amount unpaid on his or her shares.

The advantages and disadvantages of a company are often summarised as follows:

(1) Advantages

(a) Limited liability – provided the company does not trade when it is insolvent, the liability for the debts of the company will be limited to its assets. If it trades when it is insolvent, its directors may be held liable to the creditors for any unpaid debts.


(b) Asset protection – by having the business assets owned by a company, the ownership of those assets will be separated from the ownership of the shareholders’ assets. Unless the shareholders are also directors, any investment or personal assets of the shareholders will not be exposed to any of the business risks to which the business assets held by the company are exposed.

(c) Capital raising – capital can be raised by the company without the disposal of an interest in assets. The allotment of shares in a company is not a CGT event (see section 109-10 (item 2) ITAA97). If a company raises capital through the allotment of shares to a new shareholder, a taxation liability will not arise in respect of the allotment. This compares favourably to the raising of capital by the introduction of a new partner to a partnership which will result in the disposal of an interest in the partnership assets.

(d) Corporate tax rate – this rate (currently at 30%) is considerably lower than the highest marginal personal rate.

(e) Small business CGT relief provisions under Division 152.

(f) Flexibility in structuring shareholders’ rights for payment of franked dividends subject to not offending the dividend streaming rules section 160APE (ITAA36).

(g) Superannuation contributions for employees/directors.

(h) Payment of ETPs and redundancy payments.

(2) Disadvantages

(a) Taxation concessions are trapped in the company structure and cannot be fully repatriated to investors.

(b) Division 7A of Part III of the ITAA36 may cause payments and benefits provided to shareholders and their associates to be deemed dividends which will be unfranked. Nevertheless, an equivalent reduction will be made to the franking account of the company as if the dividend had been franked.

The cost of operating will usually be greater than operating the business as a sole trader or as a partnership.


Annexure A

Sole Proprietors

Advantages

➢ All taxation concessions repatriated in full to the owner.

➢ Capital profits taxed once only.

➢ Losses accrued to the taxpayer.

➢ Only taxed on taxable income.

➢ Discount capital gain exemption on disposal of assets.

➢ Small business rollover and retirement exemption provisions more readily met on disposal of active business asset.

➢ Tax-free threshold.

Disadvantages

➢ Income splitting difficult (but payments to associated person for work done is permissible).

➢ No limited liability.

➢ Limitations on deductions for superannuation contributions.

➢ Marginal tax rate applies to the principal.

Partnerships

Advantages

➢ All taxation concessions repatriated in full to the partners.


➢ Income splitting.

➢ Losses accrue to partners directly.

➢ Flow through of foreign tax credits and franking rebates.

➢ Taxed only on taxable income.

➢ Reorganisation tax concessions.


➢ Possible discount capital gain exemption to partners on disposal of assets.

➢ Partner subject to individual, personal or corporate rate of tax depending upon the legal entity of the partner.


Disadvantages

➢ Joint liability.

➢ Income splitting is inflexible.

➢ CGT and stamp duty implications on changes in composition of the partnership.

➢ No CGT rollover relief when admitting a new partner or partners.

➢ Limitation on deductions for superannuation contributions.

➢ Debt forgiveness adjustments can be attributed back to partners.

➢ Death of a partner will result in the termination of the partnership.

➢ Non-resident partners will be taxed at non-resident tax rates.

Unincorporated Joint Ventures

Advantages

➢ No joint liability.

➢ All taxation concessions repatriated in full to venturers.

➢ No separate tax return required for the joint venture.


➢ Income splitting in accordance with the joint venture agreement.

➢ Losses accrue to venturers directly.

➢ Flow through of foreign tax credits and franking rebates.

➢ Taxed only on taxable income received by each venturer.

➢ Reorganisation tax concessions.

➢ Possible discount capital gain exemption to venturers on disposal of assets.

➢ Venturer subject to individual, personal or corporate rate of tax depending upon the legal entity of the venturer.



Disadvantages

➢ Expenses borne individually.

➢ Income splitting only as per joint venture agreement.

➢ CGT and stamp duty implications on changes in joint venture interest.

➢ No CGT rollover relief when admitting a new venturer.

➢ Limitation on deductions for superannuation contributions.

➢ Debt forgiveness adjustments can be attributed back to venturers.

➢ Non-resident venturers will be taxed at non-resident tax rates.

Discretionary Trusts

Advantages

➢ Limited liability.

➢ Flexible re: asset and income management.

➢ Streaming of income and capital to beneficiaries where trust deed allows.

➢ Very flexible for income splitting.

➢ Retention of permanent differences.

➢ Capital distributions tax free.

➢ Flow-through foreign tax credits.

➢ Beneficiaries taxed only on taxable income.

➢ Orderly succession.

➢ Income retains its character in the hands of beneficiaries.

➢ Discount capital gain exemption flows through to beneficiaries on disposal of assets.

➢ Potential land tax savings.

➢ Corporate rate of tax can be achieved.

➢ Small business rollover available.

➢ Dividend streaming still possible.

➢ Favoured as asset protection vehicle to beneficiaries if trust has a tax loss.


Disadvantages

➢ Division 7A.

➢ Uncertainty re: future tax regime.

➢ Trust loss measures.

➢ Losses locked into the entity.

➢ Uncertainty re: section 99A.

➢ Specific avoidance provisions.

➢ 48.5% tax rate on accumulations in the trust and penalty rates of tax on income distributed to minors in certain situations.

➢ Potential loss of franking credits attached to dividend income when distributed to beneficiaries (dividend streaming measures).

➢ Thin capitalisation rules may deny deductions for interest paid to foreign controllers.

➢ Non-arm’s length distributions ex discretionary trusts to super funds may be taxed at 48.5%.

➢ Limited life.

➢ Potential resettlements in certain situations can trigger CGT.

➢ Complexity.

➢ Raising capital.

➢ Small business rollover more difficult to achieve.

➢ Potential franking debate.

➢ Distribution of accounting profits in excess of taxable income may reduce available tax losses of beneficiaries.

➢ Foreign beneficiaries taxed at top marginal rates.

➢ No CGT rollover of assets into a trust.

➢ Family Trust Election limits the flexibility of any future distributions.


Unit Trusts

Advantages


➢ Streaming of income and capital.


➢ Flow through foreign tax credits.


➢ Can attract equity participants.


➢ Can add new beneficiaries by issuing units.

➢ Flexibility in redemption of units.

➢ Value shifting still possible (provided it does not amount to a resettlement.)

Disadvantages

➢ Division 7A.





➢ Specific avoidance provisions.

➢ 48.5% tax rate on accumulations.

➢ Limited life.

➢ Issuing new units could have CGT implications.

➢ Potential for double tax on vesting.

➢ Potential franking rebate for unit holders lost if trust has a tax loss.

➢ Distribution of accounting profits in excess of taxable income may reduce available tax losses of beneficiaries and section 104-70 might apply to the unit holder.

➢ Thin capitalisation (foreign equity).


➢ Small business rollover relief more difficult to achieve.


Hybrid Trusts

Advantages


➢ Flexible re: asset and income management.

➢ Streaming of income and capital.

➢ Very flexible for income splitting.

➢ Flow-through foreign tax credits.





➢ Value shifting still possible in relation to any units which may be on issue.

Disadvantages

➢ Division 7A.




➢ Specific anti-avoidance provisions.

➢ 48.5% tax rate on accumulations.


➢ Potential for double tax on vesting.

➢ Potential franking rebate for unit holders lost if trust has a tax loss.

➢ Distribution of accounting profits in excess of taxable income may reduce available tax losses of beneficiaries and section 104-70 might apply to the unit holder.

➢ Thin capitalisation (Foreign Equity).




Companies

Advantages


➢ Greater certainty.

➢ R&D deduction.

➢ 30% tax rate.

➢ Access to equity funding concessions.

➢ Controlled foreign income is tax exempt.

➢ Imputation benefits for shareholders.

➢ Income can be accumulated in the company, ie no penalty for not distributing income to shareholders.

➢ Perpetual existence.


➢ Grouping of losses (both revenue and CGT) excess foreign tax credits and transfers of assets within group (concessions).

➢ Concessions re: debt forgiveness within groups.

Disadvantages

➢ Section 108 and Division 7A.

➢ Cannot repatriate the full benefit of taxation concessions to shareholders.

➢ Dividend avoidance provisions.


➢ Company loss measures.

➢ Losses locked into the equity.

➢ Double taxing foreign income.

➢ Double taxing of capital gains.

➢ No tax free threshold.

➢ Thin capitalisation rules may deny interest deductions.


➢ Unable to stream income and capital.

➢ No discount capital gain exemption available.

➢ Income distributed to shareholders does not retain its character.

➢ Foreign tax credits do not flow through to individual shareholders.

➢ Foreign shareholders in receipt of fully franked dividends are not subject to withholding tax.

➢ Foreign shareholders in receipt of unfranked dividends are subject to withholding tax only, not non-resident tax rates.

➢ Excess imputation credits can be utilised.

➢ Subdivision 122A and 122B rollover of assets available.

➢ Division 7A concession re: company to company loans and payments.

➢ No CGT disposal by existing shareholders on an allotment of new shares.

➢ Any profits on the sale of pre-CGT assets can only be distributed as an unfranked dividend.

➢ Dividend rebate is lost if the company is in losses.


➢ No flexibility in distributing capital gains.

➢ Loss of franking credits as a result of certain deemed dividends.

➢ Value shifting not possible.

End of document

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