Valuations for tax controversies

206 Pages·2017·1.211 MB·English

by  Hung Tuan Chu, Wayne Lonergan

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National Library of Australia Cataloguing-in-Publication entry:
Chu, Hung Tuan, author.
Lonergan, Wayne, author.
Valuations for tax controversies / Dr Hung Chu, Wayne Lonergan.
ISBN: 9780995362697 (ebook: epub)
Includes bibliographical references and index.
Business enterprises--Valuation--Australia.
Business enterprises--Taxation--Australia.
First published January 2017
ISBN 978-0-9953626-9-7
© 2017 CCH Australia Limited
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About the Authors
Dr Hung Chu is a Director of Lonergan Edwards & Associates Limited. Dr Chu completed his master
degree in Finance and Banking (with Merit) from the University of Sydney and his doctoral degree in
Finance from the University of Technology, Sydney, where he graduated on the Chancellor’s List for
Exceptional Scholarly Achievement in PhD research.
Dr Chu is a CFA charter-holder, a Senior Fellow of the Financial Services Institute of Australia and a
member of the Extractive Industries Working Group of the International Valuation Standards Council
(IVSC).
Dr Chu has gained a wide range of practical experience in valuations and valuation-related advisory
services. In particular, he has been responsible for numerous assignments and complex litigation and tax
dispute matters for both public and private companies as well as various government departments in
Australia.
In addition to his practical experience, Dr Chu has also been a regular contributor to the professional
literature in the area of valuation and its practical implications for various tax and commercial matters. At
the time of writing, he is the author/co-author of 35 technical papers in various academic and
practitioners’ journals.
Dr Chu was also a guest lecturer in property finance and alternative asset classes at the University of
New South Wales.
Dr Chu is married and has two children. His outside interests include tennis, soccer and travel.
Wayne Lonergan’s professional qualifications include Bachelor of Economics, Doctor of Science in
Economics (hc), Fellow and Life Member of the Securities Institute of Australia, Fellow of the Australian
Property Institute, Fellow of the Company Directors Association of Australia and a member of the
Australian Institute of Arbitrators.
His career includes being a part-time tutor and Adjunct Professor at Sydney University, an investment
advisor, and being a partner at Coopers & Lybrand for 23 years.
In 2001 Wayne, together with Craig Edwards, set up the specialist valuation practice Lonergan Edwards
& Associates Limited.
Wayne’s professional work has concentrated on valuation and related assignments, including
consequential loss and quantum assessments, business and due diligence investigations and expert
evidence in numerous litigation matters.
He has conducted numerous valuations of listed and unlisted shares and businesses, including the
preparation of Independent Expert Reports on many hundreds of public company takeover offers.
Wayne was National President of the Securities Institute of Australia (SIA) (three years), a member of the
Companies and Securities Advisory Committee (CASAC) (nine years), the Australian Accounting
Standards Board (seven years), and the International Financial Reporting Interpretations Committee of
the International Accounting Standards Board (three years).
He has served on numerous subcommittees of the SIA and CASAC and was the Australian
representative on the International Accounting Standards Sub-committee on Accounting for Financial
Instruments and for Employee Share Options.
Wayne is the author of two other valuation text books, co-author of a loose leaf service on family law
valuations, and over 110 published technical papers on valuations and associated accounting matters
and is also a regular speaker at conferences.
Wayne is married and has five children. His outside interests include sailing and travel.
Author Acknowledgments
We would like to thank our fellow directors and staff of Lonergan Edwards & Associates Limited with
whom we have worked closely and who have examined and debated numerous valuation issues with us.
Special mention should be made of Martin Hall, our fellow director of Lonergan Edwards & Associates
Limited, who reviewed and recommended changes to the earlier draft of the book.
Many issues discussed in this book have also been influenced by the thought provoking discussions with
barristers, solicitors and senior executives of clients of our firm with whom we have had the great
pleasure and great privilege of working.
Special thanks should go to Selina Lord and Christine Pardy, who have typed and proof read the
numerous drafts of the book.
In addition, we would also like to thank Alicia Cohen, Jackie White, and other members of the editorial
and production teams at Wolters Kluwer for their contributions to the timeliness of the book’s production.
Introduction
¶1-010 Overview
At the centre of many tax controversies are valuation issues. These cases typically involve either new
valuation issues or require a re-evaluation of conventional (but not necessarily correct) approaches to
existing valuation issues. The valuation issues discussed in this book arise, in particular, in the context of
stamp duty and income tax cases, and in cases which involve what is colloquially referred to as “land rich”
assessments.
In terms of stamp duty “land rich” assessments, under the land rich landholder taxing regime, a land rich
test is performed to determine whether a relevant landholder is land rich. The land rich test involves
assessing whether the unencumbered value of the land holdings of the landholder is equal to, or exceeds
a specified proportion of the unencumbered value of its total assets, other than certain excluded assets.
Under the regime, stamp duty is levied where the unencumbered value of the relevant landholder’s
landholdings in the state exceeds a certain value.
Irrespective of whether the land rich landholder taxing regime or the landholder taxing regime is in place,
the assessment of whether a liability to stamp duty or tax arises is usually conducted following the
occurrence of a commercial transaction where the market value of the total assets of the relevant
landholder is either observable or ascertainable by calculation. Thus, from a valuation perspective what is
practically (albeit not necessarily legally) required for stamp duty purposes is the assessment of the
market value of total assets, land assets and non-land assets to assess whether the percentage threshold
(under the land rich landholder taxing regime) or the absolute value threshold is exceeded and, if so, the
dutiable value of land holdings (under the landholder taxing regime).
In terms of capital gains tax (CGT) implications, under the Income Tax Assessment Act 1997 (Cth) (ITAA
97), a principal asset test (PAT) is required to assess Australian CGT payable by foreign residents. A
foreign resident will be liable to Australian CGT arising from a capital gain on a sale of shares in a
company if, among other things, the sum of the market values of the company’s assets that are taxable
Australian real property (TARP) exceeds the sum of the market values of its assets that are non-TARP.
What is legally required for the PAT is the assessment of the market value of TARP and non-TARP
assets to establish whether the market value of TARP assets exceeds the market value of non-TARP
assets. Clearly, the market value of such assets (as part of a going concern business) is not always
readily observable because they may be rarely, if ever, traded on a standalone basis. Thus, for such
specialised assets, there is generally no readily identifiable comparable sale transaction to refer to as a
guide to value. In such cases, from a valuation perspective, although technically not required under the
tax legislation, the market value of total assets, which are often ascertainable, is an important reference
point for the underlying asset value assessment in that it can either be used as a direct input to the
assessment of the market value of TARP and non-TARP assets, or an important cross-check for
reasonableness of the assessed market value of TARP and non-TARP assets by imposing a natural limit
on the aggregated values of the underlying individual assets/asset classes and also in terms of value
relativities.
Thus, for both stamp duty and CGT/PAT “land rich” assessments, the required focus on underlying asset
(or asset class) value assessment from a legislative perspective inherently involves a total asset value
assessment either because it is required by the relevant legislation, or as a practical cross-check.
Although many of the valuation issues raised are in the context of what are generally referred to as “land
rich” assessments, what comes out from a discussion of these issues certainly has broader conceptual
and practical implications for other valuation driven tax controversies.
From a valuation perspective, what is unique about “land rich” cases is that they require a shift of focus
from total asset value assessment to underlying asset value assessment/total value apportionment.
Although controversial valuation issues arise in both total asset and total equity value assessment, the
shift in the focus of the valuation exercise from total equity/asset value assessment to underlying asset
value assessment/total value apportionment involves multiple additional layers of conceptual and practical
complexities and hence requires different and often more complex valuation thinking as compared to total
asset value and total equity value assessment.
In fact, shifting the focus to underlying asset value assessment/total value apportionment opens up new
conceptual and practical issues, which may be neither present nor apparent when the focus is on total
business value or total equity value assessment.
Given that the context in which total asset value apportionment is required typically involves capital
intensive businesses which employ specialised fixed and other assets, the issues associated with the
underlying asset value assessment/value apportionment exercise are addressed within that context.
However, the conceptual framework established in this book can be applied to, or provide guidance for,
value assessment and value apportionment in respect of different types of business or in respect of
different tax contexts. In addition, while a significant part of the book is dedicated to valuation issues
directly arising from “land rich” cases, it also addresses valuation issues pertinent to different tax contexts.
¶1-020 Outline of this book
The remainder of this book is organised as follows.
Chapter 2: Common errors in applying the market value concept
This Chapter addresses the most common conceptual errors in assessing market value, including failure
to recognise the asset focus of the Spencer market value concept, failure to recognise the negotiated
price focus of the Spencer market value concept, adoption of an incorrect unit of measurement and
adoption of an incorrect view of the impact of non-transferability on market value.
Chapter 3: Financing risks and the application of the Spencer market value concept
This Chapter revisits the concept of market value in cases where financing risk is inherently pronounced
and further elevated in times of financial market dislocations like the Global Financial Crisis (GFC) and
discusses the appropriate practical way to deal with these unique valuation challenges in assessing the
total business value.
Chapter 4: The value of total assets
This Chapter re-evaluates the relationship between the value of the total assets of a business entity and
its enterprise value (EV). In practice, there are several methods commonly used to assess the value of
total assets, based on various adjustments to EV. However, this Chapter suggests that these adjustments
are generally inappropriate, with the exception of the addition of the value of surplus assets to the
discounted cash flow (DCF) based EV. The total assets to which the market value standard is applied for
tax and stamp duty purposes should include the net working capital assets. The correctly derived EV
reflects the market value of total assets. This Chapter also further clarifies the distinction between EV and
equity value.
Chapter 5: Re-evaluating the control premium
This Chapter re-evaluates the concept of control premium which is important in assessing the market
value of both equity and total assets, particularly in cases where the entity which owns the assets is a
listed entity. A correct understanding and assessment of control premium has direct implications for the
outcome of a PAT required to determine whether or not a foreign resident is liable to Australian CGT
arising from a capital gain on a sale of shares in a company and the assessment of EV and goodwill value
for tax purposes under the top-down residual method (TDRM). Unfortunately, such understanding has
proved elusive in practice.
This Chapter also discusses the important distinction between ex-ante control premium and ex-post
observed takeover premium, and the incorrect practice of mechanistically assessing the ex-ante control
premium for an entity which has not been subjected to a takeover bid as at the valuation date based on
average observed ex-post takeover premium. In fact, achieving the correct understanding and
assessment of control premium for a given entity requires significantly more complex and lateral valuation
thinking.
Chapter 6: Re-evaluating the small company risk premium
This Chapter re-evaluates the concept of small company risk premium and highlights the dangers of
routinely allowing for a small company risk premium in assessing the market value of an entity and its
total assets without properly understanding what is being valued and the nature of the empirical evidence
on small company risk premium.
Chapter 7: Re-thinking goodwill
This Chapter presents a re-think of the concept of goodwill from a valuation perspective and its interaction
with other assets of the business, particularly specialised fixed assets. This Chapter examines alternative
approaches to goodwill, namely the economic approach, the accounting approach and the legal
approach. The limitations of each approach and the differences between them are major contributors to
the protracted confusion about the nature and value of goodwill.
Having identified and evaluated the inherent limitations and the potential pitfalls associated with the
application of each approach and highlighted the differences between the alternative approaches to
goodwill, this Chapter proposes a conceptually convergent approach to goodwill under which these
differences can be analysed. The application of a conceptually convergent approach indicates that most
of the apparent conflicts between the alternative approaches to goodwill turn out to be less divergent than
they appear if the evolutionary nature of the value of identifiable assets over time is fully recognised and
goodwill is perceived as the attractive force which actively brings in custom (net of custom brought in by
identifiable assets) and generates net profit (or net cash flow) for a subject enterprise. This new way of
thinking about goodwill has important implications for the land rich assessment for stamp duty, CGT and
other tax and stamp duty purposes.
Chapter 8: Re-evaluating Murry from a valuation perspective
This Chapter re-evaluates the Murry case (FC of T v Murry 98 ATC 4585) from a valuation perspective.
Despite its importance in shaping judicial views on goodwill, the focal point of Murry is interestingly not
about goodwill value. Thus, there are unsurprisingly residual uncertainties and/or confusion in applying
the valuation principles set out in Murry to cases where the focus is on the value of goodwill. This Chapter
applies the conceptual framework on goodwill value developed in Chapter 7 to address these
uncertainties and/or confusion.
Chapter 9: Valuing contract intangibles
This Chapter discusses the valuation of contract intangibles, which is a key category of identifiable
intangible assets in “land rich” cases. This Chapter highlights the fact that the value of contract intangibles
can arise from creating either cash flow benefits or risk-mitigating (discount rate) benefits or both. While
the value of contract intangibles creating the former is often straightforward and well understood by
market participants, those creating risk-mitigating benefits are not so well understood. This Chapter
explains the nature of risk-mitigating contract intangibles and discusses a method to assess their market
value as part of a bundle of assets offered for sale.
Chapter 10: The value of mining information
This Chapter discusses the technical complexity of assessing the market value of mining information and
provides a conceptual framework to deal with these challenges. These challenges have not been the
subject of discussion in the valuation literature to date.
Chapter 11: Valuing cash holdings
This Chapter discusses the valuation treatment of corporate cash holdings (apparently the simplest
asset), particularly in cases where these cash holdings form a material or significant part of the total
assets of a going concern entity and demonstrate that the shift in focus from total business value
assessment to underlying asset value assessment (eg land and non-land assets) creates a situation
where a valuation treatment which is customarily performed and practically acceptable when the focus is
on total business value or total equity value assessment may not be appropriate when the focus is on
underlying asset value assessment/total value apportionment.
Chapter 12: The deductive valuation method
This Chapter discusses the deductive valuation methodology where the market value of specialised fixed
assets is assessed by deducting the assessed market values of other assets from the assessed market
value of total assets. The applicability of the deductive method is based on a new conceptual approach to
goodwill value assessment discussed in Chapters 7 and 8, and methods of assessing the market values
of certain key identifiable intangible assets and monetary assets discussed in Chapters 9, 10 and 11. This
Chapter also addresses the conceptual differences in the valuation methods adopted by business valuers
and other valuers for tax and stamp duty purposes.
Chapter 13: Re-evaluating deprival value
This Chapter re-evaluates the use of the deprival value method (particularly its deficiencies and pitfalls) in
assessing the market value of specialised fixed assets for tax and stamp duty purposes. This Chapter
also compares and contrasts the deprival value method with the deductive method discussed in Chapter
12.
Chapter 14: Problems with the restoration method
This Chapter explains why the restoration method is a flawed valuation method in assessing the market
value of intangible assets (ie non-land assets) in a total asset value apportionment context. This Chapter
demonstrates that the application of the restoration method results in the assessed market value of the
non-land assets being overstated and the assessed market value of the land assets being understated.
Chapter 15: Re-evaluating the marriage value concept
This Chapter discusses the controversy surrounding the complexity of the marriage value concept in the
context of land rich assessment and develops a conceptual framework that provides guidance when
dealing with issues associated with marriage value in a given case.
Chapter 16: Value allocation between upstream and downstream segments
This Chapter discusses the practical application of the netback method in assessing market value at a
notional taxing point between the upstream and downstream segments of an integrated mining or gas-to-
liquid (GTL) project.
Chapter 17: Re-evaluating the application of the comparable uncontrolled price method
This Chapter re-evaluates the practical application of the comparable uncontrolled price (CUP) method in
assessing the notional market value for a controlled commodity transaction. This Chapter highlights the
fact that the availability of observable uncontrolled prices should not be taken for granted as readily
representing CUPs.
Chapter 18: Re-evaluating the valuation treatment of accommodation bonds in the residential
aged care sector
This Chapter discusses the valuation treatment of accommodation bonds which has important
implications for the taxation treatment of residential aged care facilities (RACFs). There has been much
confusion among market participants about this valuation treatment. This Chapter examines the sources
of this confusion and provides a systematic conceptual framework to resolve the valuation uncertainty.
The conceptual framework developed in this Chapter also provides insights into the valuation treatment of
resident loans in retirement villages.
Chapter 19: Traps in valuations for land rich assessment
This Chapter identifies various fundamental traps in valuations for “land rich” assessment and suggests
ways to deal with them.
Chapter 20: Re-evaluating the concept of trading stock: the case of vendor finance loans
This Chapter provides a conceptual re-evaluation of whether or not a portfolio of vendor finance loans is
trading stock. This Chapter exemplifies the conceptual and practical challenges associated with the
application of the trading stock definition to financial assets.
Chapter 21: Valuing partly completed development projects
This Chapter re-evaluates a “sum of the parts” approach to the valuation of partly completed development
projects under the goods and services tax (GST) margin scheme, identifies deficiencies in this valuation
approach and develops an alternative conceptually sound approach to overcome these deficiencies. The
valuation issues discussed in this Chapter are also relevant to the valuation of partly completed
development projects for trading stock valuation and income tax purposes.
Chapter 22: Assessing a fair and reasonable royalty rate
This Chapter discusses two main interrelated “first principle” approaches, being the royalty cover and net
present value (NPV) approaches used to assess a fair and reasonable royalty rate which is an important
input in determining the market value of identifiable intangible assets for tax purposes. The “first principle”
approaches presented in this Chapter can also be used to assess a fair and reasonable royalty rate in
various commercial and litigation contexts, such as assessing a fair and reasonable royalty rate between
the owner of an undeveloped mineral resource and the developer of that resource into a productive
mining asset, or assessing compensation in patent infringement disputes.
Chapter 23: Re-evaluating the discounts/premia to base valuation
This Chapter provides a conceptual re-evaluation of the discounts/premia which are commonly applied
and commonly subject to dispute. Such conceptual re-evaluation focuses on the nature of the relevant
discounts/premia and identifies the conceptual delineation or overlap between these discounts/premia.
¶1-030 On the cutting edge
Many of the issues raised in this book are at the cutting edge of valuation thinking. They reflect the
evolving nature of the valuation body of knowledge and the need for valuers to continuously re-evaluate
the existing body of knowledge, particularly in the face of diverse practical circumstances, and apply the
broadened or updated knowledge to re-assess and improve existing valuation practices. It is natural to
expect that full market acceptance and court acceptance of some of the issues raised will, in some cases,
take some time to emerge.
Common errors in applying the market value
concept
¶2-010 The Spencer market value
The definition of market value in the well-known and widely-accepted sense recognised in Spencer v
Commonwealth (1907) 5 CLR 418 (Spencer market value) is the price that would be negotiated in an
open and unrestricted market between a knowledgeable, willing but not anxious buyer (WBNAB) and a
knowledgeable, willing but not anxious seller (WBNAS) acting at arm’s length within a reasonable
timeframe.
Despite the fact that the adoption of the Spencer market value definition/concept is generally not in
dispute, the application of that concept to assess market value remains susceptible to errors and dispute.
There are broadly two types of errors associated with the application of the Spencer market value
concept: conceptual errors and measurement errors.
These two types of errors are interrelated in that if a valuer makes conceptual errors in applying the
market value concept, the resultant measurement of market value is inherently technically incorrect and
unreliable (eg assessing the market value of the wrong asset). Conversely, a measurement error (eg
adopting an incorrect valuation methodology) is not only wrong as a matter of measurement, it is also
conceptually wrong because it is not the “price that would be negotiated” between a knowledgeable,
hypothetical WBNAB and a knowledgeable, hypothetical WBNAS despite the fact that assessment of
market value is the stated objective of the valuation. Measurement errors are case-specific, depending on
the choice of the valuation methodology and associated inputs given the factual circumstances of the
case.
Although this is not an exhaustive list, the most common conceptual errors in assessing market value are:
• failure to recognise the asset focus of the Spencer market value concept
• failure to recognise the negotiated price focus of the Spencer market value concept
• adopting an incorrect financial unit of measurement, and
• adopting an incorrect view of the impact of non-transferability on market value.
The difficulty associated with uncovering these errors in practice is that they are usually committed in a
subtle way, which is further complicated by the factual complexity of what asset is being valued. In fact, it
is the combination of the complexity of the asset being valued, the complexity of the factual
circumstances and the subtlety of the valuation errors that underpins many valuation driven tax
controversies.
¶2-020 Failure to recognise the asset focus of the Spencer market value concept
From a valuation perspective, the concept of market value rests on the premise that market value be
established based on negotiations between a hypothetical WBNAB and a hypothetical WBNAS, rather
than based on a transaction between a hypothetical WBNAB and an actual or specific seller, or between
an actual buyer and actual seller, or between a hypothetical seller and an actual buyer.
The application of the market value concept is driven by the nature and inherent attributes of the asset
being (market) valued and the negotiated hypothetical price between a hypothetical knowledgeable
WBNAB and a hypothetical knowledgeable WBNAS given the characteristics of the asset, rather than
being influenced or determined by the identity of either the actual seller and/or the actual buyer.
The asset focus is naturally devoid of the incorrect tendency to incorporate the specific characteristics of
the actual buyer and/or seller into the market value assessment. In addition, the asset focus and the