“Higgling, haggling and hassling” at the Grand Bazaar – What is expected of taxpayers to justify market value?

Market value is relevant for a number of tax provisions including the market value substitution rule in the CGT provisions, the maximum net asset value test (MNAV test), and for state taxes such as land tax and transfer duty.  Crucial to the application of the market value substitution rule is whether or not parties have acted at arm’s length.

Two recent decisions, from the AAT and the Federal Court, have highlighted the difficulties that can arise in determining whether parties have acted at arm’s length and the market value of transactions.

Before looking at the two cases, it is useful to look at section 116-30(2) of the Income Tax Assessment Act 1997 (ITAA 1997). It states:

The capital proceeds from a CGT event are replaced with the market value of the CGT asset that is the subject of the event if:

 (a)  some or all of those proceeds cannot be valued; or

 (b)  those capital proceeds are more or less than the market value of the asset and:

 (i)    you and the entity that acquired the asset from you did not deal with each other at arm’s length in connection with the event; or

 (ii)   the CGT event is CGT event C2 (about cancellation, surrender and similar endings). (emphasis added)

Moloney and Commissioner of Taxation (Taxation) [2024] AATA 1483

The AAT decision in Moloney and Commissioner of Taxation (Taxation) [2024] AATA 1483 (Moloney) was handed down on 7 June 2024.

The Moloney case deals with the sale of a bulk haulage freight business operated by a family trust to a related entity for $3.5 million. The capital gain was reduced to nil through the application of the 50% CGT discount and the small business CGT concessions (SBCGT concessions), specifically the small business 50% reduction under Subdivision 152-C, and the two year deferral under Subdivision 152-E.

Following an audit, the ATO denied the application of the SBCGT concessions, on the basis that parties did not act at arm’s length and deemed the market value of the shares to be $10,640,000, meaning the MNAV threshold was exceeded. This figure was based on the midpoint of a valuation obtained by the ATO (the KordaMentha valuation).

There were two main issues in this case:

1. Does the market value substitution rule in section 116-30 apply? and
2. Was the MNAV test satisfied just before the CGT event, therefore meaning the SBCGT concessions apply?

Market value substitution rule and the arm’s length test

As stated above, the Commissioner is able to substitute the capital proceeds where the capital proceeds are more or less than the market value of the asset and the seller and purchaser did not deal at arm’s length in connection with the transaction.

While defined in section 995-1, the definition of “arm’s length” is entirely unhelpful. It states:

“arm’s length” in determining whether the parties deal at arm’s length, consider any connection between them and any other relevant circumstance.

The taxpayers argued that the fact there is a connection between parties to a transaction is not determinative that the transaction between them was not at arm’s length. That is, while the parties are not at arm’s length, this does not mean that they have not dealt with each other at arm’s length, “… provided the outcome of their dealing is a matter of real bargaining”. The taxpayers argued:

… the parties acted in their respective self-interest, there was no collusion, and the sale price of $3.5 million was the product of real independent bargaining based on an independent valuation.

While accepting that related parties may deal with each other at arm’s length, Deputy President Molloy did not accept that the taxpayers had done so in this case. Even though the valuation obtained was independent, there was no real bargaining between the parties. They had left everything to the accountants and accepted the sale price to be $3.5 million.

According to paragraph 48 of the decision:

There was none of the normal indicia of bargaining which might be expected of parties dealing with each other at arm’s length. The valuation was not challenged or queried on behalf of either the seller or the purchaser. That is unsurprising because each party to the agreement was substantially controlled and directed by the same persons. As the Respondent submits, there was simply no bargaining.

As a result, it was held that the parties did not act at arm’s length. It was then necessary to determine the market value of the shares at the time of the CGT event for calculation of the capital gain, and “just before” the time of the CGT event, for MNAV purposes. A new valuation obtained by the taxpayers (the PKF valuation) was used in the proceedings, the midpoint of which was $3 million, only $500,000 less than the original valuation.

The midpoint of the ATO’s valuation was $7 million. If the taxpayer’s valuation was accepted by the AAT, the SBCGT concessions would apply, however if the ATO’s valuation was accepted the SBCGT concessions would be unavailable.

The Valuations

Both valuations used the same methodology, where maintainable EBITDA was multiplied by a capitalisation multiple to come to the valuation, with a further adjustment for liabilities.

Interestingly, several iterations of valuations were prepared by both sides over the course of the audit and the AAT proceedings. This, as well as the divergence between the taxpayers’ valuation and the ATO valuation illustrates that coming to an exact number is difficult.

The remainder of the decision considers the valuations, the underlying assumptions, and application of valuation principles. Ultimately, Deputy President Molloy held that the maintainable EBITDA was within the PKF valuation’s range, with the appropriate capitalisation multiple at the high end of PKF’s range, resulting in a valuation of $3,352,500. As a result, the SBCGT concessions apply.

Kilgour v Commissioner of Taxation [2024] FCA 687

The Federal Court decision in Kilgour v Commissioner of Taxation [2024] FCA 687 (Kilgour) was handed down by Justice Logan on 26 June 2024.

This case dealt with a sale of shares in Punters Paradise Pty Ltd (Punters), an online social platform in the horse racing industry, to News Corp. The sale price was just over $31 million.

Interestingly, the taxpayers argued that they had not acted at arm’s length in relation to the sale. This was based on their previous involvement with News Corp sharing editorial content. In addition to a reduction in the capital gain, if it was found the parties had not acted at arm’s length and the market value was sufficiently low enough, two of the taxpayers would also be entitled to the SBCGT concessions.

Justice Logan quickly concluded that the parties dealt with each other at arm’s length, particularly due to the internal decision processes of both News Corp in Australia and in New York. That is, there was no collusion or a “mere rubber-stamping” by a “not disinterested, local operational level subordinate within News Corp Australia”. Therefore, the market value substitution rule did not apply.

At paragraph 116 of the decision:

… what the whole of the evidence reveals is two unrelated parties forming their own views based on their own assessment as to what the shares were worth. They dealt with each other accordingly. News Corp’s decision was ultimately made at the very highest level, remote from Australia, based on what it considered was in News Corp’s strategic commercial interests, particularly in light of perceived synergistic benefits of News Corp’s ownership and conduct of the Punters business.

Justice Logan’s view on bargaining may be different to that of Deputy President Molloy in the Moloney decision. According to paragraph 95:

… the subject is not to be approached as if an arm’s length dealing can only occur if it is attended with an atmosphere of higgling, haggling and hassling which one might perhaps find in the purchase of a carpet in the Grand Bazaar. I respectfully doubt that the description “real bargaining” was ever intended to convey that understanding. One might equally say genuine offer and acceptance. The chronology offered above shows there was bargaining and that bargaining was certainly not a mere façade or sham. It was “real”.  But it is perfectly possible for a dealing at arm’s length in connection with the disposal of an asset to occur in circumstances where the only outwardly evident bargaining is an offer made to buy or sell at a particular price which is accepted without demur. That bargaining can also be “real”. The definition of arm’s length envisages a multi-factorial, inherently dealing specific, factual analysis in which but one factor, which may or may not be determinative, is a connection between the parties.

Special Value

While it was not necessary to consider the implications of a synergistic or “special value”, Justice Logan did consider them. He referred to the decision in Spencer v The Commonwealth (1907) 5 CLR 418 which looks at the price that could be expected where a “willing but not anxious vendor deals at arm’s length with a willing but not anxious purchaser”.

The taxpayer argued the market value of the shares was lower than the amount paid by News Corp due to the “synergistic value” of the shares to News Corp and due to this “special value” to News Corp, the market value of the shares if there was a willing but not anxious purchaser would be lower.

Justice Logan did not accept this argument. According to paragraphs 131 and 149:

… But there is nothing in the text of the provisions concerned which dictates either expressly or by necessary implication that one must exclude from this hypothetical market a particular willing purchaser present in that market who sees value particular to that purchaser in acquiring the asset concerned. Nor is there support for the exclusion of such a purchaser to be found in Spencer. A purchaser “cognizant of all circumstances which may affect its value, either advantageously or prejudicially” might well be cognisant of an advantage peculiar to that purchaser and be willing to pay for that advantage.

… However, it is contrary to over-whelming authority to exclude from the hypothetical market attributes of an asset that are of value to a specific purchaser. In truth, what Mr Churchill identified as special value was but part of the market value of a purchase of all the shares in Punters by News Corp Investments. It represented a synergistic benefit, which has a similar rationale to what sometimes called a “marriage value” upon the merger of leasehold and freehold interests …

It was also stated at paragraph 95:

… What in hindsight, and sometimes even in prospect, are advantageous or disadvantageous disposals of assets can occur between parties who have dealt with each other at arm’s length. This is just a feature of business and private life in relation to the disposal of assets. A “price taker” is not necessarily a purchaser who has dealt with the vendor other than at arm’s length in connection with the disposal of an asset. He may just want the asset for some reason, have the requisite means and be content to pay the price requested.

As such, where parties have acted at arm’s length the fact that one party obtains a synergistic benefit under the transaction and is willing to pay for that benefit, does not mean the consideration paid is not reflective of the market value.

Key observations

The principles arising from these cases appear to be:

• A sale to a related party, or an internal restructure, where there is no bargaining will be taken to not be at arm’s length even if an independent valuation is obtained. On that basis, the value of the capital proceeds is always subject to the risk that the ATO may take a different view as to the market value.
• Some prior relationship between the vendor and purchaser does not mean they are not acting at arm’s length, unless there is evidence to show there was collusion or no bargaining.
• Special value to a vendor or purchaser can be relevant in determining market value.
• Getting the ATO to agree with you regarding a valuation is extremely difficult. There are many aspects to be considered in coming to a valuation, for example, the likelihood of future revenue, the dependency on particular customers, the level of competition and barriers to entry, whether staff would stay post sale, use of specialised equipment, ability to grow the business, market conditions, etc. The number of factors and the need to predict the future means the ATO can quite easily come up with a wildly different valuation. It is then a matter of how far the taxpayer is willing to go to fight the ATO’s valuation.

How does a taxpayer support the market value when undertaking a sale to a related party or undergoing an internal restructure? In Moloney’s case, two independent valuations were not enough for the ATO. Going forward, is it best practice to obtain multiple valuations? Unfortunately valuations aren’t cheap. Maybe the best approach is for the taxpayer to use their business knowledge to critically assess the valuation report, playing devil’s advocate and quizzing the valuer to ensure the inevitable queries from the ATO can be answered and supported with evidence and relevant business knowledge.

NB: The taxpayers in Kilgour v Commissioner of Taxation [2024] FCA 687 have appealed to the Federal Court. At the time of writing the appeal has not been heard

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