When you buy a business venture or invest in one you are putting your money into something someone else has set up, organised and run. You can never eliminate all the risks but you can remove some of them by making sure that you don’t go into an investment with blinkers on. This seems obvious, but frequently I find myself trying to help people who bought a business with minimal, if any, investigation. This is generally due to one of the myths of business transactions. Myths like, it’s ok because:
Myth # 1: the vendor is a ‘good bloke’;
Myth # 2: legal investigations cost too much; or
Myth # 3: there are warranties.
This article looks at just some of the tax traps you may be caught in if you rely on myths. There are many other traps to avoid (both tax and commercial) which we will write about in later articles.
Myth # 1: The good bloke
Michael started working in Greg’s chicken bar, Cluck P/L, part-time when he was in Year 10. He liked the work and when he finished school Greg offered him a full-time position as manager. Most of the time Greg was off looking after his other businesses so he gave Michael a free hand with Cluck P/L and it did well. Michael managed the four part-time employees and even managed to grow the business. After 10 years Michael believed he knew everything about Cluck P/L and he also knew Greg pretty well. Greg was a good bloke, so when Greg offered him the opportunity to buy the business Michael jumped at it.
Michael used all of his savings and borrowed the rest from NACBZ Bank. He didn’t need to ask to see the financials because he had worked with the bookkeeper to prepare the quarterly BAS and helped compile the company financial reports and tax returns so he had all the details. Michael instructed his lawyer not to investigate the company he was buying but just to put through the sale.
The sale went through and things went well for a while. Then Michael got a letter from RevenueSA.
The letter stated that from 2003 when it was incorporated until 2014 when Michael bought it, Cluck P/L had been one of several businesses wholly owned by Greg and so grouped for payroll tax. None had registered to pay payroll tax so no payroll tax had ever been paid.
Michael explained the chicken bar’s payroll was less than $600,000 and he hadn’t owned it back when it was grouped. RevenueSA were not interested in Michael’s explanations.
Payrolls for employees in all of Greg’s companies since 2003 had averaged $2,000,000 per year so a lot of payroll tax was due. Any tax (including interest and/or penalty tax) payable under the Payroll Tax Act 2009 (SA) and/or the Tax Administration Act 1996 (SA) by a member, or members of a group, is a debt due jointly and severally by every person who was a member of the group during the period the tax became due. A company is a legal person so the company Michael had bought was liable for the payroll tax. Unfortunately, as Greg and many of Greg’s businesses seemed to have disappeared, Michael’s chicken bar was one of the most solvent left.
Michael now has no savings and no business, but some valuable experience. Also, he no longer thinks Greg is a good bloke.
Myth # 2: Legal investigations cost too much
Nathan worked in management for years. He had experience in several engineering and manufacturing businesses and a good understanding of local industry and how local markets worked. In his 40’s Nathan started to think about buying a business himself and putting some of his own theories to the test. Nathan looked about for a suitable investment and found AFM P/L. He looked into the business carefully and spoke to several of the customers whom he knew from his own previous roles at different firms. Nathan went over the financials with his accountant and looked at the tax returns.
Everything looked good and Nathan made an offer for the business. As stamp duty was so much lower he decided to buy the shares in the company rather than buy the business from the company. Also, his accountant advised him that running a business through a corporate structure would give him better asset protection and he knew himself that buyers and suppliers were more comfortable dealing with a company.
Nathan’s lawyer explained that the company would remain liable for all its debts and for any warranties given and any torts that might have been committed even if all the shares changed hands. He advised Nathan to undertake a full due diligence investigation before any contracts were signed. Nathan didn’t see the point. It was an expensive process and with all his years of business experience he knew what he was doing. Nathan decided to go ahead and save the extra expense.
The sale went through and things went well for a while. Then Nathan got a letter from the Australian Taxation Office (ATO).
The ATO said they had concerns about fringe benefits and would like to come out and take a look at some company records. Nathan knew quite well that it wasn’t the sort of request you could say no to although he thought it a bit peculiar as the business didn’t give any staff benefits and had never lodged an FBT return. They agreed on a date, a couple of ATO officers turned up and asked for some files and a couple of days later they met with Nathan.
First of all they asked about the IT ledger accounts; particularly the computer system that had been installed into the previous CEO’s home and networked for use throughout the property in 2012. They pointed out that although it was all listed as being for work purposes and so not subject to fringe benefits tax the full surround sound system in both living areas and the five plasma screens did not seem to be fully adapted for 100% business use. While Nathan was thinking about this the ATO officers went on to ask about the ledger labelled business subscriptions; they weren’t concerned about the subscriptions to ‘What’s New in Electronics’ or to the ‘Business Review Weekly’ but queried subscriptions to the ‘Royal Adelaide Golf Club’, the ‘Adelaide Club’ and the ‘Exclusive Wines Club’. Before Nathan could start to respond the ATO officers were on to the next ledger, business vehicles. Nathan knew his predecessor CEO had been driving around in an Audi R8 Spyder Quattro but he hadn’t realised that it was on a novated lease from the company and treated as 100% business travel. Before the ATO officers even asked Nathan knew there wasn’t going to be a log book in the records. In comparison, the fact that the marketing assistant, who happened to be the previous CEO’s daughter, was driving a Lexus and the part-time office assistant, his teenage son, was driving a Mini Convertible, both treated as 100% business use, paled to insignificance.
After several more unanswerable questions Nathan got the good news. None of the ledger entries since he had taken over raised issues for the ATO.
Nathan went to see his solicitor to see what, if anything, he could do. After some negotiations with the ATO a figure was eventually agreed to payout their claim for unpaid fringe benefits taxes over the last six years together with interest and penalties. Nathan asked the NACBZ Bank to increase his overdraft and fortunately they agreed. Nathan is lucky, his business will survive and he has gained some valuable experience, albeit rather expensively.
Myth # 3: There are warranties
Eddy regularly bought companies cheap. Once he got in he sold off the assets for more than the shares had cost and paid out the fully franked profits to one of his holding companies. Eddy had a good friend, Gary, who practised as a commercial solicitor and regularly did the legal work on Eddy’s acquisitions. Unfortunately, Gary did not know a great deal about tax so, although he looked into some matters for Eddy, there were some he missed.
Eddy bought Land Co P/L in 2012. Within 18 months he had wound up the business, sold all the assets and paid his holding company some significant dividends. Eddy was about to close the company when he got a letter from the ATO.
According to the ATO Land Co P/L had made something called an interposed entity election in 2008 when an associated trust had made some losses due to the GFC. This meant that every time the company paid a dividend to someone who wasn’t in the same family group as the previous owner there was a withholding tax due at the top rate. Eddy hadn’t paid this tax. Worse still there were no rebates for this tax and no franking credits allowed. Eddy had bought the shares in his holding company and was expecting the fully franked dividends to be paid there with no additional tax at all.
Eddy went back to Gary and asked if this was covered by the warranties. Gary thought not. Eddy has gained some valuable experience and is considering whether his friendship with Gary is worth more than the potential damages from suing him for negligent due diligence work on the transaction.
If you are planning to buy a business please talk to me, or another member of our specialist Tax team, before committing yourself to what might be a very expensive mistake.
This communication provides general information which is current as at the time of production. The information contained in this communication does not constitute advice and should not be relied upon as such. Professional advice should be sought prior to any action being taken in reliance on any of the information. Should you wish to discuss any matter raised in this report, or what it means for you, your business or your clients' businesses, please feel free to contact us.