Taxation Review Authority finds sale of business took place at value stated by taxpayer and sets aside Commissioner’s reassessments
2016 case note – sale of business was for the amount stated by taxpayer - onus of proof, deemed dividend, goodwill, valuation.
The Taxation Review Authority ("the TRA") has found that the sale of a business by the sole trader disputant to his company was in 2002 for the amount stated by the taxpayer. The taxpayer was reassessed by the Commissioner of Inland Revenue (“the Commissioner”) on the basis the credits to his current account were deemed dividends and shortfall penalties were also imposed. The reassessments and shortfall penalties were set aside.
In February 2002 the disputant sold the accountancy practice, which he operated as a sole trader, to his company ("the Company"). The Commissioner asserted that the amount paid for the practice was $425,000, as recorded in the Company’s 2002 financial statements. The Commissioner reassessed the disputant's income tax liability for the 2007 and 2008 tax years on the basis that certain credits made to his shareholder account with the Company were deemed dividends. The Commissioner also imposed shortfall penalties for failing to take reasonable care.
In this proceeding the disputant challenged these reassessments and the imposition of the shortfall penalties. He said that the purchase price was $2,000,000, and that instead of bringing the full amount of the goodwill into the Company's accounts in the 2002 year, he brought in $425,000. He contended that the credits in dispute (being $565,214 in the 2007 year and $725,000 in the 2008 year) were part of that purchase price, not dividends, and that the reassessments are statute barred in any event.
The goodwill payment of $425,000 was written off in the 2003 year. No further amounts were brought in and written off in the 2004, 2005 and 2006 years. In the Company’s financial statements for the 2007 year (“the First 2007 Statements”) the disputant brought in $850,000 (taking the goodwill to $1,275,000) and wrote off another $425,000. The disputant subsequently produced two further sets of financial statements for the 2007 year (the Second and Third 2007 Statements) and amended the financial statements for the 2006 year ("the 2006 Amended Statements"). In the 2006 Amended Statements the goodwill figure was increased to $2,000,000. The Third 2007 Statements were consistent with the 2006 Amended Statements.
In or about September 2007 the disputant’s family trust ("the Trust") purchased a beach property, funded by a $1,300,000 loan obtained by the Company from its bank. The loan was secured by a mortgage over properties owned by the Trust. Guarantees were provided by the disputant and the trustees of the Trust and another family trust. The funds were transferred to the disputant by way of repayment of the disputant's current account and then on-lent to the Trust.
The loan and repayment of the disputant's current account were recorded in the Company's financial statements for the 2008 year, filed with Inland Revenue on or about 5 September 2008.
Eventually all the mortgaged properties were sold by mortgagee sale. The loan was repaid but the equity in the properties was lost. The fee base of the accountancy practice was sold to another entity and the Company went into liquidation in 2013.
Counsel agreed that this case turned on whether the disputant could meet the onus of proof on him of showing on the balance of probabilities that in 2002 he sold his accountancy practice to his Company for $2,000,000.
The TRA observed that there were a number of inconsistencies in the explanations and documents supplied during the course of the investigation.
The TRA noted that, in many instances, the explanations initially given had been corrected and/or expanded upon in later correspondence and in the statement of position filed on behalf of the disputant. The TRA also observed that during much of the later period that this dispute was on-going, the disputant was dealing with an acrimonious marriage breakup, mortgagee sales of his family's assets and restructuring of his accountancy practice.
The TRA did not agree with the Commissioner’s submission that the disputant gave inconsistent and contradictory arguments in his evidence before the TRA. The TRA found that even though the disputant did not have a clear recollection of events and dates and was confused by questions in cross-examination, he was a credible and reliable witness.
Finally, the TRA did not accept the Commissioner's submission that it was not credible that a chartered accountant would have acted in the manner in which the disputant says he did. The TRA noted that the proceeding was not a negligence claim and the disputant’s conduct and performance of his professional duties were not matters for determination, although noting the disputant readily accepted that aspects of his accountancy work involving his own affairs were "sloppy".
2002 Financial Statements and Journal Entries
The disputant explained that it was his intention to bring the goodwill into the financial statements progressively and to then write it off. The $425,000 goodwill sum was written off in the 2003 tax year.
A page taken from the Company's computer generated journal for the 2002 year was produced. On the page there were debit and credit entries for $425,000 and for $1,575,000. The disputant gave evidence that he did not bring the $1,575,000 into the 2002 financial statements and that there were entries on the next page of the journal reversing out this amount. He explained that he had made these entries as a record of the goodwill which had still to be brought into the Company's accounts in later years.
The disputant’s previous lawyer had advised the Commissioner that entries reversing the entries relating to the $1,575,000 were made in 2008. The TRA found that this was not correct, finding that the accounting software used by the Company did not permit adjustments to the accounts years later and accepted the disputant’s evidence that the journal entries were made in 2002.
The disputant valued the goodwill of the company at $2,000,000, fixing the value of the fee base at $1,400,000 and the in-house software at $600,000, but he did not obtain an independent valuation. A valuation prepared for the disputant by an independent chartered accountant for the purposes of the dispute process valued the fee base at $1,040,000 and, at the hearing, the expert witness for the Commissioner, Mr H, considered a valuation of goodwill of $425,000 would be acceptable. The TRA noted that she was not required to determine the correct value in this case but it was quite evident that the disputant’s valuation substantially overstated the goodwill value of the business.
2006-2008 Financial Statements and 2008 Review
The TRA accepted that the disputant chose to amend the financial statements for the 2007 year and to bring in all the goodwill in order to comply with the requirements of a practice review by the accountants' professional body in May 2008. The TRA did not agree with the Commissioner’s contention that the disputant amended the opening balance for the 2007 year in order to gain a tax advantage by funding the purchase of the beach property through the Company.
In the TRA’s view this contention overlooked that the disputant had already brought in further goodwill of $850,000 in the First 2007 Statements, taking the goodwill to $1,275,000. This action was consistent with an earlier sale at $2,000,000. The disputant then proceeded to write off the sum of $425,000 which, again, was consistent with the earlier write off in 2003 (and, in the TRA’s view, was not consistent with wanting to achieve the tax advantage alleged by the Commissioner).
The TRA stated that there was no evidence that the disputant had any intention of purchasing a beach property in the period in which the TRA found that the First 2007 Statements were prepared. The TRA observed that if there was such an intention, it begs the question as to why the disputant did not bring the amount of $2,000,000 into the financial statements at that time.
Sale & Purchase Agreement
The disputant gave evidence that he had located a copy of the agreement for the sale and purchase. The disputant provided the agreement for sale and purchase to the Commissioner with his statement of position dated 4 October 2013 and explained the circumstances in which the document had been located. The Commissioner’s Statement of Position identified a number of irregularities in the agreement. The Commissioner argued that the agreement was a fabrication which "the disputant had produced only recently".
The standard form sale and purchase agreement used was the second edition ADLS/REINZ form produced in July 1995. The TRA considered that it is unlikely that in 2012/2013 the disputant would have used the 1995 second edition of the ADLS/REINZ form, noting that the third edition came into force in or around March 2005. After carefully considering all of the evidence, the TRA accepted the disputant’s evidence that the agreement for sale and purchase was prepared and signed in 2002.
Taking into account the factual findings and the evidence overall, the TRA was satisfied that the disputant entered into an agreement with the Company in 2002 to sell his accountancy practice to the Company for the sum of $2,000,000.00. The full amount of this goodwill payment was brought into the financial statements of the Company in the 2006 Amended Statements. Accordingly, the TRA found that the disputed credits were part of the purchase price and were not dividends.
Having reached this view, the Commissioner’s reassessments for the 2007 and 2008 years were not correct and were set aside accordingly.
Income Tax Act 2004, s CD 3; Tax Administration Act 1994, ss 108 and 149A (2)(b)