In the second Professional Planner/Commonwealth Bank session on succession planning, Martin Checketts and Anthony Carafa explain why plans can be derailed by poor preparation. Simon Hoyle reports.
Once you’ve decided to sell or to buy a business it’s natural to want to get the deal done as quickly and painlessly as possible. But rushing into the exercise can cause some major headaches later on.
Martin Checketts, a partner in law firm Mills Oakley Lawyers, says it’s easy to make simple mis- takes early in the process that lead to complicated problems as the transaction progresses.
Checketts says it’s a good idea to spend time at the beginning to get everything right – including making sure all entities involved in the transaction are structured the right way to start with.
“When looking at structures, tax is a really important part of the piece,” he says.
“But there are a number of other important aspects…such as asset protection [and] having a structure that’s facilitative of debt funding.
“And also, perhaps, a structure that is facilitative of a partial sell-down. And in the financial planning industry, there’s certainly been a trend that we’ve seen recently around older business owners perhaps selling down their business in stages to younger planners who are coming through the ranks.
“So when we’re looking at structures, I think we’d really want to take into account all of those aspects.”
Anthony Carafa, a director of accounting, tax and corporate advisory firm Dobbyn & Carafa, says that on the taxation side there are “a couple of key issues” that both vendors and buyers need to think about.
“You need to be able to deal with the taxation issues when you’re running the business itself,” he says.
“And one of the key issues there is having the flexibility of distributing profits of the business to the shareholders.
“I think probably the most important aspect of setting up a tax structure is reviewing the capital gains tax consequences of the structure. So when you compare some of the structures – for example, a company structure – one of the key issues with companies, they don’t qualify for the 50 per cent general concession, which is a capital gains tax concession. That does not apply to companies. So there’s a major negative if the company is selling its assets and goodwill out of its structure.
“One of the most problematic issues that we find is clients come into us when they’ve already done a handshake deal. And they come and talk to us about the tax issues post having done that deal. And we ask the typical questions as tax accountants do.Wesay,youknow,‘Areyousellingtheshares in the company, or the assets out of the company structure?’ – and typically, the response is blank.
“Depending on the structure and the way the deal is done, it is really, really important to under- stand the after-tax result, what actually goes into your pocket after tax.
“In the planning process it is really important to understand the optimal structure.
“For example, if you’re selling the assets out of the company and you’re not qualifying for the gen- eral concession, you can have a vastly different tax result than if you were to go to the market and say, I’m selling the shares in the company – in which case, if you’re an individual or a discretionary trust owning the shares in the company, you will get that 50 per cent general capital gains tax concession.
“So I think from a vendor perspective it’s really important to know what cash you’re going to put in your pocket at the end of the day before you go into that negotiation.”
Checketts says both parties to a transaction must be clear on what structure will work best before they start negotiating the sale. Failing to do so may not only result in an unexpected and unwanted tax bill, it can attract some unwanted attention as well.
“They must take the tax advice and they must form their view on how they want to go before any pen is put to paper,” Checketts says.
“We see quite regularly a scenario where, for
example, a business is held in a company structure, the parties get together, they talk, they do a deal in principle, the buyer understandably wants to buy the business and assets, he wants to cherry pick the assets and leave the liabilities behind in the company.
“They agree that that all sounds good, they then prepare a term sheet which sets out that transac- tion, they sign it and then they start negotiating; only once they have done all that do they come to somebody like Anthony, who points out that per- hapstherewouldbeamuch,muchbettertaxresult if they were to sell the shares.
“The problem they’ve created for themselves is a very undesirable paper trail which if anybody like the Australian Taxation Office [ATO] saw it, would give them some grounds for an anti-avoid- ance claim.
“It can really be like a red rag to a bull for [the ATO] when they see a whole trail of discoverable documents that talk about a business sale and then for no good commercial reason it flips and becomes a share sale. It’s a really bad look and it happens because people don’t get the tax advice earlier.”
The financial penalty for making a wrong tax decision can be significant, Carafa says.
“It can be huge, in terms of a company versus a trust structure,” he says.
“The net result could be 11 per cent or 12 per cent difference in your after-tax return on the actual sale proceeds, if you get it wrong.
“It is an extraordinary difference.
“What a lot of clients focus on is the gross proceeds.
“When you’re looking at the proceeds you receive from a sale it is important to understand [that] … say if a company is selling the assets out of the structure, it’s not about the cash going into the company and the company paying the tax, it’s also about getting that cash out of the company struc- ture. If you do that as a franked dividend, there can be tax consequences from that.
“Another way of doing it is getting a liquidator’s distribution out of the company, and that can have major tax consequences as well. So it is really critical for all shareholders to understand at the end of the day,‘What cash goes into my pocket after tax?’”
Structuring the terms of payment is another important aspect to consider, Checketts says.
“It’s very common in this industry to structure deals with an up-front element and then a deferred element, which is traditionally based upon…recur- ring revenues in the post completion period,” he says.
“There are some really complex issues around the tax treatment of earn-out.
“It’s pretty murky and technical.
“And the second key tax issue is that this is a terms contract; so in other words, the… event is triggered at the date the contract is entered into, notwithstanding that the payments may follow at a later date. So from a tax perspective it means that you can – depending on how it’s structured – sometimes pay tax on consideration that you haven’t yet received.”
Carafa says that if, for example, you have total sales proceeds of $1 million and half of that is subject to an earn-out arrangement, “that earn-out right can be taxable upfront – even though you haven’t received the proceeds”.
“So this can be particularly relevant; and I know with financial planning businesses there’s some family trusts that have been around for many, many years and some of them that are pre-capital gains tax; they’re like gold, as you can imagine.
“If you receive those proceeds up-front for the sale of the business but you’re still getting taxed on that earn-out right, it’s a really inefficient tax result to have.
“And this is subject to a draft ruling that’s been produced by the ATO. It’s been subject to a lot of debate amongst the profession how unfair the treat- ment would be; at this stage, we’re stuck with it.”
Checketts says professional advice is essential before any deal is agreed upon – whether formally or on a handshake – and certainly before heads of agreement are entered into. And getting advice is recommended when determining how detailed such agreements should be.
“It’s really important to get the tax and profes- sional advice before that document is drawn up,” Checketts says.
“There’s often an issue or a debate about how detailed a term sheet or a heads of agreement should be. Some people like them to be detailed to minimise the scope for negotiation when it comes time to prepare and draft the final documents.
“Other people take a view that if you put too much in the term sheet you might as well just jump straight to the contract and negotiate that. And certainly we’ve seen some deals in the financial planning industry where a very detailed term sheet hasn’t particularly assisted and it’s become, if you like, a major contract negotiation.
“The question of non-binding versus binding [agreements] is also an interesting one. As a general rule of thumb, my preference is for a non-binding term sheet, because the minute it becomes binding it can increase some of these anti-avoidance sensi- tivities that we’ve talked about.
“And in any event there can also be enforce- ability issues around a binding term sheet, or a term sheet that purports to be binding. Because even if it’s there to be binding but it is unclear or too brief, then it’s probably not going to stand up in a court.”
It’s very common for a transaction to include some form of deferred payment, with terms linked to the post-transaction financial performance of the business being bought.
“ Typically, for example, the purchaser is paying, say, 70 per cent up front, then paying 30 per cent after, say, 13 months, and with that 30 per cent
perhaps to go up or down depending on the perfor- mance of the business in that time,” Checketts says.
“So the vendor is in the position where they’ve given up the asset title and the business has trans- ferred, but they’ve only received 70 per cent of the consideration.
“We would often advise them around some ap- propriate security to take in respect of the deferred consideration. Typical [security could include] some personal guarantees, for example, from the directors of the purchasing entity.
“If that entity is a bigger company or a listed company, that kind of security isn’t generally avail- able, but from smaller companies we’d sometimes take that personal guarantee.
“Sometimes people will take a second charge over the purchaser’s assets – normally a second charge, because it will sit behind the bank, who have probably funded this deal. So that’s one that we commonly see. And often there can be a few issues and negotiations around the nature and the terms of that charge.”
If a business is approaching a potential transac- tion and it becomes clear that the current structure is likely to be inefficient, a restructuring may be needed.
“One of the common examples, particularly in the financial planning industries, [is] with business- es that are structured in family trusts,” Carafa says.
“And when, if you want to transition or part transition a business to the management team that are coming along, the next level of employee, I think obviously with a family trust you’ve only got to pull the beneficiaries, so you can’t actually transfer a unit or a share in a company.
“This is where the small business concessions can be very, very helpful. And as most [readers] would know, there are a number of concessions that are available. Not only from a family trust perspective would you get the 50 per cent discount – the general concession under the small business conces- sions – [but] if the asset you’re transferring, and that can be goodwill, qualifies as an active asset, you can get a further 50 per cent active asset concession.
“There’s also a retirement exemption, which is a $500,000 treatment exemption, which is a lifetime limit per individual. And there’s also small business rollover relief and a 15-year concession available as well. So there are some really generous conces- sions but, in order to access those concessions, you
must pay particular attention to working your way through provisions and getting the right advice to make sure you don’t trip them up.
“There are some basic conditions that have to be satisfied. Unless you get over the line with those basic conditions, you’ll fall foul of the small busi- ness concessions.
“For example, if the maximum net asset value of your business and associated entities is over $6 million, you fall outside those small business concessions.
“So what you can do…is sell the business across, say, from a discretionary trust to a new unit trust structure. The vendors can actually use the small business concessions to limit their tax on the sale of the business across [to] the new structure. And then the new unit trust structure, because it’s unitised, will enable the business to actually sell the units across to whoever it [may] be – the manage- ment team or private equity firms or the like.
“But one of the real key issues with the small business concessions – and we’ve seen it – is in the documentation with the tax office. We’ve seen examples…of problematic results that occur as a result of restructuring it. When you are accessing these small business concessions you must docu- ment every step of the process to make sure you qualify.
“I’ve seen people that have done valuations to get under the $6 million mark that aren’t appropri- ately made; they’re not done by an external party or they’re not done in accordance with generally accepted valuation principles. The ATO will grab those things and knock them down as fast as they can.
“So it is really important, and we’ve done this for clients before, where you create a folder which goes through all the provisions that need to be accessed in those small business concessions, so that when the tax office come looking, if they do come looking, you’re adequately prepared. Because I’d say probably eight out of 10 businesses are not prepared when the tax office comes looking.”
Carafa says documenting this process isn’t necessarily the most time-consuming issue – that can be the valuation process.
“If the business has got a general level of corpo- rate governance in the way it produces its financials and its corporate registers, the process shouldn’t take long,” he says.
“But a lot of the complexity can arise in relation to the valuation. If you’re close to that $6 million threshold, then you really have to do some work to make sure you do a proper business valuation to get under that threshold.
“But in terms of the balance of the issues, it’s really getting a letter of advice out of your tax accountant or your tax lawyer to make sure that it adequately protects you.”
Checketts says “a good structure is a ‘divisible’ structure”.
“In other words, a structure of which you can sell parts,” he says.
“So a company [or] a unit trust for example, as opposed to, say, a family trust. I think that’s one key aspect.
“Another aspect of bad structuring that we see in the planning industry is a structure that contains personal or non-business assets. You know, the in- vestment properties and the like. All that’s doing is exposing your non-business assets to business risk.
“But it’s also giving you a tax headache because, of course, it’s going to make it very hard for you to sell that entity if it’s got those non-business assets in it. So it can really limit your options on exit.”
Carafa says that it’s “generally the case [that] a sale of the shares or a sale of the units is going to get you the best tax result”.
“If you’ve got a private asset in that structure you’ve got a problem, because the owner’s going to take over the entity. You’ve got to get that asset out to get you the best tax result. And that can cause capital gains tax issues within the structure, and it can also cause stamp duty issues that you don’t want to trigger on sale of the property.”
Carafa says that a partnership of trusts is a very tax-efficient structure.
“Principally [that is] because…when we’re talk- ing about that maximum net asset value threshold of $6 million, under a partnership of trusts you’ve got the ability for each partner to access that threshold,” he says.
“Each partner can apply that threshold to their own interests. So from a tax perspective, it’s a fantastic structure to have.
“It’s obviously less of an effective structure from an administrative point of view if you want to in- troduce new partners on a consistent basis, year-in, year-out.
“But from the tax perspective they’re fantastic.”
Checketts says there’s a legal quirk to consider with a partnership of trusts.
“From a legal perspective it’s a kind of curious animal, because…there’s the concept of joint and several liability between partners,” he says.
“What that means is that if one of your partners commits the business to something, you can be sued for it even if you had no part in it. So there’s a live asset protection issue around that. If you’ve got a partnership of trust structure, it’s really, really important not to have any other assets in that structure.”
Checketts says financial planning businesses make for interesting transactions“because they’re largely about personal goodwill”.
“They’re about the deep client relationships that the vendor and the principal of the business and his senior people have with the clients,” he says.
“So it’s really a unique proposition from the purchaser’s side of things, because they’re paying good money for that personal goodwill and the relationships of the vendor.
“Things like restraint of trade become really, really important. These are the clauses that say, for example, that for a certain period after comple- tion – maybe it’s one year, two years, three years, whatever the period – the vendor won’t compete with the business. Or won’t solicit or deal with the clients or solicit the employees [of the business].
“It is fundamental to have a tight and abiding restraint-of-trade clause in the sale agreement. Ab- solutely. It’s just not something you can kind of deal with on an oral basis. I think the key issue legally for a purchaser is that these clauses are only en- forceable to the extent that the purchaser can prove that they are reasonable. And so there’s always an argument around the enforceability of these kinds of clauses, and it really militates in favour of draft- ing them in a tight way that isn’t too broad and too wide which is going to prejudice the enforceability.”
In other words, the more specific a restraint-of- trade clause is, the more likely it is to be considered enforceable.
“Absolutely right,” Checketts says.
“And in most states of this country, the reason- ableness will very much turn on the precise black letter of those clauses.
“Just following on from that, I also think that the handover obligations are really important. And that’s something that we sometimes see not documented quite so well in sale agreements.
“Often the lawyer might use a standard business sale agreement that they’d use in any industry, and not re- ally think about the particular aspects of this industry. Whereas in my view, what really needs to happen is that there are quite detailed obligations which govern the vendor’s duty to hand over the clients and the relation- ships in a methodical manner in the post-completion period.”
Whenever lawyers, accountants or other professional advisers get in- volved, it’s critical that they have good instructions from both vendor and purchaser and that both parties keep their advisers on a tight rein.
“The worst result – and we see this happening not infrequently – is when the lawyers or the other profes- sionals get involved in an ego battle,” Checketts says.
“I think it’s really important that the principals, who often start out friendly and want a friendly deal, control their advisers. They need to tell them that this is how it’s going to be.Andtheyneedtheiradvisersto protect them, but also take a reason- able approach, which is going to achieve what is ultimately their goal: to conclude and complete a transaction. Not to polarise the parties.”
Negotiating warranties is an im- portant aspect of any transaction, and while a warranty is no substitute for good due diligence, it’s worth spend- ing some time and effort structuring them correctly.
“A warranty is really a contractual promise,” Checketts says.
“What happens very commonly on these transactions is that the purchaser is buying an asset, they’re going to want some comfort around that asset. So they’re going to seek warranties from the seller, in relation to things like the historical performance of the business, the client list, the financials, employees, the absence of litigation, et cetera.
“In the sale agreement it’s very common for the vendor to give a suite of warranties. I think the key message that I’d like to bring across is that the best way that the vendor can mitigate his risk and exposure under the warranties is to have a re- ally rigorous process of disclosure in the due diligence phase. Because how these contracts are awarded is that they say that to the extent that a fact, matter or circumstance is disclosed to the purchaser, and the purchaser is therefore aware of it, the purchaser is not able to bring a warranty claim in respect of that matter.
“There’s a big message there around due diligence, and around vendors flushing out information before they sign the sale agreements.”
Carafa says the key message for any financial planning firm looking to be acquired, or looking to acquire another, is to “get the structure right from the start and [have] that detailed discussion with your tax ac- countantoryourtaxlawyerupfront”.
“Certainly with tax structuring it’s not a one-size-fits-all approach; there are advantages and disadvantages with any structure that you undertake and any option that you undertake,” he says.
“But you can help avoid massive issues down the track if you get the structure right up front. And that’s not just in relationship to a business; it can apply to the acquisition of an investment portfolio of shares or a property, or whatever the case may be.
“There’s an appropriate structure for every acquisition that should be addressed right at the start. If you go into a sale process, [understand] the optimum sale structure for you and your business before you actually go into negotiations. What’s going to get you the best after-tax result; then you get into the negotiations and you know exactly what you want and you fight for it. That’s really important.
“And…just getting that documentation right. If you’ve gone through the whole process of organising a sale, accessing all the capital gains
tax concessions, the small business concessions, only to find that you get hit by the ATO at the last minute because you haven’t appropriately documented your transaction, I think that is the most tragic result that can happen.”
Checketts reiterates the im- portance of structuring the deal to achieve the maximum tax efficiency, but also advises buyers and sellers to make sure each knows everything they need to about the other before proceeding.
“People often have [tax] conces- sions in mind when they’re exiting their business and retiring, for example,” he says.
“But they often don’t have them top-of-mind in the context of a restructure. So to be able to restruc- ture in a benign tax environment that gives you asset protection, gives you a saleable structure and steps up your cost base, I think is extremely attractive.
“And it might not be around forever.
“The other message would just be around warranty exposure, and the ability for vendors to mitigate [their risk] by being really rigorous in making sure they get all the skeletons out and disclose all assets of the business to the prospective purchaser.”
