During the excitement of a transaction, such as an asset sale, share sale or capital raise, many often overlook the potential tax implications. The concept of “value shifting” is sometimes thrown around during these deals. With the Australian Taxation Office (ATO) cracking down, it is more important than ever to understand your legal obligations during the course of a transaction. However, the rules can be difficult to understand, so this article will discuss what value shifting is and how it may affect certain types of transactions.
What is the Value Shifting Regime?
The value shifting regime was introduced in 2002. The purpose of the regime was to address transactions where value is “shifted” from one asset to another, which in effect, can distort the relationship between both asset’s market value and its value for tax purposes. A value shift generally occurs when a transaction occurs at less than market value.
Without the value shifting regime, these types of arrangements could:
- create artificial losses; and
- allow for unfair deferral of gains.
The regime applies to:
- shares or other interests in companies;
- units or other interests in trusts;
- loan interests in companies and trusts; and
- interests held as trading stock and on revenue account.
What are the Different Components of the Value Shifting Regime?
There are three components of the regime:
- direct value shifting rules for entity interests;
- direct value shifting rules for created rights; and
- indirect value shifting rules.
Notably, the regime only applies to transactions at less than fair market value. It will not apply in circumstances where a transaction has been performed at above fair market value.
1. Direct Value Shifting – Entity Interests
Direct value shifting addresses when an entity (a company or trust) is controlled by another entity, and a shift in value occurs in relation to an equity or loan interest in the first entity. This can occur when a company:
- issues shares at less than fair market value; or
- varies share class rights, the effect being that one becomes more valuable and the other becomes less valuable, unless the transaction is excluded from the regime (see below).
The practical effect for each taxpayer is that:
- the entities holding the interest that decreases in value will be required to reduce the taxable value of their interests. This may result in unexpected capital gains that they must declare in their assessable income in the relevant financial year; and
- the entities holding the interest that increase in value will be required to increase the tax value of their interests.
For example, Shareholder A holds 10 Class A shares in XYZ Company, and Shareholder B holds 10 Class B shares. Class A shares are worth $100 each, and Class B shares are worth $10 each. XYZ Company varies the rights of both classes so that Class A’s shares value decrease by $50 per share, and Class B’s increase by $50 per share. There has been a value shift within the company, being $500 from Shareholder A’s shares to Shareholder B’s shares. As a result, the tax value of both classes of shares may have to be adjusted.
2. Direct Value Shifting – Created Rights
Broadly, this component of value shifting applies when an entity owns an asset and a right is created out of or over that asset in favour of an associate of the entity. Likewise, that asset is later sold at a loss while that interest still exists. An associate is broadly defined and can include a trust or company which the entity controls or benefits from.
For example:
- ABC Company owns a farm that it purchased in 2010 for $3 million;
- in 2023, the farm’s market value is $5 million;
- in 2023, ABC Company grants a five-year lease to ABC Company Trust, of which the company’s sole shareholder is the trustee (an associate). The market value of the lease is $3 million; and
- immediately after ABC Company grants the lease, it sells the farm for $2 million.
In this example, the grant of the lease may trigger the value shifting rules, which will reduce the market value of the farm ($5 million) by $3 million (the value of the lease) to $2 million. The rules will then further apply to prevent a $1 million capital loss on the company’s disposal of the farm.
3. Indirect Value Shifting
Generally, an indirect value shift occurs when entities that are not dealing at arm’s length engage in a non-market value transaction. The shift is “indirect” because it can potentially affect the values of the interests held in the entities and change the relationship between the value of the interest for tax purposes. The indirect value shifting rules aim to address the change in the value for tax purposes.
For example:
- Company A wholly owns Company B and controls Company Trust; and
- Company B sells an asset with a market value of $1 million to Company Trust for $500,000.
In this example, the effect of the value shifting rules would potentially reduce the market value of the shares owned by Company A in Company B by $500,000. It would also increase the market value of the interest it has in Company Trust by $500,000. The practical effects for Company A would be that it may have to:
- adjust the value for tax purposes of the interests it owns in Company B and Company Trust; and
- reduce any loss it makes on subsequently selling any interests it owns in Company B, or reduce any gain it may make in selling interests it owns in Company Trust.
Situations Where the Value Shifting Regime Does Not Apply
The ATO has provided some exceptions to the value shifting rules. Generally, the regime does not apply to:
- small value shifts, which at the time of writing apply to:
- direct value shifting – entity interest: total value shifts are less than $150,000;
- direct value shifting – created rights: market value of the right granted exceeds the proceeds by $50,000 or less; and
- indirect value shifting: total value shifted is equal to or less than $50,000;
- normal commercial dealings conducted at fair market value; and
- dealings within groups consolidated for tax purposes.
When you are ready to sell your business and begin the next chapter, it is important to understand the moving parts that will impact a successful sale.
This How to Sell Your Business Guide covers all the essential topics you need to know about selling your business.
Key Takeaways
Value shifting can produce unplanned tax consequences throughout the course of a transaction. Therefore, it is essential to understand the rules before completing any sale or capital raise. At its core, value shifting seeks to address the discrepancy between the market value and the value for tax purposes of assets when a transaction occurs at less than fair market value. It can be direct or indirect and can impact each party differently. Further, the ATO has provided certain exemptions to the value shifting rules, which are largely when a shift is under a certain monetary threshold or a transaction occurs at fair market value.
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Frequently Asked Questions
It occurs when a transaction occurs at less than fair market value, the effect of which is a distortion between the market value of an asset and its value for tax purposes. The value shifting regime addresses this by imposing certain tax consequences on the parties depending on the circumstances.
No. The regime will not apply where the transaction:
- results in a shift under a certain monetary threshold;
- occurs at fair market value; or
- is between entities within a group consolidated for tax purposes.
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