subsequent changes in equity holders in the incorporated structure.

Transcription

1 30 January 2008 Mr Tom Rengers Assistant Commissioner Small and Medium Enterprises Australian Taxation Office GPO Box 9990 BRISBANE QLD 4001 Dear Sir Incorporation of Legal Practices Taxation Consequences The Law Institute of Victoria (LIV) recently met with a delegation headed by yourself to discuss various taxation issues arising out of the State based legislative reforms to regulation of the legal profession. To this end, it was agreed between the parties attending the meeting that the LIV would provide your office with suggestions on how best to harmonise taxation regulation in light of the move by many law firms to incorporated structures. At this juncture, it is our intention to provide a submission on the so called Base Line transfer from partnership to incorporation and related post incorporation issues. In doing so, we have not addressed the technical tax issues in any detail, as we understand they have previously been the subject of a submission from the Law Council of Australia. We will follow with later submissions on other related issues. Specifically, this letter concerns itself with transfers of interests in legal practices on: restructuring to an incorporated structure; and, subsequent changes in equity holders in the incorporated structure. Incorporated Practices On 12 th December, 2005, and again from October 2006, the Legal Profession Act 2004 (Victoria) was amended to allow more flexible practice options and restructuring. These included inter alia the provision for more flexibility in incorporated practice models for Victorian legal practices. In brief, there are now no longer restrictions on who must be shareholders in incorporated legal practices in Victoria, providing there is at least one registered legal practitioner director. Further, in certain cases, such as where there are multi-disciplinary partnerships, partners do not need to hold partnership interests personally. The introduction of the multi-disciplinary partnership structure also allows legal practices to provide a wider range of services.

2 The upshot of these changes in the process of being introduced throughout Australia - is that legal firms are becoming more cognizant of structure. Recent bankruptcy law changes, effective from 31 May 2006, are also providing a key reason for practitioners to consider the restructure of legal practices. The commonly termed claw back rules provide for a claw back period of four years prior to bankruptcy to apply against practitioners where practice income is derived by practitioners personally. With incorporated practice structures, more flexibility is available in relation to derivation of practice income, so that the practitioner is not unnecessarily, personally exposed. The Legal Services Board Victoria Annual Report for 2006/07 provides some interesting statistics in relation to incorporation. As at 31 March, 2007, there were 437 incorporated legal practices and two multi-disciplinary partnerships. Relevantly, between 1 April 2006 and 31 March 2007, 128 incorporated legal practices were registered, while only 18 law firms were registered. These statistics indicate that incorporation is being taken up, although it is noted that this is largely confined to the smaller end of practice at present (ie. of the 437 incorporated practices, 324 practices only had one principal). In the past, because of the historical regulation of legal practices, legal practitioners have been at a competitive disadvantage as it has not been possible for lawyers to establish a legal business in incorporated form, as is possible for other business service firms, eg. management consultants. This means that considerable value has been built up over long periods of time in unincorporated structures. Moreover, existing practices may be at a competitive disadvantage to newly established and incorporated legal practices, in terms of attracting the best talent, where the existing practice structure unnecessarily exposes practitioners to claims, or from a business owner s perspective, the structure is unnecessarily inefficient. While practitioners now have a range of incorporated structures available to them, an underlying concern for the LIV is the likely tax implications of transferring from one structure to another, where there are no goodwill structures or the partners have a pre-agreed formula or methodology that determines the price at which interests in the practice are transferred. At this stage we seek clarity on the ATO s position on the so called base line transfer from partnership to incorporation, where CGT rollover relief is not chosen. In this regard, we note that while CGT rollover relief could facilitate restructuring, it would not solve the difficulties for legal practices going forward if goodwill were to be recognised as having value (eg. significant unrealised capital gains and the potential for inequities between existing and new principals). Accordingly, we also seek clarity on the ATO s position on changes in equity holders after incorporation. Base Line Transfer #1: No Goodwill Practices The No Goodwill (or No Equity ) practice is typical of many medium sized and larger legal practices. In these practices, partners neither pay anything nor receive anything when being admitted to - or when exiting the practice. A representative example of the type of clause found in the partnership deed to produce this result is as follows: All Partners, for themselves and their legal personal representatives acknowledge and agree that, (both in relation to the partnership and any associated entities) no value at all shall be attributed to goodwill. Without in any way limiting the generality of the foregoing, no Partner shall be obliged to pay on his or her admission, or be entitled to receive on his or her retirement death or expulsion, any payment whatsoever in respect of goodwill. 2

3 Where such a practice incorporates, a similar clause would be found in the shareholders agreement for the incorporated practice. Shareholders agreements are typically adopted by closely held companies to regulate relationships between shareholders beyond the provisions ordinarily found in a company s constitution (eg. dealing with dividend policy, contributions of loans and equity, etc). A representative example of such a clause is as follows:- Shares in the Company may only be issued, redeemed or transferred for a consideration of 1.00 per share. The Company may not register a transfer of Shares where the consideration specified in the transfer exceeds 1.00 per share. Where these type of clauses are present, there is prima-facie no wider market for the disposal of a practitioner s equity interest, as the relevant agreement restricts consideration to a nil or nominal amount. With a partnership, there is a relative ease of admission and exit of partners. Pursuant to IT 2540, the Commissioner does not seek to impose the CGT market value substitution rules when partners are admitted to or exit the partnership on the basis that the partners are taken to be dealing with each other on an arm s-length basis. However, on incorporation, the concern is that employee share acquisition and CGT rules have market value substitution provisions which may result in deemed capital gains arising on the transfer of the practice from a partnership to an incorporated practice, and/or the admission and exit of shareholders. This is even though the relevant shareholders agreement might specifically states that nominal amounts only are to be paid for or received for shares on admission and exit of shareholders respectively. We submit that the tax position should follow the economic reality, namely that there is simply no gain in these circumstances. Base case- #2: Goodwill Practices Where transactions occur for consideration, usually in smaller practices (although some middle sized practices may also be in this group), such as say, when an equity participant pays an amount to join a practice (such as for an interest in a goodwill practice ), we have no issue with the relevant income tax provisions, such as the CGT provisions applying in respect of amounts paid. A similar position would apply where a firm lists and thereby establishes an independent market in interests in the legal practice. This would also encompass practices where amounts paid for an interest in a practice is determined by a formula. For example, the amount paid by a prospective partner to join a practice might be calculated having regard to the prospective partner s share of annual profits, determined by a formula such as: Prospective Partner Total Partners X Last 3 Years Profits 3 = Admission Price We consider that, where such practitioners are bound by a formula under their partnership agreement, the amount payable pursuant to the formula is the market value. We understand that valuers have different methodologies to determine a hypothetical market value. However, we consider that such methodologies are not applicable as the parties are dealing at arm s-length and are bound to deal at the price generated by the formula. Where such practices incorporate and the formula is carried over into dealings in shares in the incorporated entity, it is submitted that the ATO should not impose market value substitution provisions as the price generated by the formula is the only price at which transactions can take place and thus is the market value. Conclusion The LIV supports the development of a policy by the Australian Taxation Office (ATO) which encourages and harmonizes the shift by State-based legal regulators to allow incorporated legal practices. 3

4 The adoption of No Goodwill or formula driven goodwill transfers is common place in the traditional legal partnership structure, and will continue in an incorporated environment. The LIV seeks a clear and unambiguous ruling from the ATO to the assessment of Base Line incorporated legal practice transfers. Our recommendation would be an adoption of a tax follows cash approach, where supported by relevant clauses (along the lines indicated above) embodied in the agreement between the relevant legal practitioners. That is: - where the relevant equity holders agreement (partnership agreement, shareholders agreement, etc), clearly specifies that the practice is a no goodwill (and/or no equity practice) or includes a formula based price for any transfers, and - practitioners deal with each other on that basis, then there should be no application of market value substitution rules on either: the restructure of the practice to the incorporated model now allowed under the relevant State legal profession rules; or admission or exit of equity holders. We attach, at Appendix 1, an example of the potential, and arguably unfair, taxation outcomes that can arise where market value substitution rules are applied to tax transactions where economic profits do not arise. In the absence of being able to achieve an administrative solution, we believe that it is important that the ATO advise legal practitioners of these issues given that greater flexibility in incorporation of legal practices is now allowed in most states. Further, we believe that if a workable, practical solution is not achieved, legislative change is necessary. Should you have any queries, please do not hesitate to contact me or Michael Hayes of the LIV s Commercial Law Section on (03) or by at mhayes@liv.asn.au. Yours faithfully Tony Burke President Law Institute of Victoria 4

5 Incorporation Example Appendix 1 The following example is provided to highlight the potential difficulties with the potential application of market substitution rules to incorporated practices. Assume the following facts: 10 equal partners in a no goodwill practice all pay tax at top marginal tax rates. Each pays 1 on entry to the practice. Each receives 1 on exit. Each lends 150,000 on admission to the practice and is repaid that 150,000, and nothing else, on retirement. Assume the practice value (including goodwill) is worth 2m on admission and that the practitioner acquires a 10% interest. Assume at exit that the practice value (including goodwill) is worth 3m or 300,000 for a 10% share. P/Ship Company (Worst) Company (Best) Entry Tax 46.5% Nil 93, Exit Tax 23.25% Nil 23, ,750 3 Total Tax Nil 116,250 69,750 Economic Position Neutral Neutral Neutral The above table illustrates that although the economic position on admission to and exit from the practice is neutral in all scenarios, the impact of the market value substitution rules that can apply under the employee share acquisition scheme rules on admission, and the potential impact of the market value substitution rules within the CGT provisions 4 on exit, can result in equity participants paying significant amounts of tax on gains that they never derive % x 200,000 = 93, ,000 is the discount to market value on the issue of shares under ESAS (Employee Share Acquisition Scheme Rules) ,000 less 200,000 (taxed on Entry) = 100, ,000 x 46.5% x 50% CGT Discount = 23, Assumes no tax on Entry under ESAS. Exit tax is 300,000 x 46.5% x 50% CGT Discount = 69, There is no access to the CGT Small Business Concessions in the above example as shareholders have less than a 20% interest in the incorporated practice. 5