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Buying or Selling Property? The 1 July Tax Problem You Didn’t Know You Had

New rules to prevent foreign residents avoiding tax when they sell Australian property will affect everyone buying or selling property with a market value of $2 million or more from 1 July 2016.  Many transactions involving shares in a company or units in a trust will also be caught.

From 1 July, a 10% withholding tax will apply when foreign residents sell certain types of Australian property.  However, if you are selling Australian property, the new rules assume you are a non-resident unless you have a clearance certificate from the ATO.  Without this clearance certificate, the purchaser can withhold 10% of the purchase price and pay this to the ATO.  For purchasers, if you do not withhold the tax and do not have a clearance certificate, you are liable for the tax (on a $2 million property, that’s $200,000).

You can probably already see the problem here. Until everyone gets used to this new system there are likely to be quite a few issues where property contracts don’t mention the withholding tax, no clearance certificate is provided, and no tax is withheld on settlement.

The good news is that the withholding tax does not apply to real property that has a market value of less than $2 million.  This exclusion can apply to residential dwellings, commercial premises, vacant land, strata title units, easements and leasehold interests as long as they are below the $2 million market value threshold.

Where there is more than one purchaser, the market values of all of the interests to be acquired need to be aggregated to determine whether the $2 million threshold applies. For example, if mum and dad are buying a property as joint tenants with a total market value of $3 million, the rules could be triggered even though their individual interest in the property is only worth $1.5 million.

The $2 million exclusion does not apply to indirect interests in Australian real property such as shares in a company or units in a trust that hold real property in Australia.  However, the exclusion can apply to company title arrangements, where someone holds shares in a company which provides them with a right to occupy part or all of the property that is owned by the company.  This ensures that company title arrangements are treated in the same way as properties held under strata title.

The other main exception is when the foreign resident vendor is under external administration (for a company) or is bankrupt (for an individual). This is to ensure that the withholding tax rules do not disturb the priority of other creditors.

What ‘property’ is affected by the new rules?

The new withholding rules capture:  

  • Taxable Australian real property – such as residential property, commercial property, land etc., situated in Australia as well as certain mining, quarrying or prospecting rights;
  • Indirect Australian real property interests (i.e., shares in a company or units in a trust where certain conditions are met). This is generally where most of the value of the company or trust relates to real property holdings in Australia; and
  • Options or rights relating to the points above.

I’m selling a property what do I need to do?

If you are selling real property affected by the new rules after 1 July and that property is likely to have a market value of $2 million or more, you need to apply for a clearance certificate from the ATO. Without this certificate, the purchaser of your property must assume you are a foreign resident and will be permitted to withhold 10% of the purchase price and remit it to the ATO.

When a certificate is issued by the ATO it remains valid for 12 months.  The ATO has been developing an automated process for issuing a clearance certificate.  The vendor (or an agent) will be able to complete an online application form. In straightforward cases the ATO expects that certificates will be issued within a matter of days.

I’m buying a property what do I need to do?

If you are buying real property affected by the new rules after 1 July and that property has a market value of $2 million or more, you need to ensure that you receive the clearance certificate from the vendor before settlement occurs.  While the tax rules allow you to withhold 10% of the purchase price if the clearance certificate is not provided, it might also be a good idea to have this built into the sale contract to avoid any uncertainty.

If the sale proceeds and you don’t have a clearance certificate and have not withheld the tax, the tax liability rests with you, the purchaser.

Buying or selling indirect property interests – shares in a company or unit trust

If you are buying or selling shares in a company or units in a trust then a withholding obligation can also be triggered, even if the company or trust does not hold any real property interests in Australia. In this case the process of validating whether or not a withholding obligation exists is slightly different.

Withholding will be required if either:

  • The purchaser knows or has reasonable grounds to believe that the vendor is a foreign resident; or
  • The purchaser does not have reasonable grounds to believe that the vendor is an Australian resident and either the purchaser has a foreign address for the vendor or they are authorised to make payment to a place outside Australia.

In these circumstances the vendor can make a declaration to the purchaser confirming that they are an Australian resident to ensure that the withholding tax does not apply.  In general you would expect to see these declarations in the sale agreements as warranties.

A vendor can also make a declaration confirming that shares in a company or units in a trust are not classified as an indirect Australian real property interest.  Shares or units that are not classified as an indirect Australian real property interest and do not relate to company title arrangements are outside the scope of the withholding rules.

Can we vary the withholding tax?

The Commissioner has the power to vary the amount that is payable under these rules.  Either a vendor or purchaser may apply to vary the amount to be paid to the ATO. This might be appropriate in cases where:

  • The foreign resident vendor will not make a capital gain as a result of the transaction (e.g., they will make a capital loss on the sale of the asset);
  • The foreign resident will not have a tax liability for that income year (e.g., where they have carried forward capital losses or tax losses etc.,); or
  • Where there are multiple vendors, but they are not all foreign residents.

If the Commissioner agrees to vary the amount, it is only effective if it is provided to the purchaser before settlement occurs.

Warning on Super Contributions

The 2016-17 Federal Budget announcements on superannuation have caused a lot of concern.  These include:

  • A $500,000 lifetime non-concessional contributions cap from Budget night
  • A reduction in concessional contribution cap from 1 July 2017
  • The removal of the tax exemption on earnings supporting transition to retirement income streams (TRIS) from 1 July 2017
  • The extension of the 30% super contributions tax on high income earners
  • Tax free super balances capped at $1.6m from 1 July 2017

Many clients have asked, what should we be doing? The main area to be mindful of is the $500,000 lifetime cap on non-concessional contributions as what you do now, may have a lasting and potentially detrimental impact.

Under the current rules, you can use the ‘bring forward rule’ and contribute up to $540,000 across a 3 year period to your super fund.  Anyone utilising these rules in the current year may find that the proposed rules, if they come into effect, will radically change their position.  

It’s really important that anyone contemplating making large contributions to super or utilising the bring forward rule, get advice first.

Quote of the month

“A genuine leader is not a searcher for consensus but a moulder of consensus.”
Martin Luther King, Jr.

The material and contents provided in this publication are informative in nature only.  It is not intended to be advice and you should not act specifically on the basis of this information alone.  If expert assistance is required, professional advice should be obtained.

Growing to Death

Most people are not surprised when a start up business fails. But it’s not just start ups that grow to death; it’s also a common cause of business failure for mature businesses.

Start-up businesses often fail because they are undercapitalised.  They grow until the money runs out and then they can’t afford to fund further growth.  The banks refuse to lend to them as they have no history and no assets to leverage, and then they die. It’s an easy trap to fall into. The entrepreneurial spirit that drives people to start up a business is often the same spirit that keeps them focussed on a growth path.  The mentality is that the faster you drive sales and bring in the cash, the more successful the business (and the entrepreneur) will be.  However, this cycle of sales and profit is missing two key components; financial, and cash flow management. A successful and sustaining business has all of these elements.

For the more mature business, growing to death is often the result of unplanned growth opportunities. It’s ironic that seizing a major sales contract or a big new client can be your business’s ruin but it’s more common than you think.  More often than not it’s an issue that business operators don’t identify until it is too late.

Many business operators are very good at what they do.  Most have an excellent knowledge of the business they conduct and understand their products and services.  Most also have an in-depth knowledge of sales performance and revenue.  Few however have a high level of financial management expertise, so when a big new opportunity presents, critical financial questions are not asked.  As a result, there can be a sudden and unintended impact on their financial position. A rush of sales might be a great thing but it is not always counterbalanced by a rush of income and profit. Free cash and liquidity are the victims.

Big one-off opportunities can also be dangerous because they are rare. For businesses without strong financial management and control, there is simply no way of understanding what impact the opportunity will have until they have experienced it. With no background history to rely on, the warning signs of impending financial crisis don’t appear.

Sudden growth comes at a cost. That cost can be at a profit or at a cash flow level. Profit and cash flow are not the same and where operators don’t have a lot of financial expertise they generally rely on profit analysis without considering the cash flow implications. You need to understand the cash cycle and its timing within your business.

The first step is to understand that sudden change creates a different dynamic and brings cost and cash flow implications with it. It’s essential not to embark on sudden change without identifying what these implications are.

Let’s look at an example:

Jonathon runs a typical small business. Since taking over the established business a year ago growth has accelerated. The primary product of the business is brought in from overseas. The business is predicated on a budgeted turnover of $70,000 - $100,000 per month. The working capital in place accommodates the business operating at this level which is already a step up from where it was when he bought it.

Jonathon knows the business has a lot of potential and he’s been working hard to fulfil its promise. He’s ecstatic because he’s brought in five major sales all within the $50,000 - $200,000 range and all expect delivery within the coming 3 months. While the big sales required a dip in the gross profit margin, it’s still doable.

If all of the orders come through, the impact of the new sales will take his turnover from its current level of $100,000 per month to an average of $250,000 per month for the next 3 or 4 months. If you imagine yourself in Jonathon’s place, it would be hard not to be impressed with your efforts wouldn’t it? What a boost to the company.

Now add in another factor. The primary product is purchased from the supplier without trading terms so the outlay for any major sale is in advance. As a result, the cash flow implications of the time between each sale, the purchase of the product from the supplier, fulfilment and payment by the customer is critical to understand.  For Jonathon, the highest risk is the major outlay of cash required to fulfil the sale. He cannot buy time.

When Jonathon had a cash flow analysis put in place to determine the impact of the new sales it revealed that he needed $200,000 to $300,000 more cash than he had. He knew it might be tight but didn’t realise the situation was that stark. As a result of the analysis, Jonathon was able to work with the customers to stage the orders and manage the cash flow requirements.

Had he fulfilled the sales without the analysis, he would have had a funding gap of approximately 60 days where he was exposed by $250,000 without the capital base to support him.

While the details might be different, situations like Jonathon’s are not uncommon. The problem is that unless you have strong security, the chance of any bank giving you an increase in funding is unlikely. Banks want to lend to businesses that have good financial management. If you approach them once a problem such as Jonathon’s has occurred, you have already proven the case in the negative and set yourself up for rejection.

In the example above, cash flow was the major issue. In others it is profit. Large customers with large orders may expect you to cut your margin.

Or, they might ask you to discount if they ‘up the order’. The danger is that you, or your sales people, get carried away with the headline number and don’t look at the profit contribution. Some sales, even big sales are simply not worth it as you can’t trade below a certain profit level. For businesses with higher fixed costs your ability to negotiate your margin is less flexible than those with higher variable costs. The key is to know your break-even point before entering into any deals.

And, discounting can be its own trap. For example, if your margin is 40 per cent and you reduce your price by 10 per cent, you need a 33 per cent increase in sales volume to maintain your profit level!

Warning on Bank advice to business owners

Some banks are advising customers with business accounts to transfer excess cash to pay down the business owner’s home loan.  While it might sound like common sense to use the excess cash in your business, there are significant potential problems for business owners who do this.

Money in your business account is the money of the business, not your personal cash.  You can’t just take it out and move it around at will, even if it is your business.  

If you run a company, there are a set of tax rules called Division 7A that apply.  Division 7A is a particularly tricky piece of tax law designed to prevent business owners accessing funds that have not been taxed at their individual tax rate – only the corporate rate.  While these amounts are often debited to the shareholder’s loan account in the financial statements, Division 7A ensures that any payments, loans, or forgiven debts are treated as if they were dividends for tax purposes unless there is a valid shareholder loan agreement in place.

So, if you take money out of your company bank account to pay down your personal home loan, this amount might be treated as a deemed dividend.  That is, you need to declare this amount in your personal income tax return and the dividend is not frankable. This means that even though the company might have already paid tax on this amount, you will be taxed on it again without the ability to claim a credit for the tax already paid by the company (basically leading to double taxation).

If you have taken money out of the company account for personal purposes you can either pay back the amount or put a complying loan agreement in place before the earlier of the due date and actual lodgement date of the company’s tax return for that year.  To be a complying loan agreement the agreement requires minimum repayments to be made over a set period of time and the minimum benchmark interest rate to apply – currently 5.45%. The rules are also very strict when it comes to loan repayments because these can actually be ignored if it looks like you are planning to borrow a similar or larger amount again from the company.

A similar issue can also arise if you transfer funds from a trust bank account, especially where that trust already owes amounts to a related company in the form of unpaid distributions.

The material and contents provided in this publication are informative in nature only.  It is not intended to be advice and you should not act specifically on the basis of this information alone.  If expert assistance is required, professional advice should be obtained.