With a proposed capital gains tax the major talking point at the moment, Philip Morrison of Franchise Accountants looks at possible implications for franchisors and franchisees
The Tax Working Group (TWG) interim report released last week proposed the introduction of a Capital Gains Tax (CGT) that could raise billions of dollars in tax for the government by taxing profits on the sale of property, shares – and businesses.
While this is an interim draft submission only and is likely to change once it has gone through the parliamentary process, the uncertainty may send shivers down the spine of franchisors and franchisees for whom the development, growth and sale of businesses is an inherent part of their model.
However, it’s too early to make any real plans. The advisors to the TWG were divided on the submissions, so proposals are likely to be subject to robust debate in the coming year – and an election after that. We therefore suggest taking a cautious ‘wait and see approach’, looking at options, but waiting until the finalised form of the proposals is known before taking any major decisions.
What is captured in the new tax (CGT)?
The TWG propose that profits from sale of appreciating assets such as businesses, intellectual property, shares and land investment property will be subject to tax.
What is specifically excluded from CGT?
The TWG has ruled out the family home and the land it stands on.
When would the proposed CGT be introduced?
The new tax is likely to be introduced from 2021 at the earliest for assets (ie. businesses, shares, land, etc). If the same approach is taken as with other tax changes the changes could be effective from, say, 1 April 2021, and would only apply to new assets purchased after this date. So there will be two sets of rules applied.
The alternative is that they nominate a ‘Valuation Day’ for assets already owned. That is in the hands of the politicians to decide. If this approach is adopted, we could potentially see a number of business owners exiting prior to this date and a glut of businesses, land, shares and investments on the market.
It may also encourage the investors who usually buy franchise businesses to re-assess the returns or yield from any such purchase.
What is the proposed CGT tax rate?
The TWG propose linking CGT through the existing income tax system. This means the CGT tax rate applied would be applied at the marginal tax rate of the individual, so it will correspond to the tax PAYE tables.
For example: You originally purchased a business for $700,000 and sold it for $800,000. You will pay tax on the Capital Gain of $100,000. In addition to this, you have a salary of $70,000. Your assessable income will be $170,000. In this example, the $100,000 profit on the sale of your business would be taxed at 33c in the dollar.
Tax Credits on Losses
But what if the business is sold for less than you originally paid for it? At the moment, any capital lost on a franchise sale is a straight hit for the vendor; if a tax credit is allowed against loss on sale of a business, this could potentially be seen as reducing risk. Given the level of information provided so far, it is too early to provide any comment on this.
Personal Income Tax
The TWG has proposed increasing the bottom tax threshold. The adoption of this would help both business owners who employ staff, and their employees. This will see some pressure coming off low wage and salary earners who would have more pay in their pay packet.
How could this affect franchising specifically?
If the proposed tax changes are finalised and passed into law, then:
Franchise Agreements and relevant documentation will need to be updated, specifically with regard to complying with CGT legislation. For resales, the tax implications will be the responsibility of the franchisee, and there will need to be clarification of the basis on which any transfer fees are calculated – eg. on the Gross Sale value or after CGT?
Franchise Business Valuations. In the event that CGT is imposed on existing businesses via a ‘valuation day’, this could have far-reaching implications for the ultimate return on investment that a franchisee might achieve. It might depend on what valuation method is adopted or approved.
Franchise Business Re-Sales. The impending introduction of CGT could see some franchisees taking the opportunity to exit. Given the ongoing shortage of suitable new franchisees, this could also impact upon business values and franchisor growth prospects. There could also be some problematic tax issues around tax treatment in certain circumstances – for example, tax symmetry.
Franchise Recruitment. It is too early to speculate as to how the proposed CGT will affect the appetite of New Zealanders to invest their capital in buying a franchise. Will it see constraints on the capital people are looking to invest in buying a franchise business? Will it see franchisors change where they price start-up franchises to attract capital investment? Will franchise models need to be adjusted so that profit upon resale becomes less important?
Franchisee Due Diligence. CGT will be an additional element to consider prior to purchase, depending on the final form that any CGT takes. Could it work in the franchisee’s favour? Anything that encourages more robust pre-purchase evaluation process before investing in a franchise opportunity could help ensure more realistic expectations.
Family Home Exception. Some franchises promote themselves as home-based operations, or at least require admin and office work to be carried out from home. Whilst in most cases the family home is excluded from CGT, there are some circumstances where CGT may apply.
There are some tests around what is defined as a family home and what is not. For example, the property of a family home is limited to 4500m2, so if you own a 10,000m2 property, then if a gain on sale is made, CGT may apply proportionally. Also, if you operate a business from home there may be some matters you will need to take further advice on once the details on this are known. What seems a simple exclusion from CGT can get complicated.
Tax Planning for Franchisees. Franchisees with a profit on sale will need to factor in how to fund the additional tax. The treatment of loss on sale of a business would also be an element to consider, although as noted above little is known about this yet. What is certain is that the introduction of CGT is likely to place increased compliance costs on franchise business owners and the requirement to be better informed around tax matters.
These views are based on the TWG proposals published to date, which are likely to be changed before coming into law. The final shape is likely to be known in next 12 months but not enacted until 2021 – if then. Ultimately, the machinations of our political system will determine the final form of CGT. This is likely to be a topical election issue and its ultimate fate will be decided at the ballot box.
There are pros and cons of any tax changes. Widening the tax base is often seen as spreading the tax burden, and any tax changes should be measured against balancing the social and economic impacts. Where inflation increases the value of land-based assets, one could see it as a stealth tax. Others might say a better-funded government is more able to deliver its social contract and serve the needs of the country.
Whatever the eventual outcome, business will go on and franchising will continue to play a major part in the economy of New Zealand. For now, we advise that franchisors wait and see what the final form of a proposed CGT takes and then work from an informed position. Stay informed and seek tax advice from your trusted tax advisor.
Disclaimer: The views of this article are of a general nature only and are not a substitute for seeking tax advice, nor should reliance be placed on this. Each person’s circumstances can vary and need to be evaluated on their own merits. We therefore recommend you obtaining a tax opinion from your trusted tax advisor.