Understanding the new Purchase Price Allocation Rules

On 1 July 2021, a new law known as the Purchase Price Allocation Rules comes into effect.

The rules are designed to ensure that where a Sale and Purchase Agreement strikes an overall price that includes two or more different categories of an asset, the vendor and purchasers tax position with respect to the allocation of price between the asset classes must be aligned.

The IRD believe that historically there have been issues with vendors and purchasers taking different tax positions on the values allocated to assets acquired together that have led to slippage in the tax system.

An example of this might include the vendor of a commercial building disposing of fit-out assets at book value (what they are recorded at in the accounts at any point in time after subtraction of accumulated depreciation from cost) and avoiding a depreciation recovery where the purchaser engages a valuer to value the fit-out and ends up allocating far more value these items, he depreciates than the vendor has.

The new rules cover commercial property transactions over $1,000,000 and residential transactions over $7,500,000.

The rules will also capture business sale transactions and farm sales, given both of these include different classes of assets.

The new law requires the parties to approach the allocation of value with respect to the market values of the assets.

The rules will apply to all contracts entered into after 1 July 2021.

There are two methods by which values can be allocated:

1.       By agreement between the Parties.

2.       Where the parties don’t agree, by applying a “Unilateral Allocation” where the first right to allocate values falls to the vendor and if they don’t make a unilateral allocation, the right falls to the purchaser.

The law provides the IRD with an overriding power to require the parties to adopt a different allocation if they consider the agreed allocation doesn’t reflect the market value of the assets. That said, it would seem very unlikely that the IRD will exercise this power if the parties have agreed the allocations in writing as their principal concern is to ensure that the tax positions of both parties are driven from the same allocation of value.

It’s important to understand that the new rules do not require value to be allocated to individual asset items. Only to six specific classes of asset.

These classes are:

1.       Trading Stock

2.       Timber or the right to take Timber

3.       Buildings

4.       Depreciable property other than buildings (fit-out items)

5.       Financial arrangements

6.       Property for which sale does not give rise to taxable income for vendor or purchaser, e.g. land

 The current ADLS sale and purchase agreement for Real Estate is in the process of being updated to reflect the ability to allocate value across the asset classes although it seems this will not be released before the law comes into effect on 1 July.

It will be best practice to reach agreement on price allocation in the sale and purchase agreement but this is not a specific requirement. Parties can reach agreement together any time before the date for filing their respective tax returns.

If the parties fail to reach agreement the vendor has the first right to make a unilateral price allocation under section GC21. This right runs for 3 months from the settlement date.

If the vendor fails to file a unilateral allocation within this 3-month deadline the right passes to the purchaser.

Under a unilateral allocation, no value can be allocated to depreciated property below its tax book value, meaning the vendor will lose the opportunity to claim a loss on disposal if assets are in fact worth less than their book values.

If nobody notifies an allocation the commissioner will determine allocation. In this situation the purchaser is denied any deductions until the year after IRD confirms allocation. This rule is designed to incentivise parties to resolve allocation.

A unilateral allocation notification must contain:

1.       Name and IRD numbers for both parties

2.       Date of agreement and settlement

3.       Total consideration paid

4.       Amounts allocated to each asset class including zero if some have no allocation

5.       A statement that amounts are allocated in accordance with GC21

These new rules are set to have wide reaching impacts during negotiation. The vendor clearly has the upper hand given they can draw up auction terms and conditions and have first go at a Unilateral allocation.

Problems could also develop if the parties aren’t clear about who owns the fit-out items. In many cases, fit-out will have been paid for and owned by the tenant and ownership of it does not transfer with a land sale.

As always, parties to property transactions should seek independent tax advice before entering agreements.

Addenda for inclusion into Sale and Purchase agreements

The Real Estate Institute of NZ has recently released an Addenda that is being recommended for inclusion into Sale and Purchase agreements for property, tender documents and business sales. This Addenda foreshadows the release of a new standard form agreement.

There is however one very important aspect of the Addenda that vendors particularly should be aware of before signing an agreement that adopts it.

The Addenda actually seeks to remove the vendors first unilateral asset allocation right under section GC21.

Instead, the Addenda contractually binds the parties to find agreement together and forbids a vendor from making a unilateral allocation and filing it with IRD.

The Addenda prescribes a process whereby parties that can’t agree appoint a suitably qualified valuer to value the asset classes and the parties agree to be bound to this valuation.

The rationale for this is that the legal fraternity has a problem with allowing a purchaser to enter an agreement where the vendor has the first unilateral allocation right and the power to bind a purchaser to it if they can’t find agreement together.

So, vendors must appreciate that the standard form addenda, and presumably the new sale and purchase agreement when finally released, will remove these rights that the law has given.

I can anticipate circumstances where vendors will try to strike out these provisions and retain their GC21 unilateral allocation rights.