Not all taxpayers may be aware of how the use of valuations can affect their annual tax bill.
Estimates are most commonly used in apportioning expenses between private and business use. More important however, is the use of valuations to estimate the cost of transactions that are not arm’s-length or when no actual cash changes hands. A common example of this is in respect of property transactions.
The Tax Office has recently issued guidance about penalties that could arise when valuations are not done correctly. A general understanding of how the Tax Office expects valuations to be done is necessary so there are no nasty surprises when the assessment arrives. The best way to demonstrate how valuation rules apply is to look at how this guidance applies to property.
Why are valuations in property transactions important for tax?
There are times when a valuation is necessary for tax purposes. For example, let’s say that Humbert transfers his rental property to his daughter Dolores for no consideration. The CGT rules require that the transfer be made at “market value”.
If Humbert has held the property for a lengthy period of time and the property has increased significantly in value at the time of transfer, then he will be up for quite a hefty tax bill. This is so even though he has not received a single cent by gifting his property. In order to work out the extent of any capital gain, Humbert will need to obtain an appropriate market valuation of the property that appropriately reflects an arm’s length value.
While the Tax Office admits that the process of valuing an asset can range from being simple to complex, the principles remain constant. The valuation deals with a concept of market value based on the highest and best use of the asset in question.
It is recognised by valuation professionals, and tested in the courts, that particular valuation methods are more appropriate for some valuations than others based on the information available. The market value should use the most appropriate valuation method.
For commodity products, the comparable arm’s length sales data is considered the most appropriate method, or for a mature company, discounted cash flow or a multiple of Earnings Before Income Tax (EBIT). Many valuations also use one or more secondary methods to cross check the value determined from the primary method.
Where a market exists for an asset, that market is widely considered to be the best evidence of market value of the asset (because naturally the “market value” is the value that the market is willing to pay).
Valuing real property
The most appropriate method for the valuation of real property is “highest and best use”. The concept of highest and best use of the property in the market takes into account any potential for a use that is higher than the current use of the property, for example development potential based on council approvals. Factors to consider would be current market transactions, current market trends and condition of the property.
A valuation should be undertaken by a suitably qualified and experienced person in relation to real property valuation, and be fully documented to explain how the value was determined. As with many tax issues, substantiation is extremely important and the Tax Office may not accept the market value determination if the document is not “fit for purpose”.
It is also possible to apply for a market value private ruling from the Tax Office (ask us for more information on this option).
Safety grey zone
The Tax Office makes it clear that there is some fall-back for people whose intentions are on the right side of the rules. “The majority of taxpayers who use a qualified valuer or equivalent professional for taxation purposes will generally not be liable for a penalty if they have provided the valuer with accurate information where the valuation ultimately proves to be deficient,” the Tax Office says.
It uses the example of a real property valuation prepared by a qualified valuer, or an estimate of historical building cost made by a quantity surveyor. “Relying in good faith on advice of this nature is consistent with the taking of reasonable care,” the Tax Office says, “even though the advice later proves to be deficient.”
Even fall-backs have limits
But even when using the services of a qualified professional, the Tax Office says there may still be potential penalties for making a false or misleading statement, or for treating the tax law “in a manner that is not reasonably arguable”.
The Tax Office says this could be the case if:
- the taxpayer has not given correct information to the valuer to allow them to correctly assess the value of the item for the period required,
- the taxpayer or their agent should reasonably have known that the information provided by the value was incorrect, or
- the methodology or valuation hypothesis used by a qualified valuer may be based on an unsettled interpretation of a tax law provision or unclear facts.
As with all such matters where an element of informed judgement is called for, taxpayers may be well advised to seek out, and document, the wisdom of a tax professional.