Coffeys - Tourism Property Brokers ltd. | LREA

30 years in business. 1984 - 2014

Depreciation

A Painful Recovery?

When selling a motel or other accommodation operation, the business value is generally appraised on an over-all basis to arrive at a figure relative to return on investment offered.  The chattels are usually not assessed separately and, provided an adequate repairs, maintenance and replacement program has been implemented, their “insitu” value should remain relatively steady.  The issue which almost always arises however, is the apportionment to tangible assets on the sale and purchase agreement.  The tangible assets (plant and chattels) will usually have been depreciated on the books for tax purposes.  The sum calculated for depreciation will be deducted from the taxable income and therefore reduce the tax liability for the operator in that financial year.

The problem arises when it comes to selling.  The purchaser (or their accountant) will normally like to see a high chattel figure apportioned on the agreement, so as to be in a position to also claim a reasonable amount for depreciation.  The vendor on the other hand would like to show the chattel value as low as possible, if possible at book value or close to, so as not to recover the depreciation previously claimed.  Any value apportioned to the tangible assets over and above book value, up to the original cost value, will be treated as income in the year of sale.  Whilst the seller is not really paying any additional tax, rather just paying tax that they have been able to defer, the tax in the year of sale can be a painful and sometimes unexpected liability.  Further to this, the depreciation will have been claimed in gradual amounts at the tax rate applicable to the overall income for each financial year.  If and when all of the depreciation is recovered in one year, it may effectively increase the taxable income for the operator to a higher tax bracket.  If so, recovered depreciation may be taxed at a higher rate than has been claimed along the way.

The process of reaching an agreement for the purchase of a business normally involves a certain amount of negotiation.  The sum apportioned to tangible assets can certainly be part of that negotiation.  An astute purchaser may buy at a better price if they see the advantage in agreeing to a lower chattel figure, reducing the vendor’s tax liability.  This of course means that the purchaser’s ability to claim depreciation will be reduced due to the lower figure as a starting point.  We believe though that this may be a good strategy for a couple of reasons.  Firstly, as mentioned above, chattel depreciation may not be saving tax but rather just deferring it until the time of sale.  A lower depreciation claim therefore is going to result in less recovery in the future.  The other twist is that capital gain on chattels is not taxable.  If the purchaser buys at a low chattel figure and claims little or no depreciation, they have less to lose (tax to pay) by offering quite a high chattel figure at the time they sell.  This would enable the next purchaser to benefit from the higher depreciation claims.  In other words, it has gone the full circle.  If the chattel figure is high enough, the next owner may be able to claim a reasonable amount of depreciation and still be able to sell at, or close to their book value later on.  An “arm’s length” sale and purchase agreement between two unrelated parties is normally sufficient documentation as to the agreed sale and purchase price for the chattels. 

It is not compulsory to claim depreciation on chattels or other tangible assets.  If a business owner elects not to depreciate the chattels at the outset, they can leave them on their books at the same figure, (plus any additional chattels purchased) and that will not be problem for them when they sell.  (They would also be able to offer a higher figure which would be a tax free capital gain.)  This way, the business owner knows that their tax liability is up to date at all times and they are not building up a potential depreciation recovery issue.

The intangible asset of “goodwill” is often split on a sale agreement and allocated to business goodwill and lease goodwill, the latter sometimes referred to as the benefit of the lease.  The lease goodwill can be depreciated, which is termed amortisation, usually on a “straight line” basis.  (As opposed to chattels which are depreciated on a reducing value basis.)  This means that the figure for lease goodwill is divided equally by the number of years left on the lease and that sum is written off against income at the same amount each year.  Whilst the amount of depreciation (amortisation) claimed for this aspect is usually less than the chattel depreciation, we often find that the closing book value figure is acceptable to a purchaser.  This may be because the lease goodwill component is not always available and therefore seen as a bonus to be able to claim this extra depreciation.  If the lease goodwill were to be recorded in a sale agreement at higher than closing book value, then the surplus over book value would be taxable.

In the case of land and buildings such as an investment property or a freehold going concern, the buildings, in most cases, are no longer able to be depreciated for tax purposes.  The owner of the real estate though, may have been claiming depreciation up until the commencement of the 2011/12 income year, when the depreciation rate for buildings (with an estimated useful life of 50 years or more) was reduced to zero %.  The building owner will therefore sometimes face the same depreciation recovery issues on sale.  Given that the purchaser is not able to claim depreciation on the building component (a situation which seems unlikely to change in the future), then there is again the possibility for them to make the proposal more attractive to the vendor by offering to buy the buildings at or close to book value. 

It must be stressed that this article is in no way intended to offer tax, legal or accounting advice.  One should always consult with a qualified professional on matters such as this.  If we are able to provide further clarification or information on this topic, we would be pleased to do so.

Kelvyn Coffey
Principal
© 2018

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