On 1 July 2021 the way that most vendors and purchasers of commercial property enter into agreements for sale and purchase changed, with the introduction of the "purchase price allocation" (PPA) rules.
In this article, as we approach one year from the introduction of the PPA rules we:
- Recap on why the rules were introduced and provide a reminder of when and how the rules apply to commercial property transactions.
- Look at how the rules have been adopted and used in practice.
- Discuss the anomaly of agreeing PPA in sales by auction.
When and how do the PPA rules apply to commercial property transactions?
To recap, the aim of the new legislation is to have vendors and purchasers allocate purchase prices consistently for income tax purposes, preventing the practice of "mis-matched" PPAs, where vendors and purchasers adopt different allocations for the assets included in the transaction in their tax return.
The rules apply to all commercial property transactions of land and buildings greater than $1.0m.
The rules also apply to other property transactions, including rural transactions greater than $1.0m, residential transactions greater than $7.5m, and forestry transactions greater than $1.0m.
The rules do not apply to commercial property transactions less than $1.0m, residential property transactions less than $7.5m, or any transactions of bare land.
Where the rules apply, the vendor and the purchaser need to consider the allocation of the purchase price between the depreciable assets (building, fitout, chattels) and non-depreciable assets (land) when completing agreements for sale and purchase.
Vendors and purchasers should obtain accounting advice when negotiating agreements to ensure allocations that are most appropriate for their position. Inevitably, this may become part of the bargaining position between the vendor and purchaser when attempting to conclude an agreement.
How are the PPA rules being adopted and applied in practice?
To assist vendors and purchasers to address PPA when negotiating a sale, ADLS / REINZ released addenda to be used with the standard agreements for sale and purchase of real estate sales and for sales by Tender.
The addenda, if included in the agreement, provide for two situations: where the PPA is agreed between the parties; and where it isn't. If the PPA isn't agreed at the date of the agreement, then the addenda require the parties to agree it and includes a process for doing so.
In the absence of an agreed position between the parties, or the adoption of the ADLS/REINZ addendum in their sale agreement, the rules enable the vendor to unilaterally set the PPA (provided they do so within the required statutory timeframe).
To avoid being exposed to a vendor's unilateral allocation, purchasers should endeavour to negotiate and agree the PPA, or ensure the addendum is included, before entering into the agreement. Failure to do so could significantly impact a purchaser's tax position (for example, by leaving a purchaser with a lower than expected allocation for depreciable property).
The IRD does retain the power to override an allocation if it considers that it does not reflect the relative market value of the assets, so this does provide a layer of protection. However, the IRD is less likely to intervene where the parties have agreed on the allocation in the sale and purchase agreement.
The ADLS / REINZ did not release an addendum for auction sales on the basis that it was not considered practicable for those agreements.
The fact that at an auction the purchase price isn't known until the hammer has fallen does pose a challenge in relation to PPA. How can the purchase price be allocated if it is unknown?
We think the best practice is for a vendor to provide for PPA in the auction sale terms. Choosing not to do so, or specifying that the vendor is to unilaterally determine the PPA, could shy potential buyers away, due to uncertainty.
From what we have seen in the market, most auction vendors are providing for PPA via the inclusion of a mechanism for completing the PPA once the price is known.
One way that this is being done is by specifying the amount to be allocated to the depreciable assets (buildings, fitout, chattels) in the auction terms, leaving the balance of the purchase price (once known) to be allocated to the land.
At the other end of the spectrum an amount is allocated to the land in the agreement and the agreement provides that the balance of the purchase price is to be allocated to the depreciable assets with the vendor to unilaterally determine the allocation.
Another way is to allocate the purchase price between land, buildings, fitout/chattels based on specified percentages.
Seek advice before contracting
Despite the new rules being in place for almost a year now, some vendors and purchasers may still be unaware of when and how the rules apply. That puts them in danger of an unintended or undesirable tax consequence.
We strongly recommend seeking tax and legal advice before entering into an agreement for sale and purchase to ensure you understand the tax and legal consequences of the PPA rules.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.