Updated market valuation guidance from the ATO

This Tax Insight examines the updated guidance issued by the Australian Taxation Office (ATO) in October 2022 on market valuation for tax purposes.

Importance of Market Valuation in a Tax Context

Valuing an asset can be challenging. This is particularly so in the context of the Australian tax system, which features at least 206 different provisions that may require a taxpayer to determine the unrealised value of an asset or liability or an alternative value to a realised asset or liability^[1].

Examples of such provisions include:

•  Market value substitution rules used for domestic Capital Gains Tax (CGT) and income tax purposes;
•  Transfer pricing rules affecting non-arm’s length international dealings;
•  Indirect tax rules such as the Goods and Services Tax (GST) margin scheme rules; and
•  Asset threshold tests such as those in relation to the Small Business CGT concessions.

Key Features of the Updated Guidance

The ATO’s updated guidance is comprehensive and sets out its view on a range of matters, including:

(a) Definition of market value for tax purposes;  
(b) Who can determine market value for tax purposes;  
(c) Valuation fundamentals for tax purposes, including:

(i) Eight guiding principles;  
(ii) Valuation approaches and methods;  
(iii) Expectations in relation to valuation reports, including common issues.

(d) ATO’s approach to reviewing valuations.

Each of the above matters is considered, in turn, below.

(A) DEFINITION OF MARKET VALUE FOR TAX PURPOSES

Market value generally takes its ordinary meaning for tax purposes, although that meaning is modified in some cases by Subdivision 960-S of the Income Tax Assessment Act 1997 (ITAA 1997), e.g., the requirement to disregard input tax credit entitlements in arriving at market value.

In the updated guidance, the ATO refer to the seminal High Court decision of Spencer v Commonwealth of Australia [1907] HCA 82 (“Spencer”) wherein it was established that in valuing an asset, a valuer must assume a notional sale by a hypothetical buyer to a hypothetical seller, with the notional sale assumed to be made after voluntary bargaining between a ‘willing but not anxious’ seller and purchaser (i.e., rather than a forced sale), with both counterparties fully informed of the advantages and disadvantages of the asset being valued and aware of prevailing market conditions. 

Critically, market value does not reflect attributes of an asset of value only to a specific owner or purchase (e.g., potential synergies of contiguous tenements in a mining context). Market value requires any such element of value to be disregard, because at any given date it is only assumed there is a willing buyer, not a particular willing buyer.

The principles of Spencer align to the International Valuation Standards Council’s (IVSC) definition of market value, which is:

‘The estimated value for which an asset or liability should exchange on the valuation date between a willing buyer and a willing seller in an arm’s length transaction, after proper marketing and where the parties had each acted knowledgably, prudently, and without compulsion.’

Practical example

The Spencer market value requires the valuer to consider all facts and circumstances of the target company being valued. For example, let’s assume a local subsidiary of a large multinational company is being valued. The subsidiary’s operations involve the distribution of the foreign parents’ products in Australia, which is governed by a master distribution agreement with the foreign parent. Assuming no other facts, the local subsidiary will be valued as a typical distribution business.

Let’s now assume the master distribution agreement allows the foreign parent to terminate the agreement without cause by providing 30 days’ notice. Applying the Spencer market value principle, the valuer should consider whether a hypothetical buyer would be willing to pay for more than 30 days’ earnings, assuming no amendments are made to the agreement.

This could have a material impact on the concluded market value of the local subsidiary. In contrast, when assessing the reasonability of the terms of the master distribution agreement from a transfer pricing perspective, the termination clause may be ignored, illustrating how the same fact may be considered differently for different taxation purposes. Accordingly, adjustments may need to be made to reconcile transfer pricing requirements with what is being valued.

(B) WHO CAN DETERMINE MARKET VALUE FOR TAX PURPOSES

The updated guidance is predicated on the notion that the acceptability of valuation is generally dependent on the valuation process undertaken and not who conducted it, subject to the qualifications that:

•  A reasonable estimate of market value ‘requires skill, knowledge and experience’; and
•  Only prescribed professionals may value certain asset classes (e.g., formally registered persons for Property, Plant and Equipment).

The ATO note that the IVSC is the independent global standard setter for the valuation profession, that most professional bodies adopted the International Valuation Standards (IVS), and that it will accept valuations complying with the IVS (observing also that compliance therewith will add credibility to a market valuation).

(C) VALUATION FUNDAMENTAL FOR TAX PURPOSES

The substance of the updated guidance is arguably the valuation fundamentals for tax purposes, which provide relevant practical instruction to taxpayers.

(i) Eight guiding principles

The updated guidance enumerates the following eight guiding principles:

1. Valuations should be specific to the tax or superannuation provision being applied, taking into account pertinent requirements, including those arising from ATO guidance and case law;
2. Market value is conceptually distinct from historical cost;
3. The nature and source of valuation inputs must be consistent with the bases of value (i.e., fundamental premises on which the market valuation will be based) and the valuation purpose;
4. The valuer should adopt the most relevant and appropriate valuation methodology based on industry standards and practice, which could be influenced by such issues as the data available or circumstances relating to the market;
5. The ATO recommends (where possible) using a secondary or cross-check methodology to provide additional support for an estimated value from the primary methodology;
6. The valuation process requires the valuer to make impartial judgments as to the reliability of inputs and assumptions. Such judgments should be made in a way that promotes transparency and reduces subjectivity (e.g., state the inputs, and assumptions made);
7. The valuer should retain evidence to ensure the valuation is properly supported;
8. Market valuation for tax purposes requires a valuation for a date specified by the legislation and a prospective assessment will not be considered reasonable or acceptable.  
    

(ii) Valuation approaches and methods

The updated guidance references the following three internationally-accepted valuation approaches:

•  Market approach – estimating market value by reference to market prices in actual transactions and asking prices of assets currently available for sale – essential that of comparison and correlation between the asset to be valued and other similar assets;
•  Income approach – estimating market value based on the income or cashflows that the asset can be expected to generate in the future; and
•  Cost approach – estimating the market cost of replicating the valuation asset in a similar conditions as at the valuation date as a suitable indicator of market value.

The updated guidance notes that within each valuation approach, there are a range of valuation methods that can be used by a valuer to determine market value. For example, when using the ‘income approach’, the valuer might choose to apply the discounted cash flow method, the capitalisation of earnings method, or other applicable methods within that approach.

The primary valuation methodology should be the most suitable approach and method for the valuation asset, determined by reference to the relevance and reliability of information available at the valuation date.

(iii) Expectations in relation to valuation reports, including common issues

The updated guidance sets out the ATO’s minimum expectations in relation to a valuation report, noting that the objective of a valuation report is to provided convincing and compelling support for the conclusions reached.

Common issues identified by the ATO in reviewing market valuation reports include:

•  Inappropriate choice of methodology;
•  Incorrect application of methodology;
•  Misalignment between the methodology and the relevant tax or superannuation provisions, case law or ATO guidance;
•  Unreasonable or incorrect assumptions;
•  Inappropriate apportionment of value across assets;
•  Lack of appropriate analysis and scrutiny of base information;
•  Failure to verify inputs; and
•  Omission of assumptions from valuation reports.

These common issues, together with the ATO’s specified minimum expectations, provide taxpayers and valuers with clear instruction on what valuation reports must and must not contain. 

(D) ATO’S APPROACH TO REVIEWING VALUATIONS.

Finally, the updated guidance provides insight regarding the ATO’s review process in relation to market valuations, as well as the ability of taxpayers to obtain private rulings from the Commissioner of Taxation on an asset’s value market, provided it is relevant to a question of tax law.

Referring to the former, it is self-evident that the likelihood of an ATO review will generally correspond to an asset’s value or the level of contention associated with the valuation methodology used.

When reviewing a market valuation, the ATO will use a valuer to confirm whether the purported market value is acceptable and assess whether the valuation process complied with accepted valuation industry practice. This process includes examination of:

•  How adequately the valuation process was documented;
•  The market value definition used;
•  The appropriateness of the chosen method; and
•  The underlying assumptions and information.

Depending on the circumstances, the ATO may engage independent professionals to verify taxpayers’ market valuations. In order to effectively and fairly review a market valuation, the ATO requires comprehensive valuation reports to be in place, as well as evidence that valuers have been appropriately instructed by taxpayers.

In summary, valuing an asset (or liability) is inherently complex, particularly in the context of Australian’s tax system. Fortunately, RSM Australia’s Corporate Finance and Tax teams have significant expertise in this area and are on hand to assist.

For more information

Please contact local RSM office if you require valuation support in the context of any of the (at least) 206 tax provisions that may require you to complete a market valuation.

^[1] Inspector General of Taxation, Review into the Australian Taxation Office’s administration of valuation matters: A report to the Assistant Treasurer, 2014, para 3.1 < Review into the Australian Taxation Office’s administration of valuation matters (igt.gov.au)>