In April 2000, Forrester Research predicted that, due to the combination of weak financials, increased competitive pressures and investor flight, most of the online retailers that existed at that time would be out of business by 2001. Whilst the number of dotcom retailers that have gone out of business in the past 12 months has yet to be determined, there is no doubt that the year 2000 was a battle for survival for most online retailers.
This situation will probably continue well into the current year. For many of those that remain, cash reserves are running low, and for others, those reserves may actually run out well before achieving profitability. In fact, it has not only been the online retailers that have had a difficult year, other sectors such as information services have also struggled.
The options for those dotcom entities that are going out of business are few: fold, merge with another entity or sell the business. Any one of these options can have a number of significant tax effects.
Unique to dotcom start-ups
Those start-ups that are struggling and are considering restructuring or disposal of their business typically have a few common characteristics that are meaningful for tax purposes:
- They are generally in a tax loss position (if not currently then at least in the past with carried forward tax losses available for future utilization);
- They maintain a high level of capital investment (namely computer related equipment and software); and
- A large proportion of the company’s value can be attributed to intangible assets such as goodwill and/or the value attributed to the development of a web site or the value of a advertiser or customer base.
Merge with another entity
Basically, the concept of merger is not recognized within Hong Kong’s tax law framework. In general, where there is an economic merger of two Hong Kong entities, the transaction is generally effected as a transfer of assets from one entity to another and a cessation of business of the old entity. The tax implication of a transfer of business is discussed in greater detail below.
Sale/transfer of business
A business can be sold or transferred by one of two means: the sale of the shares in the business or the sale of assets owned by the business. Each method has its advantages and corresponding disadvantages from a tax perspective, depending on the tax status of the buyer and seller.
For the purposes of this article let’s consider the following scenario. Company ‘A’ intends to purchase an online retail operation currently being operated in Hong Kong by an unrelated company, ‘C’. The principal assets of ‘C’ are a web site, subscriber base and certain computers and equipment. ‘C’ has accumulated tax losses; ‘A’ does not have any accumulated losses and is in a tax paying position. ‘A’ will finance the acquisition of ‘C’ by way of bank borrowing.
With the above scenario in mind, lets consider some of the issues that could arise purely from a Hong Kong tax perspective.
Deductibility of acquisition costs (interest)
Generally, an entity is able to claim a deduction for interest expense where that interest has been incurred in the production of assessable income. By ‘A’ acquiring the shares of ‘C’, ‘A’ will not be able to get tax relief for the interest expense as ‘A’s’ income would be non-taxable (dividends from ‘C’). If ‘A’ acquired the assets instead, the interest from the loan would then be deductible for ‘A’ because the loan is now financing the assets which generate taxable profits.
Losses carried forward
It is not uncommon to see internet-related start-ups with operating losses, as invariably the income generated in the initial years of operation is insufficient to cover operating expenses. Losses for tax purposes typically exceed operating losses due to the timing differences created by generous tax depreciation allowances. For example, prescribed assets such as computers can be fully depreciated for tax purposes in the year of purchase. It should also come as no surprise that internet-related businesses hold mostly prescribed assets. The effect of which can be that significant carried forward losses for tax purposes can be accumulated in the first few years of a start-up’s operations.
By ‘A’ acquiring the shares of ‘C’, ‘A’ will not be able use the losses accumulated by ‘C’ to offset its own taxable income as there is no group tax relief in Hong Kong. It may only use the losses to offset future taxable income of ‘C’.
Alternatively, if ‘A’ was to purchase the “assets” of ‘C’ and not the company itself at market value, it would create a balancing charge (taxable income) for which ‘C’ would be accountable. This taxable income would, however, be sheltered by tax losses held by ‘C’. ‘A’ could in turn depreciate the fixed assets purchased. Essentially, the tax losses of ‘C’ could be transferred to ‘A’, thereby reducing the tax profits and tax cost of ‘A’ immediately after the acquisition.
Value of assets to be transferred
There is the chance of conflict when allocating the proceeds of the sale. Company ‘A’ will want to allocate as much expenditure as possible to the assets in respect of the tax deductions they can claim, whilst minimizing the value placed on the acquisition of goodwill, subscriber base/advertiser contact lists, as such expenditure is non-deductible. Conversely, Company ‘C’ may seek to maximize the value attributable to goodwill subscriber/advertiser contact lists because the proceeds it receives in respect of the same will be non-taxable.
Stamp duty
Stamp duty only applies to the transfer of stock, therefore it will only be a consideration where shares of a company are being transferred.
It would appear, from the scenarios above, that when a vendor of a business is in a tax loss position, it may be more appropriate to sell the assets of the entity rather than the entity itself. In situations where it is important that the entity is to be purchased outright, a tax efficient structure can still be established, although it will involve using a debt pushdown type of structure.
In conclusion, the decision to sell or acquire an entity will invariably depend on a number of factors, with tax considerations merely being one of those factors. However, tax should always be given some consideration, given the implications of a transfer of a business.
Stephen C Bruce, manager, Tax & Legal Support Services, PricewaterhouseCoopers. Email: [email protected].
