We were supposed to be talking about acquisitions, right? Surely not about formal tax law? Unfortunately, in view of recent case law, I cannot avoid dealing with formal tax law, as it can play a major role in acquisitions.
The importance of a required return plays a particular role in family takeovers and employee shareholdings. Usually children and employees do not yet have sufficient liquidity and do not succeed in financing the acquisition sum externally. And often the family or employer is willing to lend a helping hand as far as financing is concerned.
In practice, this is done by a 'soft loan' or a structure with cumulative preferred shares. Cumulative preferred shares are entitled to a fixed percentage return calculated on the value of those shares and they come before the ordinary shares in the distribution of profits. In this sense, they are also similar to a loan, although the legal differences from a loan are significant.
How does the Inland Revenue view this?
In situations of transfers to employees and family members, the Tax Office not only looks closely at the transfer price, but also at the financing terms. If the seller provides excessively "soft" financing, the Tax Authority will tax this benefit (for children or employee). With employees, the benefit is then considered (net) wages. With family members, there will soon be a distribution (dividend) plus a gift.
The required return
If a taxpayer does not file the required return, the burden of proof is reversed and increased. However, the Tax Authorities must first (!) make it plausible that an under-declaration has clearly been made and that the difference is considerable, both in absolute terms and proportionally, and that the taxpayer is aware of this.
Especially in situations where there is a wide margin for discussion (such as valuations), this division of the burden of proof can be of great importance. The taxpayer must then "prove" that the Tax Office's position is incorrect. However, the Tax Administration must act reasonably.
Recent case law
Recent case law shows that the courts usually follow the Tax Administration in its position after reversal of the burden of proof. In the case of an employee participation, the court ruled that the value of the employee's shares was 26x (!) as high as the price at which the shares were acquired. In that case, the value could be even higher now that the ruling has been referred (the Tax Court held that the value should be 260x higher).
A recent family ruling involved parents who had revenue from their ordinary shares into 4.25% cumulative preferred shares (cumprefs) and placed ordinary shares with the children. In this case, the court ruled that the burden of proof should be reversed because the required return had not been filed and found that the inspector's contention that a 36.5% return should be provided on the cumprefs (and thus there was a substantial distribution (dividend) and gift was reasonable.
According to the court, the required return had not been made because the differences were too great and it was already clear from further calculations by the taxpayer's own adviser that the 4.25% was not defensible (during the negotiation with the tax authorities, the cumpref return as increased to 7.5%).
Conclusion
Make sure that in the event of a business succession to children and employees, the Inland Revenue cannot claim that the 'required return' has not been filed.
