What is an earnout arrangement?

Earnout arrangements are commonly used in the sale of a business when buyer and seller cannot agree on how and/or when the sale price should be paid. Under an earnout arrangement, the parties usually agree to pay the full consideration based on the future performance of the business. This commercial arrangement is struck to give confidence to the buyer that an excessive price is not being paid.

The application of the Australian income tax and capital gains tax (CGT) laws to earnout arrangements has been uncertain for a number of years. However on 25 February 2016, laws were enacted to clarify the tax treatment.

These laws now, finally, apply to rights created under an earnout arrangement (earnout rights) in a way that reflects the economic reality. The law now looks through the earnout arrangement to link later contingent payments to the consideration for the sale of the business. Further, earnout rights themselves are disregarded, for tax purposes, as separate CGT assets.

Why did the law need to change?

In 2007, the Commissioner of Taxation issued a draft Taxation Ruling TR 2007/D10, setting out the Australian Taxation Office (ATO) view regarding the application of the tax and CGT laws to earnout rights. That Ruling confirmed that rights created under an earnout arrangement were separate CGT assets for tax purposes. Although that conclusion was not itself controversial, some undesirable tax consequences resulted.

First, the seller’s capital gain on the disposal of their business asset had to be calculated by including in capital proceeds all money, plus the value of any property received by the seller in relation to the disposal. Because the seller’s consideration for the sale includes an earnout right, that right had to be valued at the time of the business disposal in order to calculate the seller’s capital gain.

In practice, valuing an earnout right is challenging; indeed the premise of the earnout arrangement is that the value of the right is contingent on many factors that affect the future performance of a business.

Second, assuming that the earnout right could be valued at more than zero, the seller’s capital gain at the time of the original business sale would include that value, meaning that CGT was payable on money yet to be received by the seller.

Third, the buyer’s later payments under the earnout would not be included in the buyer’s cost base for the underlying business asset – only the value of the right provided at the time of the purchase would be included in the cost base.

Finally, the occurrence of a second CGT event on realisation of the earnout right, meant that certain CGT concessions that would apply to the original sale (for example the general 50% discount and the small business CGT concessions) may not apply to amounts paid for the creation of the earnout right or the subsequent financial benefits provided under the right.

These adverse consequences led the Federal Treasury to consult on changing the legislation to better deal with earnout arrangements. A discussion paper released in 2010 advocated for ‘look-through’ capital gains tax treatment for qualifying earnout arrangements.

This treatment was strongly supported within the taxpayer and tax professional community, and after much debate, was followed by the release of draft legislation on 25 April 2015, Parliament finally passed the amending law which was given royal assent on 25 February 2016.

How does the law apply now?

The new law overcomes many of the adverse consequences noted above by, principally, disregarding any capital gains or losses arising in respect of earnout rights – that is, the creation of a separate CGT asset (the earnout right) does not give rise to CGT events subsequent to the business disposal event.

Instead, the law ‘looks through’ the earnout arrangement, and links earnout payments to the disposal of the business (the earnout payments are included in the sale price of the business and the cost base for the buyer), but only when they are actually paid. This is effected by allowing the taxpayer to amend the income tax return for the year in which the original CGT event occurred (the year in which the business was originally sold). The amendment period extends up to four years after the last potential financial benefit under the earnout right was due to be paid.

The amendments will only apply to ‘look-through’ earnout rights, specifically defined in the amending legislation, and only to earnout arrangmenets entered into on or after 24 April 2015. Certain ATO administrative protection is also given to taxpayers who have entered into earnout arrangements prior to 24 April 2015 and have reasonably and in good faith anticipated changes to the tax law.

What now?

These amendments have clarified the tax treatment of earnout arrangements, restoring the attractiveness of earnouts in negotiating a business sale or purchase. If you are contemplating an earnout arrangement in the context of a business sale or purchase and are unsure about how the new laws apply to you, please contact me for advice.

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