An earnout is a common way of structuring the purchase price in the sale of shares or business assets. They are often used where the parties cannot agree on the value of a company or business, and so agree to calculate and pay additional consideration based on the future performance of the company or business.
For the last eight years, the tax treatment of earnouts has been in a state of flux, and there has been much confusion around the proper application of relevant capital gains tax (CGT) concessions.
The current position
In 2007, the Commissioner of Taxation (Commissioner) released draft taxation ruling TR 2007/D10. In the Draft Ruling, the Commissioner viewed an earnout right as constituting a separate ‘financing arrangement’ and CGT asset. Practically, it meant that the seller needed to value that right at the date of the sale and be subject to CGT on that right when no cash might be received in respect of that asset until a future date. Also, as a separate CGT asset, in the Commissioner’s view the earnout right could not be subject to the CGT discount (because it was not held for more than 12 months) and was not an ‘active asset’ for the purposes of the small business CGT concessions.
The Commissioner’s position in the draft ruling caused an outcry among many tax advisers, which was exacerbated because the draft Ruling has been neither finalised nor withdrawn.
In 2010 the then Government announced that the tax law would be amended to provide a ‘look-through’ treatment for qualifying earnouts. The proposed amendments were then expanded on in a Discussion Paper released by the Treasury on 12 May 2010. Broadly, the Discussion Paper's version of a 'look-through' approach involved a 'cost recovery' model, under which a payment under the earnout 'recouped' the cost base incrementally, so an overall capital gain only arose once the cost base was reduced to nil. This treatment was akin to the outcome of tax free distributions under CGT event E4. Despite the promising outlook for clarifying the tax treatment of earnout arrangements, no relevant legislation was passed.
Recognising the confusion caused by a lack of legislation, the Australian Taxation Office (ATO) announced an administrative concession allowing taxpayers to apply either the proposed look-though approach or the Commissioner's approach in TR 2007/D10.
Five years after the proposed look-through amendments were announced by the former Government, exposure draft legislation has finally been released detailing how earnout arrangements will be treated from 23 April 2015.
The draft law
In substance, the draft legislation is aimed at introducing 'look-through' income tax treatment for certain earnout arrangements.
Critically, while the substance of the 'look-through' approach has been preserved, the mechanics are very different from the 2010 model. Broadly, the earnout attaches to the CGT event that occurs on the sale of the asset. The CGT concession and small business CGT concessions can apply, where they would otherwise not be available. However, it also will require an earnout payment to be recognised in the year in which the relevant CGT event occurred and will, in most cases, require the amendment of prior year tax returns as and when earnout payments are received.
Under the draft legislation, taxpayers may disregard capital gains or losses that arise in relation to the grant of a look-through earnout right. Instead, the value of any ‘financial benefits’ made or received under the earnout right will be included in the either the capital proceeds (for the vendor), or the cost base of the acquisition of the asset (for the purchaser).
In order for the look-through treatment to apply, earnout arrangements must meet the following criteria:
- the earnout right must be created as part of an arrangement for the sale of a business or its asset;
- the asset being sold must be an ‘active asset’ of the business: the definition of an ‘active asset’ used for the purposes of the small business CGT concessions is adopted, but with an administrative ‘shortcut’ to avoid the need for underlying business and asset valuations;
- future financial benefits provided under the right must be linked to the future economic performance of the asset or business in which the asset is used;
- the financial benefits provided must not be capable of being reasonably ascertained at the time the right is created (critically, the Explanatory Memorandum to the draft law notes the distinction between an earnout, that is entitled to ‘look-through’ treatment, and the payment of deferred consideration that is not entitled to that treatment);
- the arrangement must be on an arm's-length basis; and
- the right must not involve payments that span for more than four years from the original date of sale and must not include an option allowing the parties to extend the period for more than four years.
Date of application
The provisions of the draft legislation will apply to all earnout arrangements entered into on or after 23 April 2015.
However, taxpayers (either purchasers or vendors) that have acted reasonably and in good faith anticipated changes to the tax law in this area, as a result of the former Government's announcement, will have their current tax income preserved (if the arrangement was entered into pre- 24 April 2015) even if their earnout arrangements do not meet the newly proposed look-through criteria.