Earnouts are a very common financial arrangement used in the sale of an asset whereby the parties agree to calculate and pay additional consideration for the sale of the asset based on performance of, return on, or other similar measure in respect of the asset for an agreed period following sale. The parties may enter into an earnout arrangement for a variety of reasons.
Despite their prevalence, there has been some uncertainty in relation to the income tax treatment of earnout arrangements.
Before 2007 there was a lack of symmetry in the tax treatment of earnouts for vendors and purchasers and confusion around the application of certain CGT concessions. In 2007 the Commissioner released a draft ruling TR 2007/D10 to provide a clear view on the income tax treatment of earnouts in which he expressed a view that the earnout right is treated as property provided by a purchaser to a vendor at the time the earnout arrangement is entered into, thereby giving rise to a taxing event for a vendor where no cash exchanged hands. The Commissioner neither finalised nor withdrew this draft ruling.
In 2010 the Treasury released a discussion paper under which they proposed to amend the law to address this confusion around the two views. They proposed to introduce a look through approach to earn outs, whereby amounts paid under the earn out are assessed for a vendor and included in cost for a purchaser when paid. The discussion paper was generally met with enthusiasm.
Acknowledging the potential for law change, the ATO announced an administrative concession under which they indicated that taxpayers would be allowed to adopt either the look through approach or the Commissioner's approach in TR 2007/D10 while we awaited law change.
Finally, some eight years following the draft ruling and five years following the Treasury discussion paper, we have draft laws to resolve the confusion. But does it?
The draft law
For what is a commonly understood business arrangement, the draft law to address the taxation treatment of earnouts is not particularly simple. For that reason we do not provide an overview of all of the detail in this alert and advice should be sought to understand how it might affect your particular circumstances.
At a high level, the proposed law change is aimed at introducing look through income tax treatment, however only for certainearnouts.
Where the previous views in the Treasury discussion paper and ATO administrative announcement were not restrictive in their application to earnouts, the proposed law is being seen as a concession and accordingly it is narrow.
The look through treatment will only be available for a specific type of earnout arrangement. Importantly, the earnout will need to:
(a) apply in relation to a sale of business effected by a traditional transfer (even though business transfers can be undertaken in a number of ways);
(b) be in relation to the disposal of an active asset (this gives rise to a number of issues including the look through treatment not being available to the sale of an interest in a foreign entity, potentially requiring a valuation of the assets of the business and its subsidiaries at the time of the transaction and in certain cases vendors needing to hold at least 20% of the target entity); and
(c) involve payments that span no more than 4 years from the date of the original sale, without any ability to extend the earnout payments beyond that period (in practice, this may mean it is limited to earnouts involving only 2 or 3 payments, given that they are generally made after an analysis of year end accounts can be made).
Sensibly, the proposed law allows the grandfathering of earnout arrangements entered into prior to 23 April 2015. This appears to allow taxpayers that have entered into earnout arrangements prior to yesterday to apply the ATO’s announced administrative look through concession (even though their earnout might not meet the newly proposed look through earnout definition).
While the draft law will introduce the highly anticipated look through approach to earnouts, it is clear that the policy decision is now to treat this as a concession and limit the availability of the look through treatment to what could be only a small number of earnouts in practice.
For any transaction going forward, there is likely to be the possibility that entering into an earnout arrangement results in crystallising a taxing event at a point where there is no exchange of cash between parties to fund that tax liability.
Even though it appears that a sensible decision to grandfather existing earnout arrangements is being proposed, where a taxpayer (either as purchaser or vendor) did enter into an earnout arrangement in recent years it would be prudent to revisit the arrangement to ensure that the transitional provisions will apply.
Although consultation is open and the draft law remains subject to change, now would be the time to start asking some questions about both historical and proposed earnout arrangements to which you might be a party.