- 5 years after the initial announcement the Government has finally released draft legislation to clarify the taxation of earn-outs.
- The proposed changes will apply a 'look through' approach for both the buyer and seller for earn-outs that meet the restrictive qualifying criteria.
- For those earn outs that don’t qualify for the new regime, the tax position for the parties is uncertain, and will have to take account of the ATO’s draft ruling, which it issued in 2007.
M&A parties will sometimes use an earn-out to bridge the gap between the buyer’s and seller's views on value of the target. However, since the Australian Tax Office issued a draft tax ruling in 2007, the taxation implications of earn-outs in Australia has been unclear from the perspective of both parties.
From the seller's perspective, applying the draft ruling the seller's capital gain was calculated by the reference to the cash proceeds on completion plus the market value of the earn-out, based on the likelihood of the earn-out being paid out. The earn-out right is considered a separate asset for the purposes of the CGT rules. When the earn-out is paid out, the seller then has a separate CGT event.
From the buyer's perspective, the buyer's cost base similarly comprises the cash proceeds on completion plus the market value of the earn-out. The tax treatment for the buyer of the actual payout of the earn-out is unclear.
The effect of the draft ruling is that the seller is incentivised to attribute a low value to the earn-out right so that they only pay tax on the earn out when the cash is received. Conversely, the buyer wants to attribute a high value to the earn-out right so the maximum amount is included in the buyer's cost base. This is inherently contradictory - the parties use an earn-out because the seller thinks the target is worth more than the buyer.
This tax uncertainty has hindered the use of earn-outs as the tax position of the buyer and seller is open to review by the ATO.
The proposed new rules will apply a 'look through' agreement for 'qualifying earn-outs'. This means that the seller will treat any earn-out payment as referable to the capital gain or loss from the sale of the target and the buyer will include the actual amount paid under the earn-out in the cost base. These new rules will apply to earn-outs created on or after 23 April 2015 even though the rules have not yet been finalised.
These changes should remove tax as an impediment for the use of earn-outs that meet the qualification criteria. However, the definition of a qualifying earn-out is not straightforward and will probably require both parties to obtain advice on whether these new rules will apply.
The definition of a 'qualifying earn-out' is convoluted, particularly if the assets disposed of are shares, rather than business assets. To be a qualifying earn-out:
- the earn-out must be a right to future financial benefits that are not reasonably ascertainable when the right is created,
- the earn-out must be created under an arrangement that involves the disposal of a CGT asset (depreciating assets are not covered),
- the asset must be an ‘active asset’. The test for whether a share is an active asset is complex but broadly includes:
- an asset used or held ready for use in a business (passive assets, such as assets generating rent, are excluded),
- a share in a company or interest in a trust if at least 80% of the value of the company or trust is referable to active assets, or
- a share in a company or interest in a trust if (a) the taxpayer holds 20% or more of the shares or interests, (b) the company or trust carried on a business in the immediately preceding income year and (c) 80% or more of the company’s or trust’s income in that year came from carrying on an active business. The 20% threshold is likely to prove problematic for example, where management exits a private equity investment,
- all of the financial benefits under the earn-out must be provided within 4 years (after the sale documentation is signed),
- the value of the financial benefits must be contingent on, and reasonably relate to, the economic performance of the active asset or business. Benefits contingent on the outcome of litigation, such as the earn-out in Sportingbet’s acquisition of Centrebet, or on discovering more information about an asset such as the existence of resources, will not be considered to be sufficiently contingent on economic performance of the business assets to qualify, and
- the parties must deal with each other at arm’s length.
If the earn-out doesn't meet the qualifying criteria, the parties are back into the uncertainty caused by the draft ruling.
The amendments will apply to earn-out rights created on or after 23 April 2015 with protection for taxpayers who applied the 2010 Federal Budget announcement.