Mergers and acquisitions - new legislation changes CGT treatment of earnout arrangements
The Commonwealth Government recently passed the Tax and Superannuation Laws Amendment (2015 Measures No. 6) Act 2016 (“Act”), which changes the CGT treatment of sales and purchases of businesses involving certain earnout rights.
An “earnout arrangement” is an agreement between parties to the sale or purchase of a business or asset where payment for the business or asset will be made at a later date subject to the performance of that business or asset. This provides an alternative to the value of the business or asset being agreed between the parties and full payment being made upfront.
Earnout rights have traditionally been treated by the ATO as a separate CGT asset, meaning a separate capital gain or loss arises at the time of expiry or satisfaction of an earnout right.
Under the new legislation, earnouts will no longer be treated as a separate CGT asset, and instead as an additional amount received by the business or asset seller as part of the proceeds of sale.
Effectively, this new “look-thorugh” CGT treatment of earnout rights means that taxpayers can disregard capital gains or losses arising in relation to the grant of earnout rights as the earnout will attach to the CGT event occurring on the sale of the underlying business and/or assets.
In most instances, this will require prior year tax returns (for the year in which the original sale occurred) to be amended when earnout payments are made or received, if the payment results in an overall gain. The Act provides for the extension of amendment periods for this purpose so that all payments pursuant to relevant earnout rights can be taken into account.
Prior to the introduction of the Act, the CGT event(s) would have occurred in the year when the earnout payment was made.
A range of criteria must be met in order for the Act to apply, including:
- The earnout is a right to a future financial benefit not readily ascertainable at time the earnout arrangement is made.
- The transaction involves the disposal of a CGT asset.
- The future financial benefits must be reasonably tied to the performance of the business or asset.
- It must be an arm’s length (commercial) transaction.
- The earnout must not involve payments over more than 5 years from the time the relevant CGT event occurs.
The implication of the Act, therefore, is that amounts received pursuant to earnout rights under a business or asset sale will be included in determining the capital proceeds or costs of the underlying business or asset to which the earnout arrangement relates.
The Act applies to earnout rights created after 24 April 2015, with various drafts of the Act applying to rights created between 11 May 2010 and 24 April 2015.
Non-qualifying earnout rights remain subject to draft Tax Ruling TR 2007/D10.
To download the new legislation, click here.