An earnout is a common way of structuring the purchase price in the sale of shares or business assets. It is 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. In April, an Exposure Draft was released on the tax treatment of earnouts. Following consultation, changes were made to address some concerns and overcome technical deficiencies in the ED. The outcome was the release of a Bill that deals with the tax treatment of earnouts for vendors and purchasers (Bill).
The key outcomes
In substance, the Bill introduces ‘look-through’ income tax treatment for certain earnout arrangements that are (or have been entered into) from 24 April 2015 [earnout arrangements made prior to this date may still receive ‘look through’ treatment under the announcement made in May 2010 or are subject to the treatment outlined in draft Taxation Ruling 2007/10 – see our earlier Tax Update].
Broadly, the earnout is not treated as a separate asset for CGT purposes and taxpayers may disregard capital gains or losses that arise in relation to the grant of a look-through earnout right. Rather, 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.
The rules require an earnout payment to be recognised in the year in which the relevant CGT event occurred. 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).
This treatment of the earnout right will, in most cases, require the amendment of prior year tax returns as and when earnout payments are received. The amendment period for these purposes has been extended to ensure all relevant payments can be brought to account. Interest will not be charged provided the amendment is requested by the due date of lodgement for the year when the payment was received or paid.
The Bill also makes it clear that entitlements to the small business concessions can be revisited as and when payments under the earnout are received.
The criteria for qualifying earnout
Not all earnout arrangements will qualify for the look through treatment under the Bill. In order for the look-through treatment to apply, earnout arrangements must meet the following broad criteria:
- the earnout right must be created as part of an arrangement for the disposal of a business or its assets;
- the asset being sold must be an ‘active asset’ of the business. There are a number of aspects to this criteria:
- the ‘active asset’ concept takes its general meaning from the small business CGT concessions, although for earnout purposes, the definition is extended to interests in foreign entities;
- if the asset is shares in a company or units in a trust, at least 80% of the assets (by value) in the entity need to be active assets (and not passive investment-type assets);
- an administrative ‘shortcut’ to avoid the need for underlying business and asset valuations is made available, but relevantly is only available if the vendor is a ‘CGT concession stakeholder’, broadly, they must own a minimum 20% interest;
- 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. This is assessed on a case-by-case basis. While an earnout that is only triggered on the business meeting certain profit targets is likely to meet this requirement, an earnout that is only conditional on a key employee remaining employed on a certain date may not;
- 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 Bill 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 five years (this is a change from the ED which had a 4 year time limit) from the end of the increase year in which the relevant CGT event occurs and must not include an option allowing the parties to extend the period beyond that five year limit.
Date of application
The Bill 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.