Since Treasury released a Discussion Paper in 2010 about earnouts there has been uncertainty about how they are treated for tax purposes. The ATO last published their own views on earnouts in 2007 as TR 2007/D10 and the way that they consider earnout arrangements should be taxed is both complicated and imposes additional costs on parties to an earnout arrangement (in getting valuations to comply with the ATO view of the law).
An earnout is an arrangement, usually entered into on the sale of an asset or a business, where part of the sale price is contingent on something that happens after settlement. It may be that a later payment is made contingent on profits; on customers being retained; or other targets being met.
In December 2015 Government introduced the Tax and Superannuation Laws Amendment (2015 Measures No. 6) Bill 2015 into Parliament. It has since progressed to the Senate. It contains what will be the law on earnout arrangements from 24 April 2015 once the bill receives Royal Assent.
The new law is broadly in line with what Treasury proposed in 2010, and under the new law a 'look-through earnout right' (the new jargon):
- Will not need to be valued at the time of selling the underlying asset;
- Will not result in tax being payable until an amount is received under an earnout arrangement;
- Will result in that tax being payable by amending the assessment for the year of sale to include the amount received under the earnout as part of the original sale proceeds; and
- Will not result in any interest being charged by the ATO so long as an amendment is requested within a specified time period.
The big difference between the new law and the Treasury Paper was that Treasury had proposed that while no tax would be payable until an amount was received under an earnout arrangement, that tax would be levied in the year in which the earnout amount was received.
The fact that the amount received under the earnout will be included as capital proceeds for the original sale will mean that any concessions available on the original gain will effectively be available on the amount received under the earnout arrangement – so if the original asset sale resulted in the gain being disregarded because the asset was pre-CGT, or the general discount or the small business concessions being accessed, then the same treatment will apply to the amount received under the earnout.
There are special rules as well to delay recognition of a capital loss where a sale includes an earnout arrangement until all of the amounts receivable under the earnout have been received and these rules could lead to anomalous tax outcomes.
For a purchaser any amounts paid under an earnout will simply be included in cost base.
The new rules also accommodate ‘reverse’ earnout arrangements where any amount repaid by a seller reduces the capital proceeds received and is treated as a recoupment of the purchaser’s cost base.
The most difficult part of the new rules will be whether the eligibility conditions that need to be met for an earnout to be a ‘look-through earnout right’ are satisfied. The two main conditions are that an earnout cannot last for more than 5 years, and the asset being disposed of must be an ‘active asset’.
The new law also tweaks some aspects of the small business CGT concessions so that they work better with the new treatment of earnouts.
As with any tax law the ‘devil is in the detail’, but the new rules are a welcome simplification to the way earnouts might be taxed.