Earnout Clarity

KSV 9
9
Jun

Earnout Clarity

09.06.15

Earnout arrangements are a way of structuring the sale of a business when uncertainty exists regarding its value.  In this type of arrangement, the sale of the business includes a lump sum payment plus a right to further payment that are contingent on the performance of the business for a certain period of time following the sale.

 

The ATO has made numerous announcements over the past eight years seeking to clarify the taxation treatment of earnouts.  Recently, legislation has been introduced to correct the technical issues and confusion for earnouts created by one of the ATO’s public rulings in 2007.

 

SO WHAT IS THE ISSUE?

For standard earnouts, the vendor’s proceeds for the underlying asset consist of two items: cash and the market value of the earnout right (i.e. a separate asset).  The subsequent payment relates to the earnout right, not the underlying asset. This directly impacts on the ability of the vendors to access certain CGT concessions (e.g. small business CGT).

 

The ATO’s approach has practical implications – for example, it results in the vendor needing to determine the market value to the earnout right, which then sets its cost base.  As a result, unintended CGT consequences can arise if a loss is made in respect of the earnout right, but a gain is made on the sale of the underlying asset.

 

There are other consequences for the purchasers and similar issues for reverse earnouts. 

 

PROPOSAL

The solution offered by the draft legislation is to adopt a ‘look-through’ approach.  Qualifying earnouts will then obtain concessional treatment such that: 

  • the earnout will not be treated as a separate CGT asset; and
  • earnout payments will adjust the vendor’s proceeds.

 

Ultimately this will require taxpayers to amend their historical tax return when payments are received in later income years to the asset sale.  A qualifying earnout has a number of criteria, including but not limited to:

  • all of the benefits under the earnout must be provided within 4  years of executing the sale document;
  • the asset must be an ‘active asset’.
  • the value of the earnout must be contingent on and relate to the economic performance of the asset.

 

The amendments will apply to earnout rights created on or after 23 April 2015 with protection for taxpayers who applied the 2010 Federal Budget announcement. 

 

Should you have any queries in relation to the above please contact your relevant ESV engagement partner on 9283 1666.

Article by David Prichard