RSM Australia

New tax rules for earnout arrangements

On 23 April 2015, the government released exposure draft legislation to implement the long awaited changes to the treatment of ‘earnout arrangements’ connected with the sale of a CGT asset (typically shares/units in a company/trust, or the sale of business assets).

The draft rules implement the ‘look through’ approach as previously foreshadowed by government, but only for those earnout arrangements which satisfy a number of stringent conditions (referred to below as ‘eligible earnout arrangements’). This bifurcated approach to earnouts has implications for both future and past arrangements.

As expected, there are significant ‘challenges’ arising from this simple policy decision, and this is reflected in the complexities of the draft legislation.  There is a consultation period and it could be expected the final legislation will have some of the rougher edges smoothed.  The consultation ends on 21 May 2015.

Background

In 2007, the ATO issued a draft tax ruling which reversed its previous ‘look through’ treatment of earnout arrangements.  The draft ruling treated earnout rights as separate CGT assets:  different to the relevant business sale CGT assets (shares, goodwill, etc.); requiring valuation; with the consequence the tax outcomes could be differ significantly from the commercial results.

Previous governments committed to reinstating the ‘look through’ approach, and that commitment is reflected in the draft legislation now released. (However, only for ‘eligible’ earnout arrangements.)

Application dates

The new rules will apply to earnout arrangements entered into on and after 23 April 2015. There will be transitional provisions to cover those earnout arrangements entered into, or concluded, prior to 23 April 2015, and the transitional treatment of arrangements which do not satisfy the statutory eligibility conditions, may well cause concerns.

‘Look through’ approach – tax deferral

The ‘look through’ approach is confirmed: that means the ‘separate asset’ approach as set out in the ATO’s 2007 draft ruling, is now history (but only for eligible arrangements). Put another way, the pre-2007 status quo has been broadly restored, albeit by way of codification.

Where sale proceeds arising from the sale of a CGT asset (shares, goodwill, etc) are adjusted up or down in subsequent years to reflect the post-sale economic performance of the underlying business, then the quantum of sales proceeds (and of any capital gain or loss) will be adjusted accordingly.

This approach provides vendors (and purchasers) with outcomes broadly consistent with those that would have arisen had the value of all financial benefits under the earnout right been included in the capital proceeds from the disposal of the underlying asset for the vendor, and the cost base of the underlying asset for the purchaser, in the tax calculation of the transaction year.

This means that the quantum of sale proceeds ultimately paid/received will be the figure used in calculating a vendor’s capital gain/loss and a purchaser’s cost base.

Where there are later year adjustments, the disposal year tax return will need to be amended to reflect the later year adjusted financial benefits, but this is a small inconvenience to ensure the tax outcomes mirror the commercial outcomes.

The tax due on contingent consideration payable under an earnout arrangement is deferred and only payable in later years, when the quantum of those contingent receipts is known with certainty.

The consequences for the purchaser will be the same as for the vendor, but in reverse. The purchaser’s cost base will be set by reference to the total amount of consideration paid.

To achieve this result, the value of the earnout rights will be disregarded for CGT purposes (but only where those rights arise from eligible earnout arrangements).

CGT concessions

Eligibility for CGT concessions, including the various small business CGT reliefs, will be determined in the transaction year, with the proceeds being amended to reflect later year financial benefits received. This reverses the disadvantageous consequences of treating earnout rights as ‘separate assets’ as per the ATO’s 2007 draft ruling.

‘Look through earnout right’

This is the core concept which sits at the heart of the new rules. Where the earnout arrangements give rise to a ‘look through earnout right’ as defined (ie. an eligible right), then the deferral consequences as noted above will apply.

However, where a commercial earnout arrangement does not give rise to a ‘look through earnout right’ as defined, then the deferred tax treatment will not be available. If deferral is not available, then the earnout rights will need to be treated (and valued) as separate CGT assets, ie. the treatment provided for in the ATO’s 2007 draft tax ruling will apply.

To qualify as an eligible ‘look through earnout right’ the following conditions must be satisfied:

  • future earnout ‘financial benefits’ cannot be ‘reasonably ascertainable’ at sale date
  • the right is created under an arrangement involving the disposal of a CGT asset (share, unit, goodwill, etc)
  • CGT even A1 must apply (the basic disposal case)
  • the CGT asset the subject of the sale must be an active asset just before the sale time
  • all future financial benefits must be provided no later than 4 years after the sale date
  • the future financial benefits must be contingent upon the future economic performance of the business
  • the value of the future financial benefits must be proportionate to that of the future economic performance of the business
  • the parties must be dealing at arm’s length

Amendment periods

Consequential changes ensure that the tax return of the transaction year will remain open for amendment in order to give effect to these rules. And because of the possibility the rules could be manipulated, to simply defer the payment date of tax on sales proceeds which are not ‘reasonably unascertainable’, there are a number of integrity measures, but none which presently appear unworkable.

Example of a standard earnout arrangement

Facts: vendor’s cost base in business: $1m

Sale proceeds: 

Upfront  - $800,000
Year 1  - $100,000
Year 2  - $150,000
Year 3  - $100,000

(Earnout consideration in years 1 to 3 is contingent on meeting performance hurdles).
 

  Cost base Capital loss quarantined (carried forward) Capital proceeds Capital loss quarantined Capital gain
Year 2016 $1m   $800,000 ($200,000) $0
Year 2017

 

($200,000) $100,000 ($100,000) $0
Year 2018

 

($100,000) $150,000 $0 $50,000
Year 2019

 

$0 $100,000 $0 $100,000
Total $1m   $1.15m   $150,000

 

It will be necessary to amend the vendor’s 2016 tax return twice – to reflect the capital gain made on receipt of the 2018 contingent receipt, with that gain increased on receipt of the 2019 contingent receipt.

No penalties or interest will be payable, provided the 2016 tax return amendments are made within lodgement deadlines.

The consequences for purchasers will be the mirror image of the treatment for the vendor. Where the acquisition involves a tax consolidated group, specific provisions apply to facilitate adjustments.

Where a vendor may make a capital loss in an earlier year, that loss will be temporarily ‘quarantined’, until the total tax outcome of the deferred earnout arrangement has been determined.

Action required

For those currently involved in M&A transactions, particularly where it is likely an earnout will be included in the deal, it is mandatory to consider the implications of these new rules.

For earnouts arising from transactions which closed prior to 23 April 2015, taxpayers will need to review the new rules and determine what, if any, prior period amendments may be necessary. Problems may be anticipated for pre 23 April 2015 transactions where the earnout arrangements do not satisfy the requirements to be ‘eligible’.

Finally, the consultation period closes on 21 May 2015, and if there are any observations or modifications of merit, these must be lodged with treasury by that date.

RSM in Sydney - providing accountanting, auditors and consultants for sydney Businesses