In brief - New legislation applies to earn-out arrangements that qualify
On 25 February 2016, Parliament passed new legislation that will treat qualifying earn-out arrangements entered into on or after 24 April 2015 with a "look-through" approach for the purposes of capital gains tax (CGT). Earn-out arrangements that don't qualify will need to apply draft taxation ruling TR 2007/D10.
Sellers gain more certainty as a result of CGT amendment
The new legislation means that any capital gains or losses arising out of qualifying earn-out arrangements will be viewed as part of the initial transaction and disregarded for the purposes of CGT until and to the extent that they become certain. This will provide greater certainty to sellers in merger and acquisition (M&A) transactions that are subject to earn-out arrangements in respect of the tax treatment of the earn-out.
Prior to these amendments, the only guidance on how an earn-out arrangement would be treated by the Australian Taxation Office
was the draft taxation ruling TR 2007/D10, Income tax: capital gains: capital gains tax consequences of earnout arrangements
issued by the Commissioner in 2007.
Although an earn-out arrangement is a common business transaction, the law surrounding them is quite complex. This article provides a simple overview and as such, legal advice should be sought to ascertain how the law will apply to an earn-out arrangement.
What are earn-out arrangements?
Earn-out arrangements arise between a buyer and seller in a M&A transaction where consideration may be paid to the seller after completion of the transaction based on specified conditions being satisfied, such as the future performance of the business.
Alternatively, a reverse earn-out arrangement is where the seller agrees to make repayments to the buyer if the business or asset does not perform to those standards within a specified timeframe.
Earn-out arrangements are generally used in transactions where the value of the assets or business cannot be agreed upon or is contingent on future events. They reduce the buyer's risk for a portion of the transaction and provide a mechanism for the seller to maximise its return.
Earn-out arrangements must meet certain criteria to qualify for look-through treatment
To qualify for the "look-through" treatment under the new legislation, the earn-out arrangement must meet the following conditions:
- The earn-out arrangement is a right to future financial benefits that are not reasonably ascertainable at the date of the transaction
- The earn-out arrangement involves the disposal of a CGT asset which causes a CGT event A1 to occur
- The asset being disposed of, either tangible or intangible, is used in the business of the disposing entity
- All of the financial benefits that are provided under the earn-out arrangement are provided within five years after the end of the income year in which the CGT event occurs
- The financial benefits being provided are contingent on the economic performance of the active asset or business
- The value of those financial benefits reasonably relates to the economic performance of the active asset or business
- The parties deal with each other at arm's length
If an earn-out arrangement does not qualify under these criteria, the draft taxation ruling TR 2007/D10 will need to be applied.
TR 2007/D10 treats future payments as separate CGT event
Under the draft taxation ruling, any future payments under the earn-out arrangement are considered a separate CGT event.
For sellers, this means that any capital gains arising from future payments need to qualify independently for concessions. Sellers are also not able to use any capital losses from future payments to offset the capital gain from the original transaction.
For buyers, this means that any future payments in excess of or less than the market value of the original transaction are not included in their cost base or cannot be used to reduce their cost base.
Parties to an earn-out arrangement should seek legal advice
Those who have entered into an earn-out arrangement after 24 April 2015, or are considering entering into an earn-out arrangement, should seek legal advice regarding its possible CGT implications under the new legislation or the draft taxation ruling.
Taxpayers will be afforded protection where they have reasonably and in good faith anticipated the changes to taxation on earn-out arrangements since the announcement of the changes in May 2010. In these cases, the Commissioner will be barred from amending an income tax assessment and applying the law in a way that is inconsistent with what the taxpayer has anticipated.
This is commentary published by Colin Biggers & Paisley for general information purposes only. This should not be relied on as specific advice. You should seek your own legal and other advice for any question, or for any specific situation or proposal, before making any final decision. The content also is subject to change. A person listed may not be admitted as a lawyer in all States and Territories. © Colin Biggers & Paisley, Australia 2022.