Amendments to capital gains tax treatment of Earnout rights

On 23 April 2015, the Government introduced exposure draft legislation dealing with the capital gains tax (CGT) treatment of the sale and purchases of businesses involving certain earnout rights. The proposed law supersedes the changes announced by the previous Government in 2010.

2015-05-01

Who will be impacted by the proposed changes?

The proposed changes will affect acquisition or disposal contracts containing an earnout right/ component.  In general, an earnout right enables one of the contracting parties (usually the seller) to receive further consideration should the business sold meets or exceeds (within a timeframe) certain predetermined performance targets.

Earnout arrangements are commonly used and are often useful in situations where the parties have difficulty in agreeing on /determining the future economic performance of the business being sold.

What are the key implications of the changes?

The key implications of the proposed changes can be summarised as follows:

  • The creation and ending of an eligible earnout right will not give rise to separate CGT calculations;

  • For the seller under a standard earnout right, when the original business is disposed, the value of the eligible earnout right is not added to the disposal proceeds.  The earnout right payment/receipt is only included in the CGT calculation (as capital proceeds) when it is received.  This may require an amendment of the income tax return containing the capital gain/loss from the sale of the business.

  • For the buyer under a standard earnout right, the cost base of the assets acquired (or entity acquired) will be increased for any earnout payments made.  The changes make it clear that earnout payments subsequently made will require a revision of the allocable cost amount (“ACA”) calculations.

  • Capital losses arising from a CGT event related to an earnout right may not be taken into account in determining tax liabilities until such time as they cannot be reduced by future financial benefits received under a relevant LTER.

When do the changes apply from?

The rules come into effect from the date the proposed law receives royal assent and will apply to all eligible earnout arrangements entered into on or after 23 April 2015.

A salient point to note is that taxpayers may have been relying on the look through treatment contained in the original announcement on 11 May 2010 and the discussion paper issued on 12 May 2010.  In this regard, there is a protection rule which provides protection to taxpayers who have relied on the original announced changes.

Why are the changes important?

The changes are important as they affect the capital gain or capital loss calculations in relation to sale contracts containing earnout clauses.  The initial capital gain or loss calculation will change as earnout payments are received or paid.  Where these payments straddle across income years, amendment of previously lodged tax returns may be required.

ACA calculations for tax consolidated groups may also be required to be revised.

What are the proposed changes?

There is currently no specific legislation dealing with earnout rights.  Accordingly, the normal CGT principles/rules apply.  In applying these rules, the Commissioner of Taxation in Draft Taxation Ruling TR 2007/D10 opined that earnout rights are to be treated as separate CGT assets.  This means that the right will need to be valued and may form part of the sale proceeds (where the right is provided by the buyer).  The expiration of the right will then give rise to a separate CGT event. Further, certain CGT concessions that would otherwise apply to the sale of business assets may not apply to this separate CGT event.

Under the proposed changes, capital gains and losses arising in respect of “look-through” earnout rights (the “LTER”) will be disregarded.  Instead, financial benefits received under the earnout rights will affect the capital proceeds and cost base of the underlying asset or assets to which the earnout arrangement relates.  This means that:

  • A separate valuation of the LTER will not be required;
  • The expiration of the LTER will in effect not give rise to a separate CGT event;
  • Payments made resulting from the LTER will broadly be applied in:
    • For the seller, determining the proceeds of the disposal of the relevant asset(s);
    • For the buyer, determining the cost base of the underlying asset(s) acquired;
  • When payments are made under the LTER, the income tax return of the parties may be required to be amended. The time limit for the amendment is up to four years after the earnout arrangement expires.

Which earnout rights are eligible for the look through treatment?

A LTER is a right to future financial benefits, and unascertainable at the time the right is created.  The right must be created under an arrangement involving the disposal of a CGT asset (under CGT event A1) that is an active asset of the seller.  Further, the financial benefits under the right must be contingent on and reasonably related to the future economic performance of the asset (or a related business).  A four year restriction also applies to the payments made under the right.  The parties must also deal with each other at arm’s length.

A right will also be a look-through earnout right if it is a right to receive a certain financial benefits provided for ending a right that is a look through earnout right under the general rules. 

The requirement for the right to be linked to the economic performance of the asset/related business means that earnout rights framed around the satisfaction of non-economic performance criteria (such as the key person remaining in the business or outcome of any contentious litigation) will not satisfy this requirement.  Similarly, payment contingent on discovery of further information (e.g. the existence or value of mineral resources) will also not satisfy this requirement.  Further, the value of the earnout payment must not be disproportionate to the benefits that could have been reasonably expected to result from the performance to which they are linked.

Another important consideration is that the active asset requirement effectively limits the LTER treatment to sale of businesses (or entities with active assets).  Broadly, and subject to certain exclusions, an active asset is an asset of the taxpayer that is used in the business of the taxpayer (or certain related parties).  Membership interests in an Australian resident company or trust will also be an active asset if at least 80 per cent of the value of the assets of the company or trust is represented by active assets (rather than passive investment to derive interest, royalties, rents etc.). 

In relation to shares or trusts interests, valuation of the underlying assets of these entities may prima facie be required to determine whether the above 80% active assets requirement is satisfied.  There is a proposed concession that treat certain eligible shares or trust interests as active assets without the need to perform such valuations. Certain conditions/ tests will need to be satisfied before this concession can be relied upon.

Interaction with the tax consolidation provision

Subsection 705-65(5B) of the Income Tax Assessment Act 1997 was previously introduced which broadly requires consolidated groups to revise the ACA of an entity that joins the group to take account of subsequent money or property provided in respect of the acquisition of a membership interest in the entity where the subsequent money or property was not taken into account in working out the ACA when the entity joined the group.  There was some doubt as to whether this provision could apply to earnout rights.

The proposed changes provides certainty that the value of the LTER is explicitly disregarded when determining the initial cost base and subsection 705-65(5B) of the ITAA 1997 will operate as originally intended.

Example of application of the proposed rules (from the EM)

Anna sells her business, ABC Co, to Purple Ltd in March 2016.

Under the sale arrangement, Anna receives an upfront payment of $1 million at the time of sale and a right to two future payments in March 2017 and March 2018, each of $100,000, provided the turnover of ABC Co exceeds an agreed threshold during 2016 and 2017 respectively.  This right is a look-through earnout right.

At this time Anna’s capital proceeds for the sale of the business are $1 million – the total of the upfront payment she has received.  Anna has also received the right to future payments which she would generally need to include in the capital proceeds, but as this is a look‑through earnout right, the value of right is disregarded when working out the capital proceeds.

As Anna has a cost base of for ABC Co of $600,000, at this time Anna has a capital gain of $400,000 (capital proceeds of $1 million less the cost base of $600,000) as a result of the sale.

ABC Co’s turnover exceeds the agreed threshold in 2016 and so Purple Ltd pays Anna a further $100,000.

As a result of this payment, the capital proceeds for the sale of ABC Co are now $1.1 million – made up of the 1 million initial payment and the $100,000 payment she received in March 2017.  She has now made a capital gain of $500,000 (capital proceeds of $1.1 million less the cost base of $600,000) as a result of the sale.

Finally, in July 2017, Purple Ltd decides it would prefer to end the arrangement immediately.  It offers to pay Anna $50,000 if she will agree to forgo her right to further payments under the look-through earnout right and Anna agrees to this offer.

This financial benefit provided to terminate a look-through earnout right is treated in the same way as a financial benefits provided under the right.

As a result, Anna’s total capital proceeds for the sale are now $1.15 million, made up of the $1 million initial payment, the subsequent $100,000 payment under the earnout right and the $50,000 payment to end the earnout right.

Anna’s final capital gain from the sale is $550,000 (capital proceeds of $1.15 million less the cost base of $600,000).

Amendment period

The normal amendment period is understandably extended under the proposed changes.

The proposal extends the period of review for all of a taxpayer’s tax-related liabilities that can be affected by the character of the look-through earnout right.

For these tax-related liabilities, the period of review is the later of the period of review that would normally apply and four years after the final date when financial benefits could be provided under the look‑through earnout right. 

Further taxpayers may also be able to amend a choice previously made where the choice relates to a capital gain or loss that can be affected by financial benefits provided under a look-through earnout right.

Finally, neither taxpayers nor the Commissioner will need to pay interest solely because a financial benefit is provided or received under a look‑through earnout right.

If you have any queries in relation to this article, please contact Daren Yeoh on 03 8635 1800 or your ShineWing Australia relationship partner or manager.