Tax on Earnouts

Anyone who ever bought a business knows a vendor always wants more than the business is worth. Anyone who ever sold a business knows a purchaser always undervalues the business they want to buy. As a solicitor involved in negotiation of business sales and purchases I often deal with questions of value. The value of a business relates to future performance which may be subject to unknown factors; markets, weather, even federal budgets. Balancing risk between the parties is key to negotiating a sale.

An earnout is a commercial means of dealing with this risk. Essentially, a purchaser is reluctant to pay for profits which may or may not be derived and a vendor is reluctant to sell without reward for profits they believe will be derived. An earnout gives the purchaser the opportunity to restrict payments if profit does not eventuate and enables the vendor to receive the value if it does.

Earnouts also align the interests of the vendor with those of the purchaser where the vendor remains in the business for a period after acquisition. The most common form of earnout is for an agreed payment to be made on settlement with a further payment or payments later on - the quantum of which is dependent on the profitability of the enterprise during the relevant time period.

In 2007 the ATO published a draft ruling^[1] accepting that an earnout is a legal right or collection of legal rights and so should be valued as an asset provided as part of the consideration for the business. In May 2010 the previous Government announced^[2] that they would change the law to put in place a ‘look through’ approach that taxed amounts received in respect of an earnout as if those cash amounts were themselves the consideration for the original acquisition. This was never enacted although it was stated that the change would be backdated to 10 May 2010 (when the announcement was made).

In 2013 the current Government said it would implement the 2010 announcement by the end of 2014^[3], but the measure would only be backdated to the date of the announcement made in 2013 (with some unspecified transitional provisions from 10 May 2010). On 23 April 2015, eight years after the ATO’s 2007 draft ruling, an exposure draft of legislation to change how these common commercial arrangements are taxed was finally published.

How the earnout is taxed matters especially if the vendor can use capital gains tax (“CGT”) concessions on the amount received. If the earnout is taxed separately from the transaction the concessions generally cannot be used in relation to the earnout, whereas if all the payments are taxed as part of the initial transaction the concessions may be available. Equally, if amounts received under the earnout arrangement are small the vendor could be taxed on a capital gain in the year the business is sold and make capital losses in subsequent years that cannot be used.

Importantly, the base position in the draft law remains that an earnout is a legal right or collection of legal rights and as such should be valued as an asset provided as part of consideration for an acquisition. Only if an earnout meets specific conditions is the cash received (or not received) later to be taxed as part of the original transaction. These conditions are:

• the entire arrangement is concluded within four years of the initial transaction;
• earnout amounts are contingent on ‘unascertainable’ economic performance;
• the assets or business being sold meet the technical definition of an ‘active asset’ under the tax legislation; and
• the capital gain under consideration is from a transfer of an asset rather than any other type of transaction.

Not all business sales will meet this definition. Some earnout arrangements extend over more than four years and often the asset being sold (particularly if it is shares in a company) may not meet the technical definition of an ‘active asset’ in tax legislation. Both the draft legislation and the explanatory documents published with it are unclear on what is to be considered ‘unascertainable’ and what qualifies as ‘economic performance’. For example, whether a mining company finds minerals is not considered to relate to its ‘economic performance’.

If an earnout meets all the conditions the vendor can go back and amend income tax returns each time an amount is received under the earnout to include that amount in the initial transaction. Apart from a lot of administrative work (and accounting fees) this will solve many of the tax problems involved in an earnout for those lucky enough to meet the criteria.

Although tax returns can be amended there seems to be no way that amounts paid into superannuation can be taken out again if the vendor ceases to be entitled to the small business concessions. Potentially, such amounts might even be subject to penalty tax if the vendor has already made other superannuation contributions in that year or in previous years.

Several organisations with which members of the DW Fox Tucker Tax team are involved, including the Taxation Institute and the Law Society of South Australia, are making submissions on this draft legislation to try to improve the operation of the law before it is passed by Parliament and we will keep you informed of any changes. Meanwhile, if you are negotiating the sale of a business, ensure you get advice before agreeing to an earnout arrangement so you know just how much tax you may have to pay.