In broad terms, a standard earnout arrangement is one where a vendor sells their business and receives for that sale consideration which includes a right to receive a future amount both contingent upon and calculated with reference to the future economic performance of the business sold for a defined period following the sale. Earnouts might also be referable to non-economic performance indicators, or work in reverse, whereby a vendor receives a gross amount but is under an obligation to repay to the purchaser an amount if, for example, the future economic performance of the business fails to meet agreed minimum thresholds.
As earnouts, from a legal perspective, are distinguishable from installment sales (pursuant to which a vendor receives a right to a future sum of money in respect of the sale that is both certain as to amount and as to its receipt), the conventional taxation treatment of them has been problematic, inequitable and, as to the ATO’s attempts to provide a level of clarity to the provisions’ practical operation, uncertain. Consequently, whilst their use might assist to facilitate business sales where there is uncertainty in the value, such use has been inhibited by taxation considerations.
In response to the concerns, after almost 10 years of promise but in reality legislative vacuum, exposure draft legislation was published by Treasury in April last year, with final legislation passed in February this year introducing new Subdivision 118-I with effect back to this April 2015 date. Subdivision 118-I seeks to legislatively adopt for qualifying arrangements a ‘look-through’ approach to the taxation of earnout payments pursuant to which, in broad terms, capital gains (losses) related to the creation of the earnout right are disregarded with the financial benefit under the earnout right instead being attributed (and taxed) as part of the underlying original CGT event happening to the business assets.
This note is not intended to explore in any depth the detailed operation of these provisions, and it is assumed that a broad understanding of the provisions operation is known. Instead, this is limited to the special rules when determining the “net value of the CGT assets” under the small business CGT concession in Div 152, in circumstances where there is an earnout right. These rules were only inserted into the Bill after the exposure draft was published and on which consultation was sought.
It is one of the basic preconditions of the small business CGT concessions, under Div 152, that the taxpayer satisfy the “maximum net asset value test” under s 152-15. This test requires a taxpayer to value their CGT assets, together with the CGT assets of any entities connected with them (or are affiliates of, or connected with affiliates of theirs). Necessarily therefore, this includes CGT assets that are an entity’s earnout rights, because those assets are proprietary choses in action.
That this is required is notionally inconsistent with one of the key underlying purposes of the look-through earnout provisions, being to prevent taxpayer’s from having to problematically value the earnout rights received by them. That value may indeed be crucial in determining whether a taxpayer is within or over the $6 million threshold.
Following submissions made after the release of the Exposure Draft, Treasury introduced specific provisions to, amongst other things, allow taxpayers when testing whether they satisfy the maximum net asset value test, to choose to take into account any financial benefits that may have been provided or received under the look-through earnout right after that time. However, this choice is only available to a taxpayer after the last of the financial benefits under the earnout right has been paid (or able to be paid). Therefore:
Consequently, it may be that if a taxpayer is, for example, close to failing the maximum net asset value test but, after valuing their earnout right, they consider they satisfy the test and access the concessions (such as the small business reduction and retirement exemption), but that value is less than the total financial benefits subsequently received by them on satisfaction of the earnout right such that the maximum net asset value test is failed, then:
Of significance, with respect to both the tax shortfall and possible excess non-concessional contributions tax, is that, whilst protection from the shortfall interest charge is available when that shortfall arises as a result of the increase in the capital proceeds a vendor taxpayer subsequently receives under the earnout, that protection does not extend to situations where a taxpayer might have in their original year accessed a concession for which they are ultimately not eligible, such as in the present context where the small business tax concessions are not unavailable to the taxpayer because of an increase in their capital proceeds, but rather because they fail the prerequisite eligibility conditions because the value of the net assets exceed the requisite threshold.
In practical terms therefore, taxpayers who, with their connected entities and affiliates, have worth close to the $6,000,000 threshold and who seek to rely on the small business concessions, need to pay attention to their choice of two competing alternatives:
Then, at the end of the earnout period, the taxpayer with the benefit of being able to remake their choices:
Then, at the end of the earnout period the taxpayer:
Not an easy choice!
 All references to the Income Tax Assessment Act 1997
 Though detailed commentary is available for example, through Thomson Reuters legal tax commentary which the author was commissioned to write.
 As noted in the Explanatory Memorandum to the introduction of the provisions
This communication provides general information which is current as at the time of production. The information contained in this communication does not constitute advice and should not be relied upon as such. Professional advice should be sought prior to any action being taken in reliance on any of the information. Should you wish to discuss any matter raised in this report, or what it means for you, your business or your clients' businesses, please feel free to contact us.