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u003ch2u003eWhat is an earnout arrangement?u003c/h2u003enu003cpu003eAn earnout arrangement is where a business is sold for a set amount plus a percentage of profits in the future for a specified period. u003c/pu003enu003cpu003eThe CGT rules provide that capital gains and losses arising in respect of look-through earnout rights are disregarded and, instead, payments received or paid under the earnout arrangements affect the capital proceeds and cost base of the underlying asset or assets to which the earnout arrangement relates.u003c/pu003enu003cpu003eThis tax treatment of earnout rights will result in the amount of the capital gain or loss made on the original disposal of business assets changing because of financial benefits provided or received in subsequent income years.u003c/pu003ennu003cp style=u0022text-align: justify;u0022u003eu003cstrongu003eAn Example from the Explanatory Memorandum of the Legislationu003c/strongu003e u003cbru003e Anna sold all the u003ca class=u0022wpil_keyword_linku0022 href=u0022https://bristax.com.au/business-articles/shares/u0022 title=u0022sharesu0022 data-wpil-keyword-link=u0022linkedu0022 data-wpil-monitor-id=u00221496u0022u003esharesu003c/au003e in her business, ABC Co, to Purple Ltd in March 2016.u003c/pu003enu003cp style=u0022text-align: justify;u0022u003eUnder the sale arrangement, Anna received an upfront payment of $1 million at the time of sale and a right to two future payments of up to $100,000 in March 2017 and March 2018 provided the turnover of ABC Co exceeded an agreed threshold during 2016 and 2017 respectively. This right to future income is referred to as a look-through earnout right.u003c/pu003enu003cp style=u0022text-align: justify;u0022u003eAnna’s capital proceeds for the sale of the shares 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 the right is disregarded when working out the capital proceeds.u003c/pu003enu003cp style=u0022text-align: justify;u0022u003eAs Anna has a cost base for the ABC Co shares of $600,000, she has a capital gain of $400,000 (the capital proceeds of $1 million less the cost base of $600,000) because of the sale.u003c/pu003enu003cp style=u0022text-align: justify;u0022u003eABC Co’s turnover exceeded the agreed threshold in 2016 and so Purple Ltd paid Anna a further $100,000.u003c/pu003enu003cp style=u0022text-align: justify;u0022u003eAs a result of this payment, the capital proceeds from the sale of the ABC Co shares at the time of the original u003ca class=u0022wpil_keyword_linku0022 href=u0022https://bristax.com.au/cgt-articles/cgt-events/u0022 title=u0022CGT eventu0022 data-wpil-keyword-link=u0022linkedu0022u003eCGT eventu003c/au003e are now considered to be $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) because of the sale.u003c/pu003enu003cp style=u0022text-align: justify;u0022u003eFinally, in July 2017, Purple Ltd decided it would prefer to end the arrangement immediately. It offered to pay Anna $50,000 if she would agree to forgo her right to further payments under the look-through earnout right and Anna agreed to this offer.u003c/pu003enu003cp style=u0022text-align: justify;u0022u003eThis financial benefit provided to terminate a look-through earnout right is treated in the same way as a financial benefit provided under the right.u003c/pu003enu003cp style=u0022text-align: justify;u0022u003eAs a result, Anna’s total capital proceeds for the sale are $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.u003c/pu003enu003cp style=u0022text-align: justify;u0022u003eAnna’s final capital gain from the sale is $550,000 (capital proceeds of $1.15 million less the cost base of $600,000). Note this is considered to have arisen in March 2016 at the time of the original u003ca class=u0022wpil_keyword_linku0022 href=u0022https://bristax.com.au/cgt-articles/cgt-events/u0022 title=u0022CGT eventu0022 data-wpil-keyword-link=u0022linkedu0022u003eCGT eventu003c/au003e. This would necessitate going back and amending the return for that year.u003c/pu003e

u003ch2u003eConditionsu003c/h2u003enu003cp style=u0022text-align: justify;u0022u003eAccording to u003ca href=u0022http://www8.austlii.edu.au/cgi-bin/viewdoc/au/legis/cth/consol_act/itaa1997240/s118.565.htmlu0022u003eSection 118-565 ITAA 97u003c/au003e, a look-through earnout right satisfies all the following conditions:u003c/pu003enu003culu003enu003cli style=u0022text-align: justify;u0022u003eis created as part of an arrangement for disposal of the business or its assets (i.e. the disposal must cause u003ca class=u0022wpil_keyword_linku0022 href=u0022https://bristax.com.au/cgt-articles/cgt/u0022 title=u0022CGTu0022 data-wpil-keyword-link=u0022linkedu0022u003eCGTu003c/au003e event A1 to happen)u003c/liu003enu003cli style=u0022text-align: justify;u0022u003eis a right to future financial benefits which are not reasonably ascertainable at the time the right is createdu003c/liu003enu003cli style=u0022text-align: justify;u0022u003ethe financial benefits under the right are contingent on and reasonably related to the future economic performance of the asset (or a related business) and the value of the benefits reasonably related to this performanceu003c/liu003enu003cli style=u0022text-align: justify;u0022u003eis created as part of arrangements entered into on an arm’s-length basisu003c/liu003enu003cli style=u0022text-align: justify;u0022u003eall the financial benefits that can be provided under the right must be provided over a period ending no later than more than five years after the end of the income year in which the relevant CGT event occurs concerning the disposal of the relevant active asset. The 5-year requirement will be breached if the agreement includes an option for the parties to extend the period over which financial benefits are provided or to enter into a new agreement providing for the continuation of substantially similar financial benefits.u003c/liu003e

u003ch2u003eChoices and timingu003c/h2u003enu003cp style=u0022text-align: justify;u0022u003eAs mentioned, this taxation treatment of earnout rights results in the amount of a capital gain or loss changing because of financial benefits provided or received in subsequent income years. As a result, several special rules were inserted into the ITAA 97 to ensure that this does not disadvantage taxpayers or impose unnecessary compliance and administrative costs.u003c/pu003enu003cp style=u0022text-align: justify;u0022u003eAs the financial benefits may be provided up to 5 years after the end of the income year in which the CGT event occurred, the period of review for the income year in which the CGT event occurred may have passed before the taxpayer has provided or received the financial benefits requiring the amendment. As a result, the period of review is extended for all a taxpayer’s tax-related liabilities that can be affected by the character of the look-through earnout right to the latter of:u003c/pu003enu003culu003enu003cli style=u0022text-align: justify;u0022u003ethe period of review that would normally apply, andu003c/liu003enu003cli style=u0022text-align: justify;u0022u003e4 years after the end of the final income year in which financial benefits can be provided.u003c/liu003enu003c/ulu003enu003cp style=u0022text-align: justify;u0022u003eThis extension also applies to taxpayers’ rights to object where they are dissatisfied with an assessment.u003c/pu003e

u003ch2u003eGIC and SICu003c/h2u003enu003cp style=u0022text-align: justify;u0022u003eTaxpayers will not be subject to General Interest Charge (u003ca class=u0022wpil_keyword_linku0022 href=u0022https://bristax.com.au/tax-articles/general-interest-charge/u0022 title=u0022GICu0022 data-wpil-keyword-link=u0022linkedu0022u003eGIC)u003c/au003e on any shortfall that arises because of financial benefits provided or received under a look-through earnout right, as long as they request an amendment to their relevant income tax assessment within the period they must lodge their income return for the income year in which the financial benefit was provided or received. (Likewise, the Commissioner will not be liable to pay interest on any overpayment of tax that arises as a result of financial benefits provided or received.)u003c/pu003enu003cp style=u0022text-align: justify;u0022u003eTo the extent a taxpayer has accessed a concession for which they are ultimately not eligible due to these financial benefits, the taxpayer will be subject to a shortfall interest charge (SIC).u003c/pu003enu003cp style=u0022text-align: justify;u0022u003eu003cstrongu003eTEMPORARY DISREGARD OF LOSSESu003c/strongu003e u003cbru003e In cases where entities dispose of assets and receive a look-through earnout right that initially results in a capital loss position, such capital losses will be “temporarily disregarded” until and to the extent that they become certain.u003c/pu003enu003cp style=u0022text-align: justify;u0022u003eHowever, once such losses become certain, they will become available from the year in which the loss was originally incurred, not when the amount became certain.u003c/pu003enu003cp style=u0022text-align: justify;u0022u003eu003cstrongu003eAn example from the Explanatory Memorandum of the legislationu003c/strongu003e u003cbru003e In June 2016, Lucas sold the shares in his business, Software Ent u003cbru003e erprises Ltd (a u003ca class=u0022wpil_keyword_linku0022 href=u0022https://bristax.com.au/cgt-articles/small-business-entity/u0022 title=u0022small business entityu0022 data-wpil-keyword-link=u0022linkedu0022u003esmall business entityu003c/au003e with only active assets) to Buyer Co.u003c/pu003enu003cp style=u0022text-align: justify;u0022u003eLucas received a fixed upfront payment of $750,000 and has several additional entitlements to future payments under several look‑through earnout rights contingent on a variety of profit and performance targets being met by Software Enterprises.u003c/pu003enu003cp style=u0022text-align: justify;u0022u003eAs he has a cost base of $800,000 for the shares, at this stage Lucas has made a capital loss of $50,000. However, as Lucas may potentially receive further payments of an amount greater than $50,000 under the look-through earnout rights, he must disregard this loss.u003c/pu003enu003cp style=u0022text-align: justify;u0022u003eIn the 2016-17 financial year, Lucas received further payments totalling $250,000 under the look‑through earnout rights. This payment is included in the capital proceeds of the sale of the shares in Software Enterprises, meaning that Lucas has now received a total of $1 million and has a capital gain of $200,000. This gain resulted in an increase in his income tax liability for that year.u003c/pu003enu003cp style=u0022text-align: justify;u0022u003eAt the same time as Lucas lodged his tax return for the 2016-17 year, he also requested an amendment to his assessment for the 2015‑16 income year to include the additional capital gain resulting from the payment under the rights. As a result, he will not be subject to a shortfall interest charge on any amount of additional tax he must pay for the 2015-16 year as a result of this amendment – in effect he is in the same position as if the payment had been taxed in the income year in which it was received.u003c/pu003enu003cp style=u0022text-align: justify;u0022u003eIn June 2020, Lucas received a final payment of $100,000 under the look‑through earnout rights. Consistent with the previous payments this amount is included in the capital proceeds of the sale and Lucas requests an amendment to his income tax assessment for 2015-16 to reflect the increased capital gain of $300,000.u003c/pu003enu003cp style=u0022text-align: justify;u0022u003eAs an individual who did not satisfy any of the conditions for a longer amendment period, Lucas’s assessment for 2015-16 would normally only be able to be amended by the Commissioner for two years from the date of the original assessment. By June 2020, this period would have passed.u003c/pu003enu003cp style=u0022text-align: justify;u0022u003eHowever, in this case, the Commissioner may still amend Lucas’s assessment in respect of the payment as it is a financial benefit under a look‑through earnout right that affects the amount of Lucas’s income tax liabilities for the year in which the sale occurred and the amendment is sought within four years of the end of the income year in which the final potential financial benefit under the right was to be provided.u003c/pu003e

u003ch2u003eAccess to CGT concessionsu003c/h2u003enu003cp style=u0022text-align: justify;u0022u003eThe tax treatment of look-through earnout rights affects a taxpayer’s entitlement to CGT concessions insofar as this may occur because of the value of the underlying disposal now including all the amounts provided for and under the earnout right.u003c/pu003enu003cp style=u0022text-align: justify;u0022u003eAs a result, taxpayers may reconsider any choices and their entitlement to concessions in light of subsequent receipts and payments to ensure that the resulting gain, loss or cost base reflects any available concessions.u003c/pu003enu003cp style=u0022text-align: justify;u0022u003eLikewise, in some cases, a taxpayer may not initially be in a position to elect that a concession applies to a CGT event. Alternatively, a taxpayer may be concerned that anticipated future financial benefits in respect of a look-through earnout right may mean that they cease to be eligible for a concession to apply after they have taken irrevocable actions based on this concession (such as making u003ca class=u0022wpil_keyword_linku0022 href=u0022https://bristax.com.au/superannuation-articles/super-contributions/u0022 title=u0022superannuation contributionsu0022 data-wpil-keyword-link=u0022linkedu0022u003esuperannuation contributionsu003c/au003e). In these cases, as the taxpayer can remake choices, they can simply wait until it is clear whether they will be finally eligible for the concession before making any choice.u003c/pu003enu003cp style=u0022text-align: justify;u0022u003eNote that while the receipt of financial benefits under a look-through earnout right may allow the taxpayer to remake choices, it does not entitle the taxpayer to undo the actions they have taken in that period. For example, if taxpayers have made u003ca class=u0022wpil_keyword_linku0022 href=u0022https://bristax.com.au/superannuation-articles/super-contributions/u0022 title=u0022superannuation contributionsu0022 data-wpil-keyword-link=u0022linkedu0022u003esuperannuation contributionsu003c/au003e to access a concession, they cannot withdraw these contributions now they are no longer available.u003c/pu003enu003cp style=u0022text-align: justify;u0022u003eFurther, the CGT small business concessions can also require things to be done within a fixed period (e.g. the CGT small business retirement exemption generally requires taxpayers to contribute a relevant amount to their superannuation when the proceeds are received or at the time the choice is made for an individual or seven days after these times for a u003ca class=u0022wpil_keyword_linku0022 href=u0022https://bristax.com.au/misc-articles/family-trust/u0022 title=u0022trustu0022 data-wpil-keyword-link=u0022linkedu0022 data-wpil-monitor-id=u0022341u0022u003etrustu003c/au003e or u003ca class=u0022wpil_keyword_linku0022 href=u0022https://bristax.com.au/business-articles/pty-ltd-company/u0022 title=u0022companyu0022 data-wpil-keyword-link=u0022linkedu0022u003ecompanyu003c/au003e). In such cases, the period for accessing such concessions is extended appropriately.u003c/pu003e

u003cpu003eThis article is general information only and does not provide advice to address your personal circumstances. To make an informed decision you should contact an appropriately qualified professional.u003c/pu003e