Earnout Arrangement

Contents

• What is an earnout arrangement?
• Conditions
• Choices and timing
• GIC and SIC
• Access to CGT concessions

What is an earnout arrangement?

An earnout arrangement is where a business is sold for a set amount plus a percentage of profits in the future for a specified period. 

The 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.

This 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.

An Example from the Explanatory Memorandum of the Legislation
Anna sold all the shares in her business, ABC Co, to Purple Ltd in March 2016.

Under 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.

Anna’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.

As 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.

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

As a result of this payment, the capital proceeds from the sale of the ABC Co shares at the time of the original CGT event 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.

Finally, 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.

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

As 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.

Anna’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 CGT event. This would necessitate going back and amending the return for that year.

Conditions

According to Section 118-565 ITAA 97, a look-through earnout right satisfies all the following conditions:

• is created as part of an arrangement for disposal of the business or its assets (i.e. the disposal must cause CGT event A1 to happen)
• is a right to future financial benefits which are not reasonably ascertainable at the time the right is created
• the 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 performance
• is created as part of arrangements entered into on an arm’s-length basis
• all 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.

GIC and SIC

Taxpayers will not be subject to General Interest Charge (GIC) 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.)

To 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).

TEMPORARY DISREGARD OF LOSSES
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.

However, 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.

An example from the Explanatory Memorandum of the legislation
In June 2016, Lucas sold the shares in his business, Software Ent
erprises Ltd (a small business entity with only active assets) to Buyer Co.

Lucas 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.

As 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.

In 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.

At 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.

In 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.

As 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.

However, 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.