CGT Earnout Arrangements
Capital Gains Tax (CGT) Earnout arrangements are generally where a business is sold for a set amount plus a percentage of profits in the future for a specified period. The tax treatment of these rights to income in the future has varied over the years. The latest change was provided for by the Tax and Superannuation Laws Amendment (2015 Measures No 6) Act 2015 (the legislation) which introduced rules into the Income Tax Assessment Act 1997 (ITAA 97) that took effect 24 April 2015.
The rules now 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 taxation 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.
Example from Explanatory Memorandum (EM) to 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 to be satisfied to be an earnout right
According to Section 118-565 ITAA 97, a look-through earnout right is one that satisfies all the following conditions:
- is created as part of an arrangement for a 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 relates 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 in relation to 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 benefit.
Choices and timing
As 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.
As 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 later of:
- the period of review that would normally apply, and
- 4 years after the end of the final income year in which financial benefits can be provided.
This extension also applies to taxpayers’ rights to object where they are dissatisfied with an assessment.
General interest charge (GIC) and shortfall interest charge (SIC)
Taxpayers will not be subject to a 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.
Example from the Explanatory Memorandum the legislation
In June 2016, Lucas sold the shares in his business, Software Enterprises 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 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.
Access to CGT concessions
The 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.
As 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 concessions that are available.
Likewise, 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 contributions to superannuation). 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.
Note 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 contributions to superannuation to access a concession, they cannot withdraw these contributions now they are no longer available.
Further, the CGT small business concessions can also require things to be done within a fixed period of time (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 trust or company). In such cases the period for accessing such concessions is extended appropriately.
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