In PART 1 of our series on earnouts, we discussed the commercial benefits that an earnout can provide to buyers and sellers of small businesses where they can’t agree on a price.
While understanding the potential commercial benefits is the starting point when considering an earnout, understanding the tax implications for both the buyer and the seller is the crucial next step.
Before diving head first into the tax rules, we should first step back and briefly touch on the two ways in which the sale of a business can take place:
- Sale of the shares in a company (or units in a trust); or
- Sale of assets used in the business.
In the context of a share sale, only one asset is disposed of – the shares in the company that is carrying on the business.
Where the shares are held by the seller with the intention of investing in the business for the long term (as is generally the case with small businesses), this disposal is taxed under the CGT rules.
Where there is an asset sale, multiple assets used in the business may be disposed of by the seller. Common examples include:
- Plant & equipment
- Intellectual property
The tax consequences for the disposal of each type of asset need to be considered separately, as different tax rules can apply.
Using the above assets as an example:
taxed under the trading stock rules;
- Plant & equipment
taxed under the uniform capital allowances rules;
- Intellectual property
can be taxed under either the uniform capital allowances rules or the CGT rules, depending on the nature of the intellectual property; or
taxed under the CGT rules.
When dealing with earnouts, the CGT rules are the main area of focus, given:
- Where there is a share / unit sale, the CGT rules would generally apply; and
- Where there is a business asset sale, any proceeds that may be received under the earnout will generally relate to the goodwill of the business, as that is the business asset that will be of uncertain value. Therefore, the CGT rules would apply.
Note: Since 2007 there have been a number of changes to the treatment of earnouts under the CGT rules, so I’ve tailored the remainder of this post toward dealing with earnouts that have been been (or will be) entered into since the most recent change of rules, which apply from 23 April 2015 onwards.
Do we even have an earnout?
The starting point of our analysis should begin with ensuring that the business sale agreement actually gives rise to an earnout and not deferred purchase consideration.
The line between the two can be blurry, and the tax outcomes certainly different, so making this distinction is an important first step.
DEFERRED PURCHASE CONSIDERATION
Deferred purchase consideration arises where part of the consideration payable for the business is deferred under the sale agreement. For example, where $100,000 is due upon settlement of the business sale, with another $500,000 due exactly 1 year from that date.
As the amount of the deferred component (i.e. $500,000) is ascertainable with certainty at the time the sale agreement is signed, it would constitute deferred purchase consideration and not an earnout.
Where there is deferred purchase consideration, the taxing point arises at the time that the sale agreement is signed – regardless of whether all the cash proceeds are actually received at that time or not.
This can result in cashflow issues for the seller who would be required to pay tax on the entire capital gain, despite not receiving the second cash payment of $500,000 until over a year later.
Therefore, when dealing with deferred purchase consideration, it is important to ensure that the upfront payment is sufficient to cover the seller’s tax liability.
An earnout arises where a business sale agreement stipulates that additional purchase consideration only becomes payable where the business meets certain future performance metrics.
For example, an earnout would arise where $1,000,000 is due upon settlement of the business sale, with another $500,000 contingent upon a 10% increase in gross profit being achieved in the following financial year.
In this situation, at the time of settlement, the seller would not know with certainty whether a 10% increase in gross profit will be achieved in the following year.
It is this element of uncertainty that is the fundamental difference between an earnout and deferred purchase consideration.
So, we have an earnout. What are the tax consequences?
The two methods under which an earnout can be taxed are known as the:
- Separate asset approach; and
- Look-through approach.
Whether the buyer and seller have a choice as to which method to apply will depend on whether the specific conditions to apply the look-through approach are met.
Where these conditions are met, the taxpayer could choose to apply either the method. However, where the conditions are not met, only the separate asset approach can be applied.
Under the look-through approach, the earnout right is effectively ignored (i.e. looked-through).
Following the initial sale of the business, subsequent payments arising where the earnout targets are achieved are treated as additional proceeds relating to the sale of the underlying business CGT asset (i.e. the shares or the goodwill being disposed of).
Importantly, this approach allows the seller to access the small business CGT concessions and the general 50% CGT discount to reduce any additional gain on the sale that may arise where such payments are made.
Note: while the look-through approach has been available in practice, since 2010, draft legislation supporting the approach was only released effective 23 April 2015. The below conditions are based on this draft legislation and are current at the time of writing, although they may be subject to change once the legislation is released in final form.
*Edit: legislation supporting the look-through approach received royal assent on 23 February 2016. The remainder of this post has been edited to reflect the legislation in its final form.
The conditions that must be met in order to apply the look-through approach are as follows:
- Future financial benefits must not be ‘reasonably ascertainable’ at the time of the sale (that is, at the time of the business sale, the parties could not determine whether any future payments would be required under the earnout);
- CGT event A1 (basic disposal of a CGT asset) must happen;
- The asset must be an ‘active asset’ (the asset must be used in carrying on a business);
- The future financial benefits must be linked to the economic performance of the business (they can’t be linked to another outcome, for example, a successful court proceeding);
- All future benefits under the earnout must be provided within 5 years (the earnout can’t provide for potential payments more than 5 years after the end of the income year in which the the business asset was disposed of); and
- The parties to the earnout (i.e. the buyer and seller) must be dealing at arms-length.
Where the above conditions are met and the look-through approach is available, the tax outcomes for the seller and the buyer are described below.
For the seller
The seller would realise a capital gain to the extent that the total proceeds received in relation to the business asset (either upfront, or in the future where earnout targets are achieved), exceeds their cost base in the asset.
To give effect to this, the seller would need to amend their tax return for the year in which the business was disposed of to increase their capital gain in line with any additional payments received under the earnout.
On the other hand, where the seller realises a capital loss on the sale based on the upfront proceeds received, that loss cannot be included in their tax return until it is ‘reasonably certain’ that the loss will crystallise (that is, where it is no longer possible that the loss will be subsequently reversed due to additional payments being received under the earnout).
For the buyer
Both the initial payment made under the business sale, as well as any subsequent payments required under the earnout, would be included by the buyer in their cost base for the business asset that is acquired.
SEPARATE ASSET APPROACH
Where the conditions to apply the look-through approach are not met, the ‘separate asset approach’ would apply. In this way, it acts the default method for taxing earnouts.
Under the separate asset approach, the sale proceeds that the seller is taken to receive from the buyer upon disposing of their business is the sum of two components:
A) The upfront consideration (cash proceeds paid upon settlement); plus
B) The market value of the earnout right (this is a separate ‘right’ to receive an amount, that is contingent upon the business meeting future performance targets).
Component B, being the earnout right, is created at the time the business is disposed of and is treated as a separate asset to the underlying business being sold.
In order to determine the value of the earnout right, a market valuation is required based on the likelihood of the earnout resulting in additional payments. This can be a costly exercise, especially for small businesses.
In addition to the cost of obtaining a market valuation, treating the right as a separate asset can also give rise to unexpected, often unfavourable, tax outcomes for both the seller and the buyer.
For the seller
The imprecise nature of calculating the market value of the earnout right can give rise to unfavourable tax outcomes for the seller when the earnout right ends, where the actual payments made under the earnout are more or less than what the predetermined market value was at the time of the disposal.
For example, the seller could realise a capital loss where the the market valuation was in fact too high, as may be the case where the earnout targets are not achieved.
This would leave the seller in the unfortunate position of having paid tax upfront on the market value of the right at the time of disposal, while being left with an unutilised capital loss when the earnout ends.
Further, with the underlying business already sold, the seller would need to realise a capital gain at some future point in time in order to derive any benefit from the capital loss. If the seller had no more capital assets left to dispose of, the loss may simply go unutilised.
Not an ideal outcome for the seller.
On the other hand, where the earnout targets are achieved, it is possible that the market value obtained at the time of the disposal may in fact have been too low and the seller may end up with an additional capital gain.
Under the separate asset approach, accessing the CGT concessions to reduce this gain is problematic, as eligibility for the concessions is assessed separately from the underlying business asset that was sold.
The general 50% CGT discount would only be available where the earnout right has been held for at least 12 months. This means that at least 12 months would need to have elapsed between when the sale contract was signed and the earnout period ends. This remains the case regardless of whether the underlying business asset that was sold had been held by the seller for 12 months or more (and therefore eligible for the CGT discount).
Further, the small business CGT concessions would not be available to reduce any capital gain relating to the earnout right, regardless of whether the gain on the underlying business asset was eligible for the concessions.
Again, potentially a very unfavourable outcome for the seller.
For the buyer
The buyer of the business would include the market value of the earnout right at the time they acquired the business in the cost base of the business asset acquired. This amount would remain the same, regardless of whether the amount actually payable to the seller under the earnout turns out to be more or less than the market valuation obtained at the time of acquisition.
For example, if the market value of the earnout was $100,000 and subsequently the earnout targets weren’t achieved, the buyer could still include $100,000 in their cost base. That is, they could still include $100,000 in the cost base, regardless of whether the amount they were actually required to pay to the seller under the earnout was $Nil!
However, where the earnout targets are achieved, it can work against the buyers.
Continuing with the above example, if the market value of the earnout was $100,000 and subsequently the earnout targets were achieved, the buyer could only include $100,000 in their cost base, regardless of whether the amount they were actually required to pay to the seller was significantly more.
Given these unpredictable and potentially unfavourable outcomes that can arise under the separate asset approach, the best option available to buyer and sellers is to ensure that any proposed earnout will satisfy the conditions for applying the look-through approach.
While there are clear commercial benefits to be had in incorporating an earnout into a business sale, if an earnout is included without proper consideration as to the eventual tax outcomes for the buyer and seller, it can prove costly – both in professional fees, and potentially, in taxes.
It is important to remember that everyones situation is different. The information contained in this post should not be relied upon as specific professional advice. Please contact us to obtain specific advice in relation to your particular situation.
Please leave any questions and comments below and we will do our best to get back to you.