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In brief
- The tax treatment of earn out arrangements has been in limbo since the ATO released TR 2007/D10 in October 2007.
- This uncertainty should be partly alleviated through announced changes to the treatment of qualifying earn outs.
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The tax treatment of earn out arrangements—where on the sale of a business asset some part of the agreed price is contingent on future economic performance—has been in limbo since the Australian Taxation Office (ATO) released TR 2007/D10 in October 2007. This uncertainty should be partly alleviated, with the Federal Government announcing in the 2010 Federal Budget that all payments under certain ‘qualifying’ earn out arrangements will be treated as relating to the sale and purchase of the underlying business assets. Further details of the proposed changes are contained in a Proposals Paper released by the government for consultation.
The proposed changes address both ‘standard earn out arrangements’ (where the seller receives a right to future payments contingent on the performance of the asset sold) and ‘reverse earn out arrangements’ (where the seller receives a set amount as the sale price, but undertakes to pay an amount to the buyer if the performance of the asset does not meet specified criteria).
This article focuses on qualifying standard earn out arrangements given their prevalence.
Taxation of standard earn out arrangements
Under a ‘standard earn out’ for the sale of a business asset, the seller receives a right to future payments that are contingent on the economic performance of the business asset.
Under the ATO’s view in TR 2007/D10:
- The seller is considered to receive two assets for the sale of the asset sold—the initial consideration, such as shares or cash paid at completion, and the right to receive further payments under the earn out. The seller includes the market value of that right at the time of the sale in its capital proceeds for calculating its capital gain or loss on sale. Any subsequent payments under the earn out are considered to be in respect of the earn out right rather than the underlying asset. This limited the ability of the seller to access the CGT discount and small business concessions in respect of the earn out payments. If the payments received under the earn out are less than the market value ascribed the seller makes a capital loss which, if received in a later income year, cannot be offset against any gain made on the sale of the original asset.
- For the buyer, its cost base in the business asset is the cash paid plus the market value of the earn out right at the time of sale. Any amounts subsequently paid by the buyer under the earn out are not included in the cost base of the asset acquired.
The government proposes a far more practical solution to the taxation of qualifying earn outs. Where the earn out satisfies the qualifying criteria, a ‘look through’ approach will be adopted so that the earn out right is disregarded, and all payments are treated as relating to the sale (or purchase) of the business asset. Under this look through approach:
- For the seller, it will reduce the cost base of the asset sold as and when amounts it is due to receive become certain (including the initial purchase price and subsequent payments). Once the cost base of the asset is reduced to zero, the seller will derive a capital gain in the income year in which the payments are received (rather than the income year when the business asset was sold). Importantly, the capital gain will be eligible for all CGT concessions that the business asset was eligible to receive. If an overall capital loss would be realised, this cannot be realised until either the end of the earn out arrangement or the seller would still realise a capital loss even if it receives the maximum amount possible under the earn out arrangement.
- For the buyer, the cost base of the business asset will be the total amount paid to the seller.
Example
Seller sells business asset in Year 1 with a cost base of $800,000 for a sale price of $1 million cash, plus a right to a future payment in Year 2 with a market value of $200,000. Ultimately, a payment of $250,000 is made by the buyer to the seller in Year 2.
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TR 2007/D10 |
New proposal |
| Seller |
Year 1: Capital gain from business asset equals $400,000 ($1m cash plus market value of earn out right of $200,000 less cost base of $800,000). Capital gain eligible for CGT discount and small business CGT concessions. |
Year 1: Capital gain from business asset equals $200,000 ($1m cash less cost base of $800,000). Capital gain eligible for CGT discount and small business CGT concessions. |
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Year 2: Capital gain from earn out right equals $50,000 ($250,000 payment received less cost base of earn out right of $200,000, being market value at time of business asset sale). Still eligible for CGT discount but not small business CGT concessions. |
Year 2: Additional capital gain from business asset of $250,000 realised in Year 2 (as cost base has been reduced to nil). Capital gain eligible for CGT discount and small business CGT concessions. |
| Buyer |
Cost base of business asset equals $1.2 million (being $1 million cash paid plus market value of earn out right of $200,000).
$50,000 excess over initial market value of earn out right does not form part of the cost base. |
Cost base of business asset equals $1.25 million (being $1 million paid in Year 1 and $250,000 paid in Year 2). |
Qualifying criteria
In order to qualify for the proposed measures the earn out arrangement must satisfy the following criteria:
- a maximum time limit for the earn out arrangement (for example, five years)
- payments must be genuinely contingent and related to the performance of the asset acquired
- the earn out right must exist due to uncertainty about the value of one or more of the assets
- the transaction must be at arm’s length, and
- the relevant business asset(s) must not be a revenue asset or trading stock.
Application date and transitional rules
The proposed changes to earn out arrangements will apply from the date of Royal Assent of the enabling legislation, with specific transitional provisions for pre-existing earn outs.
This article was written by Richard Hendriks, Director and Cameron Blackwood, Senior Associate, Greenwoods & Freehills.
More information
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