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Earnout arrangements are often employed as a way of structuring the sale of a business to deal with uncertainty about its value. In an earnout arrangement, the proceeds for the sale of the business (or assets of the business) generally include a lump sum payment. However, the terms of the sale contract require either the buyer or the seller to make more payments that are contingent on the performance of the business. The right to receive more payments is called an ‘earnout right’.
There are two types of earnout arrangement:
- a standard earnout arrangement, in which the seller holds the earnout right and may receive additional payments
- a reverse earnout arrangement, in which the buyer holds the earnout right and may receive additional payments.
Draft Taxation Ruling TR 2007/D10 sets out the ATO view on the application of the CGT provisions to earnout arrangements. The view taken in the draft ruling is that dealings in earnout rights have CGT consequences that are independent from those that arise from the sale of the business.
Government announcement: Look-through treatment for earnout arrangements
On 12 May 2010, as part of the 2010 Budget, the Government announced 'Look-through' treatment for earnout arrangements to simplify sale of business assets.
Under this measure:
- additional payments made under a 'standard' earnout arrangement will be treated as relating to the original asset for the seller and will be added to the cost base for the buyer
- payments made under a 'reverse' earnout arrangement will be treated effectively as a repayment of part of the capital proceeds.
This change will apply to earnout arrangements any taxpayer enters into on or after Royal Assent of the amending legislation. It also applies, where a taxpayer makes a choice for the changes to apply from either 12 May 2010 or, in limited situations, 17 October 2007.
For more information on current law treatment, see Draft Taxation Ruling TR 2007/D10 – Income tax: capital gains: capital gains tax consequences of earnout arrangements.
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Information on earnout arrangements are shown at Part O of the CGT schedule.