Explains earnout arrangements and your CGT obligations depending on when you enter into the arrangement.
CGT consequences of earnout arrangements
Earnout arrangements are often employed as a way of structuring the sale of a business to deal with uncertainty about its value. Generally, they arise where the contract for the sale of a business (or assets of the business) provides for an initial lump sum payment by the buyer and a right to subsequent financial benefits that are contingent on the performance of the business for a specified period after the sale.
In a standard earnout arrangement, the buyer agrees to pay the seller additional amounts if certain performance thresholds are met within a particular time. The seller holds the earnout right.
In a reverse earnout arrangement, the seller agrees to repay amounts to the buyer if certain performance thresholds are not met within a particular time. The buyer holds the earnout right.
Some earnout arrangements combine the features of both a standard earnout arrangement and a reverse earnout arrangement as both the buyer and seller may be obligated to provide financial benefits depending on performance.
TR 2007/D10 Income tax: capital gains: capital gains tax consequences of earnout arrangements, sets out the ATO view on the application of the CGT provisions to earnout arrangements entered into before 24 April 2015. While this draft ruling has been withdrawn it still applies to earnout arrangements entered into during the time it was in force. Under the view taken in this ruling, where the sale of a business involves an earnout arrangement, the earnout right or rights created are separate CGT assets and dealt within the CGT provisions accordingly.
Legislation, which became law on 25 February 2016 provides for a look-through CGT treatment of certain earnout arrangements entered into on or after 24 April 2015. The law as described in TR 2007/D10 continues to apply to earnout arrangements to which the 25 February 2016 legislation does not apply.
Earnout arrangements entered into before 24 April 2015
A taxpayer who entered into an earnout arrangement before 24 April 2015 and who has lodged previous returns on the basis of the law as described in TR 2007/D10 should continue to use that basis.
Transitional provisions apply to a taxpayer who entered into an earnout arrangement prior to 24 April 2015, and who, in a previous tax return, reasonably and in good faith anticipated that the law would be retrospectively amended to a look through basis. The transitional provisions allow the taxpayer to lodge subsequent tax returns on the same look through basis.
Earnout arrangements entered into on or after 24 April 2015 – where the new law applies
Look-through CGT treatment applies to 'look-through earnout rights' created on or after 24 April 2015, if:
- the right is a right to future financial benefits that are not reasonably ascertainable at the time the right is created
- the right was created under an arrangement involving the disposal of a CGT asset
- the disposal caused CGT event A1 to happen
- just before the CGT event, the CGT asset was an active asset of the entity which disposed of the asset
- all of the financial benefits under the right are to be provided within 5 years after the end of the income year in which the CGT event happened
- the financial benefits must be contingent on the economic performance of the CGT asset or a business for which it is expected that the CGT asset be an active asset for the period to which those financial benefits relate
- the value of those financial benefits reasonably relates to that economic performance, and
- the parties to the arrangement deal with each other at arm's length in making the arrangement.
Under the look-through CGT treatment:
- the capital gains or losses in respect of look-through earnout rights are disregarded
- for the buyer, any financial benefit provided (or received) under a look-through earnout right increased (or decreased) the cost base and the reduced cost base of the underlying asset
- for the seller, any financial benefit received (or provided) under the look-through earnout right increased (or decreased) the capital proceeds from the disposal of the underlying asset
- capital losses arising from the disposal of assets to which look-through earnout rights relate are temporarily disregarded until and to the extent that they become certain, that is, the capital losses could not be further reduced by you receiving one or more financial benefits. Once the losses become certain, they are available from the income year in which they were originally incurred, and not when the amount of the losses became certain.
You may need to seek an amendment to your net capital gain (or capital losses carried forward amount) of an earlier income year. You may be able to seek such amendment by simply completing labels 7F and 7G of the CGT schedule. For more information go to Item 7 Earnout arrangements under step 4 of Part C How to complete the CGT schedule.
Earnout arrangements entered into on or after 24 April 2015 – where the new law does not apply
Where an earnout arrangement entered into on or after 24 April 2015 does not satisfy the conditions of the new legislation described above, the law as described in TR 2007/D10 still applies.
Differences between the application of TR 2007/D10 and the new look-through CGT treatment
The following example illustrates the differences between the application of the view contained in TR 2007/D10 and the look-through CGT treatment. This example does not consider any CGT concession that may be available.
A business is sold on the following terms:
- the buyer agrees to pay an initial upfront amount of $800,000
- the buyer agrees to pay the seller 50% of the revenue above $500,000pa for the next 3 income years.
The market value of the earnout rights at the time of the contract is $300,000 in total.
Revenue for the business in the following 3 income years is $700,000, $800,000 and $700,000. Therefore the buyer makes additional payments of $100,000, $150,000 and $100,000 to the seller.
The following assumptions are made:
- each right to a financial benefit is a separate CGT asset with an equal market value of $100,000
- the seller's cost base for the business is $700,000
- all the conditions of a look-through earnout right are met (when considering look-through CGT treatment)
- there are no other CGT events
- there are no capital losses brought forward from prior years
- seller is not eligible for the 50% CGT discount
- no other expenditure has been incurred.
|
Year |
TR 2007/D10 |
Look-through CGT treatment |
|---|---|---|
|
0 |
CGT event A1 happened and the seller's capital proceeds from this event include the value of the earnout rights totalling $1,100,000 (i.e. $800,000 plus $300,000) and the cost base is $700,000. The capital gain is $400,000. The seller also acquired 3 separate CGT assets (3 earnout rights) in the form of a chose in action. The first element of the cost base of each right is $100,000. |
CGT event A1 happened and the seller's capital proceeds are $800,000 and the cost base is $700,000. The capital gain is $100,000. |
|
1 |
CGT event C2 happened. Capital proceeds (financial benefits received) are $100,000 [($700,000 − $500,000) × 50%] and the first element of the cost base is $100,000. No capital loss or gain. |
Financial benefits of $100,000 received. Amend Year 0 capital proceeds by $100,000 to $900,000, which results in a capital gain of $200,000. |
|
2 |
CGT event C2 happened. Capital proceeds (financial benefits received) are $150,000 [($800,000 − $500,000) × 50%] and the first element of the cost base is $100,000. The capital gain is $50,000. |
Financial benefits of $150,000 received. Amend Year 0 capital proceeds by $150,000 to $1,050,000, which results in an amended capital gain of $350,000. |
|
3 |
CGT event C2 happened. Capital proceeds (financial benefits received) are $100,000 [($700,000 − $500,000) ×50%] and the first element of the cost base is $100,000. No capital loss or gain. Note: the total capital gains reported over the life of the arrangement is $450,000. |
Financial benefits of $100,000 received. Amend Year 0 capital proceeds by $100,000 to $1,150,000, which results in an amended capital gain of $450,000. |
From the example above, under the look-through CGT treatment:
- a valuation of the earnout right itself is not required
- the CGT consequences for the seller are not reported and assessed until the financial benefits are received or provided.
Extension to period of review
Financial benefits under a look-through earnout right can be provided or received up to 5 years after the end of the income year in which the CGT event occurred. In some cases, the period of review may have passed before you have provided or received the financial benefit requiring the amendment.
Accordingly, the period of review for all entities’ tax-related liabilities affected by a look-through earnout right is the later of the period of review that would normally apply and 4 years after the end of the income year in which the last possible financial benefit could be received or provided under the look-through earnout right. This includes liabilities in subsequent years and tax related liabilities for taxes other than income tax.
Penalties and interest
You will not be subject to shortfall interest charge on additional tax that you must pay as a result of providing or receiving financial benefits under a look-through earnout right. This is provided you request an amendment to the relevant income tax assessment by the due date for lodgment of the income year in which you received or provided those financial benefits.
However, the above exception to the shortfall interest charge does not apply to the extent you accessed a concession for which you are ultimately not eligible as a result of receiving or providing those financial benefits.
The Commissioner is not liable to pay interest on any overpayment of tax which results from financial benefits being provided or received under a look-through earnout right.
Remaking choices affected by look-through earnout rights
You can remake any choice previously made where the choice relates to a capital gain or loss that can be affected by financial benefits provided or received under a look-through earnout right. However, you need to remake the choice at or before the time you are required to lodge your income tax return for the income year in which the financial benefit is provided or received.
Therefore, you may need to reconsider any choices and your entitlement to concessions in light of financial benefits provided or received to ensure that the resulting gain, loss or cost base reflects any concessions that are available. Alternatively you can wait until it is clear whether or not you will be finally eligible for the concession before making any choice.
Additionally, if you have made contributions to a superannuation fund in order to access a concession, you cannot withdraw these contributions if the concessions are no longer available.
Effect of look-through earnout rights on CGT Small business concessions
The future financial benefits received or provided under a look-through earnout right may affect your eligibility for some CGT concessions. It may also impact on the time allowed for you to take certain actions to satisfy the eligibility requirements.
For more information see Small business CGT concessions.
Allocated cost amount (ACA) affected by look-through earnout rights
Consolidated groups may need to revise the entry ACA of an entity that joins the group if:
- the membership interest in the entity was acquired under a look-through earnout arrangement
- subsequent financial benefits were provided or received under the look-through earnout right
- the subsequent financial benefits were not taken into account in working out the ACA when the entity joined the group.
Continue to: Part B – Completing the capital gains section of your tax return