Explains what earnout and deferred consideration arrangements are.
Earnout and deferred consideration arrangements are often employed as a way of structuring the sale of a business (including business assets or an interest in an entity carrying on a business) to deal with uncertainty about its value. They create a contingent right to a future payment (or other financial benefit) that is unascertainable at the time the right is created.
Often the sale contract provides for:
- an initial lump sum payment by the buyer
- a right to subsequent financial benefits that are contingent on satisfying conditions about the performance of the business, market prices, or meeting certain milestones.
In a standard earnout or deferred consideration arrangement, the buyer agrees to pay the seller additional amounts if the relevant conditions are met. The seller holds the contractual right.
In a reverse earnout or deferred consideration arrangement, the seller agrees to pay amounts to the buyer if the relevant conditions are not met. The buyer holds the contractual right.
Some earnout and deferred consideration arrangements combine the features of both a standard arrangement and a reverse arrangement as both the buyer and seller may be obligated to provide financial benefits which are dependent on contingencies.
Legislation that became law on 25 February 2016 provides for look-through CGT treatment of certain earnout arrangements entered into on or after 24 April 2015. Under the look-through CGT treatment in Subdivision 118-I, capital gains or losses associated with look-through earnout rights are disregarded, and the financial benefits of the arrangement are instead applied to the capital proceeds or cost base of the underlying asset.
The tax considerations for earnouts and deferred consideration arrangements outlined in this section are general in nature and may not be relevant to all sale transactions that include earnout or deferred consideration arrangements. This section does not address arrangements such as a discount for prompt payment, the provision by the seller of an indemnity, warranty, or guarantee or financing arrangements which result in an equity interest being issued by an entity. The tax outcomes for such transactions will be dictated by the nature of the rights in question and the circumstances of the wider transaction of which they form part.
Look-through CGT treatment applies to a contractual right to future financial benefits created under an earnout or deferred consideration arrangement if:
- the contractual right was created on or after 24 April 2015
- the contractual 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 increase (or decrease) 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 increase (or decrease) 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.
Where an earnout or deferred consideration arrangement does not satisfy the above conditions, the contractual right or rights created under the arrangement are considered separate CGT assets.
Taxpayers who are subject to the Taxation of Financial Arrangement (TOFA) provisions in Division 230 of the ITAA 1997 should consider whether their earnout or deferred consideration arrangement is a 'financial arrangement' subject to those provisions. Earnout and deferred consideration arrangements contingent on the economic performance of the relevant business are generally excluded from the TOFA provisions. However, the TOFA provisions may apply to certain types of earnout or deferred consideration arrangements. Where the TOFA provisions apply to an earnout or deferred consideration arrangement that also satisfies the definition of a look-through earnout right in Subdivision 118-I, TOFA will apply in priority to look-through CGT treatment.
For more information, see Guide to taxation of financial arrangements (TOFA)
If you have an earnout arrangement that does not satisfy the requirements for look-through treatment under Subdivision 118-I or TOFA treatment under Division 230 of the ITAA 1997, and you are unsure of the tax treatment of your arrangement, you can request an early engagement discussion or seek a ruling.
Example: the look-through CGT treatment
This example does not consider any other CGT concessions 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 $500,000 per annum 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:
- the seller's cost base for the business is $700,000
- all the conditions of a look-through earnout right are met
- the seller has no capital losses brought forward from prior years
- the seller is not eligible for any CGT discount
- no other expenditure has been incurred
- the TOFA rules do not apply to the seller or buyer.
CGT event A1 happens. The seller's capital proceeds are $800,000. The cost base is $700,000. The capital gain is $100,000.
The buyer acquires an asset with a cost base of $800,000.
Financial benefits of $100,000 received. Increase Year 0 capital proceeds by $100,000 to $900,000, which results in a revised capital gain or $200,000.
The buyer provides financial benefits of $100,000. The buyer's cost base is increased to $900,000.
Financial benefits of $150,000 received. Increase Year 0 capital proceeds by $150,000 to $1,050,000, which results in a revised capital gain of $350,000.
The buyer provides financial benefits of $150,000. The buyer's cost base is increased to $1,050,000.
Financial benefits of $100,000 received. Increase Year 0 capital proceeds by $100,000 to $1,150,000, which results in a revised capital gain of $450,000.
The buyer provides financial benefits of $100,000. The buyer's cost base is increased to $1,150,000.
Under the look-through CGT treatment:
- a valuation of the earnout rights is not required
- the CGT consequences for the seller is reported and assessed when the financial benefits are received or provided.
- the cost base of the buyer reflects the financial benefits provided by the buyer, including the benefits provided under the earnout arrangement.
To apply look-through CGT treatment, 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 completing labels 7F and 7G of the CGT schedule.
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.
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 lodgement 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.
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.
For more information, see Choices
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.
Subsection 705-65(5B) requires consolidated groups to revise the ACA amount of an entity that joins the group to take account of subsequent money or property provided in respect of the acquisition of a membership interest in the entity where the subsequent money or property was not taken into account in working out the ACA when the entity joined the group.
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 considered when working out the ACA when the entity joined the group.
For more information, see Consolidation