Explanatory Memorandum(Circulated by authority of the Treasurer, the Hon Scott Morrison MP)
Chapter 1 Capital gains tax treatment of earnout rights
Outline of chapter
1.1 Schedule 1 to this Bill amends the Income Tax Assessment Act 1997 (ITAA 1997) to change the capital gains tax (CGT) treatment of the sale and purchase of businesses involving certain earnout rights - rights to future payments linked to the performance of an asset or assets after sale.
1.2 As a result of these amendments, capital gains and losses arising in respect of look-through earnout rights will be disregarded. Instead, payments received or paid under the earnout arrangements will affect the capital proceeds and cost base of the underlying asset or assets to which the earnout arrangement relates.
Context of amendments
1.3 On 12 May 2010, the former Government announced that the tax law would be amended to provide look-through CGT treatment for qualifying earnout arrangements entered into as part of the sale of business assets.
1.4 On 14 December 2013, the then Assistant Treasurer announced that following consultation on a number of the 92 announced but unenacted measures of the former Government, the Government would proceed with several of the measures including the proposed amendments to provide look-through CGT treatment to qualifying earnout arrangements.
1.5 An earnout arrangement is an arrangement whereby as part of the sale of a business or the assets of a business, the buyer and seller are not able to agree on a fixed payment and instead agree that subsequent financial benefits may be provided, based on the future performance of the business or a related business in which the assets are used.
1.6 In a standard earnout arrangement, the buyer agrees to pay the seller additional amounts if certain performance thresholds are met within a particular time. 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. Some earnout arrangements combine the features of both a standard earnout and a reverse earnout as both the buyer and seller may be obligated to provide financial benefits depending on performance.
1.7 Earnout arrangements are used in the sale of businesses where there is difficulty agreeing about the value of the business. In this situation, the earnout arrangement allows parties to reach a mutually acceptable arrangement despite differences in how the parties value the business by linking additional financial benefits (or, for a reverse earnout, refunds of prior financial benefits) to the future economic performance of the business.
1.8 For example, two parties are negotiating the sale of the business where a significant part of the value of the business linked to its customer base - that is its goodwill. There is considerable uncertainty about how the sale and other factors may impact upon this goodwill. The parties could agree to a price based on the best available estimate of the business's value, but there would be a significant chance that the estimate would not reflect the actual future economic performance of the business. Alternatively, the parties could agree to an earnout arrangement under which part of the consideration for the sale was linked to the future economic performance of the business. This avoids the need to rely on an estimate by linking financial benefits to future events.
CGT and earnouts arrangements
1.9 For the purposes of CGT, a business consists of a number of CGT assets (including the business's goodwill, debts and contractual rights as well as the physical assets of the business).
1.10 The sale of a business will generally either involve the disposal of some or all of these assets, or, if the business is held through a company or trust, the sale of an interest or interests in the relevant entity, all of which will generally give rise to capital gains or losses.
1.11 The Commissioner of Taxation (Commissioner) provided public advice setting out the treatment of earnout rights - rights to future financial benefits under earnout arrangements - in a draft public ruling in 2007 (Draft Taxation Ruling TR2007/D10).
1.12 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.
1.13 Where an earnout right is provided by the buyer to the seller in relation to the disposal of a business (a standard earnout arrangement) the earnout right will be property the seller received (or is entitled to receive) in relation to the disposal and forms part of the capital proceeds of the disposal. Where a right is provided from the seller to the buyer (a reverse earnout arrangement), the right is an additional asset being provided along with the other business assets and the capital proceeds must be apportioned between the rights created and the other CGT assets that have been sold.
1.14 In all cases the tax consequences for the parties to the disposal are tied to an estimate of the value of the earnout right at the time the CGT event occurs. As the rationale for the creation of the earnout right is the difficulty in estimating the value of the business, it is likely that any estimate of the value of the earnout right will differ from the financial benefits that are in fact provided or received. If the estimated amount of these future financial benefits differs from the financial benefits actually provided or received there will be no change to the capital proceeds and cost base of the relevant business asset or assets.
1.15 Subsequent financial benefits provided under the right can result in a capital gain or loss for the holder of the right as a result of CGT event C2 occurring (see section 104-25 of the ITAA 1997). However, there are no CGT consequences for the entity obliged to provide financial benefits under the right. As a result, the costs of providing these financial benefits are generally not recognised in the CGT provisions.
1.16 The CGT concessions that can apply to the sale of business assets will not be relevant to either the amounts paid for the creation of the earnout right or subsequent financial benefits provided under the right. While the right may be linked to a business, it is a separate CGT asset with different characteristics and, unlike the business assets, will not satisfy the tests for relevant concessions (including the active asset test in the CGT small business concession - see section 152-35 of the ITAA 1997).
1.17 This measure was subject to extensive stakeholder consultation.
1.18 Confidential consultation on proposed drafting instructions took place from 21 July 2014 to 4 August 2014. In this process, stakeholders were broadly supportive of the proposed approach. A number of technical issues were raised that result in changes to the instructions as well as some issues around the proposed scope of the amendments that resulted in a review of the proposed changes in light of the Government's announced policy.
1.19 Following the completion of preliminary draft legislation, confidential consultation on this draft legislation and explanatory material then took place from 29 January 2015 to 12 February 2015. In this process stakeholders raised a number of issues about the scope of the proposed changes. A number of these issues were out of the scope of the Government's announced policy, such as extending the proposed concessions beyond CGT. However, a number of changes to the draft were made to address other identified concerns, such as replacing the proposed retrospective application of the measure with an extension of the protection provided for reasonable anticipation of unenacted measures. A number of technical issues were also identified and addressed.
1.20 Finally, public consultation on updated exposure draft legislation and explanatory material took place from 23 April 2015 to 21 May 2015. A number of further minor changes were made to the proposed legislation following this consultation to address concerns and technical issues identified by stakeholders.
Summary of new law
1.21 Schedule 1 provides that taxpayers may disregard capital gains or losses that arise in relation to a qualifying right to financial benefits - a 'look-through' earnout right.
1.22 Instead, taxpayers must include financial benefits provided or received under or in relation to such rights in determining the capital proceeds of the disposal of the underlying asset (for the seller) or the cost base and reduced cost base of the underlying asset for the buyer.
1.23 Schedule 1 also amends the rules around amendments to assessments, interest charges, recognition of capital losses and access to CGT (and other) concessions to ensure this new treatment provides taxpayers with outcomes broadly consistent with those that would have arisen had the value of all of the financial benefits under the earnout right been included in the capital proceeds from the disposal of the underlying asset for the seller and the cost base or reduced cost base of the underlying asset for the buyer at the time of the relevant CGT event.
Comparison of key features of new law and current law
|New law||Current law|
|Capital gains and losses in respect of a look-through earnout right are disregarded.||No special rules apply to capital gains or losses in respect of rights to future financial benefits under earnout arrangements.|
|Financial benefits under or in respect of a 'look-through' earnout right are included when determining the capital proceeds or cost base of the underlying business assets to which the arrangement relates.||No special rules apply to financial benefits provided under or in respect of earnout rights.|
|A taxpayer's assessment for a tax related liability that can be affected by financial benefits provided or received under a 'look-through' earnout right may be amended for up to four income years after the end of the income year in which the last potential financial benefit under the right was due to be paid.||No special rules apply to financial benefits provided under or in respect of earnout rights.|
|Capital losses arising from a CGT event related to an earnout right may not be taken into account in determining tax liabilities until such time as they cannot be reduced by future financial benefits received under a relevant look-through earnout right.||No special rules apply to losses arising under or in respect of earnout rights.|
Detailed explanation of new law
1.24 Schedule 1 makes a number of modifications to the operation of the CGT provisions in respect of CGT events that happen in under or in relation to certain earnout rights - referred to as a look-through earnout right.
Look-through earnout rights
1.25 A look-through earnout right is a right to future financial benefits which are not reasonably ascertainable at the time the right is created. The right must be created under an arrangement involving the disposal of a CGT asset that is an active asset of the seller, and the financial benefits under the right must be contingent on and reasonably related to the future economic performance of the asset (or a related business). [Schedule 1, item 4, sections 118-560 and 118-565 of the ITAA 1997]
1.26 This definition reflects a variety of policy considerations around the scope of this measure.
1.27 Broadly, these amendments will allow for the deferral of the payments of income tax in relation to part of the consideration for the sale of a business or its assets. However, this deferral will be available only in particular circumstances - it is not intended to allow taxpayers to generally delay the payment of income tax.
1.28 Instead, the proposed changes are intended to ensure that the CGT provisions do not present a deterrent to a specific type of transaction - the sale of a business where a genuine disagreement about the value of the business going forward is resolved by at least one of the parties agreeing to provided future financial benefits linked to the performance of the business. The requirements around look-through earnout rights limit the availability of the deferral to this specific circumstance.
1.29 To this end, to be a look-through earnout right, a right must be created as part of an arrangement for a disposal of the business or its assets - that is, the disposal must cause CGT event A1 to happen. [Schedule 1, item 4, paragraphs 118-565(1)(b) and (c) of the ITAA 1997]
1.30 Under the CGT provisions, where a disposal occurs, CGT event A1 will happen, either on its own or, in some cases, in addition to one or more other CGT events. Sometimes, when CGT event A1 happens in addition to another CGT event, it will not be the most specific CGT event that happens in that situation. In this situation, the gain or loss that arises may be determined under the rules applying to the other CGT event (see section 102-25 of the ITAA 1997). However, in this situation, CGT event A1 still happens in addition to the other event and so the relevant right may still be a look-through earnout right.
1.31 The requirement around disposal is intended to limit the benefit of this concession to arrangements for the disposal of a business. The CGT concession for look-through earnout rights is intended to address the difficulties in determining the value of a business (or certain assets of the business). It is not intended to provide tax benefits to temporary transfers (such as a loan or the granting of a lease), ongoing business relationships (such as the purchase of an ownership interest) or complex financing arrangements where there is no final disposal of the underlying asset.
1.32 In some cases a right may relate to the disposal of more than one CGT asset. In this case, the financial benefits provided under the right will need to be reasonably apportioned between the various assets, consistent with the general apportionment rules for CGT (see sections 112-30 and 116-40 of the ITAA 1997)
The business or its assets
1.33 Additionally, what is disposed of must be an active asset of the business before it is sold. [Schedule 1, item 4, paragraph 118-565(1)(d) of the ITAA 1997]
1.34 As discussed this measure applies to the sale of a business or the assets of a business. The concept is already found in the CGT law as 'active asset'.
1.35 Active asset is defined in section 152-40 of the ITAA 1997. Broadly, and subject to certain exclusions, an active asset is an asset of the taxpayer that is used in the business of the taxpayer or a connected or affiliated entity. A membership interest in an Australian resident company or trust will also be an active asset if at least 80 per cent of the assets of the company or trust (by value) are active assets (rather than passive investments).
1.36 It is important to note that applying the special rules around membership interests may involve a number of steps - for example, if the sole asset of Company A is a share in Company B, which itself only holds a share in Company C, the character of interests in both A and B will depend on the character of the assets of C.
1.37 Assets that are not active assets are not sufficiently linked to the conduct of a business to fall within the intended scope of the concession for earnouts.
1.38 However, the general definition of active asset gives rise to two difficulties in the context of the application of these amendments to shares and interests in trusts.
1.39 First, the definition of active asset specifically excludes interests in non-resident entities. This exclusion reflects particular policy considerations in the context of the general small business concessions. However, in the context of this measure there is no policy reason why interests in foreign entities should receive different treatment.
1.40 To address this first issue, the amendments allow interests in foreign entities to be active assets for the purpose of this measure. [Schedule 1, item 4, subsection 118-570(2) of the ITAA 1997]
1.41 Secondly, determining if such interests are active assets requires valuing the assets of the underlying entity. As one of the problems these amendments are intended to address is that businesses and their assets can be difficult to value, requiring a valuation to access the concession would run counter to this purpose.
1.42 To address this second issue, the amendments provide that an eligible share or an interest in a trust is treated as an active asset in the hands of an entity for the purpose of determining if a look-through earnout right exists. To be an eligible share or interest:
- the entity holding the share or interest must either:
- if they are an individual, be a CGT concession stakeholder in relation to the company or trust; or
- if they are not an individual, own a sufficient share of the business that they would be a CGT concession stakeholder were they an individual,
- the trust or company must carry on a business and have carried on a business or businesses for at least one prior income year; and
- for the immediately preceding income year, at least 80 per cent of the assessable income of the trust or company must have come from the carrying on a business or businesses and not been derived as an annuity, interest, rent, royalties or foreign exchange gains, or derived from or in relation to financial instruments.
[Schedule 1, item 4, section 118-570 of the ITAA 1997]
1.43 This alternative test allows taxpayers to avoid the need to value the assets of the trust or company. Instead, they need only look at how the trust or company has earned its income over the past income year. This achieves broadly the same policy goal - of ensuring the concession is available only in relation to the sale of a business - while relieving taxpayers of the compliance costs associated with obtaining a reliable valuation in respect of contingent future financial benefits.
1.44 This alternative test is only available for taxpayers that have a sufficiently large interest in the relevant entity that they qualify as a CGT concession stakeholder (or would qualify if they were an individual). Generally this means that the entity must be entitled to at least 20 per cent of any distributions and hold at least 20 per cent of any voting rights. This reflects the intention of the amendments to apply to disposals of a business, not to the sale of a passive investment.
1.45 Consistent with the rules for active assets generally, this alternative test is not restricted to assets held by the taxpayer. Where the character of a share or interest held by the taxpayer depends on the character of the shares or rights held by other entities, this alternative test can also apply when determining the characters of the shares or interests held by that other entity.
1.46 For the purposes of this test, it does not matter if the relevant interest is an interest in an Australian resident or foreign entity.
Jonathan is approached by XYZ Ltd which wishes to purchase Gardening Ltd and Building Ltd. Both companies are both wholly-owned by Holding Ltd, a company wholly-owned and controlled by Jonathan.Following negotiations Jonathan and XYZ Ltd agree that Jonathan will sell his shares in Holding Ltd to XYZ Ltd for $1 million, plus the right to a further payment of up to $250,000 based on the performance of Gardening Ltd and Building Ltd against certain profit targets over the next two years.For this right to be a look-through earnout right, amongst other things, Jonathan's shares in Holding Ltd must be an active asset.For shares in a company to be an active asset of a taxpayer for these purposes, either:
Contingent on the future economic performance of the asset
1.47 For a right to be a look-through earnout right, future financial benefits provided under the right must be linked to the future economic performance of the asset or a business in which the asset is used and not reasonably ascertainable at the time the right is created. [Schedule 1, item 4, paragraphs 118-565(1)(a), (f) and (g) of the ITAA 1997]
1.48 The concession provided to look-through earnout rights is only intended to cover rights created to resolve uncertainty about the value of the business that is being sold due to difficulties determining future economic performance, not to all deferred payment arrangements.
1.49 Where the measure of performance relates to a business, there must be a reasonable belief at the time of the disposal that the asset will actually be used in this business. If there is no intention to use the asset in the business, then the economic performance of the business is not a reasonable proxy for the performance of the asset.
1.50 In the case of the entity disposing of the asset, this will be based on what is reasonable given their knowledge of the intention of the other party (which may well be limited). Generally, in the absence of evidence to the contrary, if the assets of a business are sold to an entity for use in carrying on a business, they will continue to be used for this purpose.
Contingent on economic performance
1.51 Economic performance is a flexible and wide concept, broadly encompassing the success of the relevant economic activity. Given the breadth of the concept and the variety of context in which it can apply, there is no one means of measuring economic performance. Instead, measuring this performance generally involves identifying various features that represent or are associated with performance in the particular context.
1.52 For financial benefits to be contingent on the economic performance of a particular business or asset, the benefits must be linked to a reasonable measure of this performance in the context of the business or asset.
1.53 Whether a particular measure appropriately identifies economic performance will depend on the context of the business or asset in question. Measures that may be appropriate include both financial measures such as the profit, sales or turnover of the business (or the business in which the asset is used) and non-financial measures such as the number of clients retained or attracted. In some cases, indirect measures of performance may be appropriate - for example, in the case of a CGT asset that is an interest in a holding company, the sole asset of which is a controlling interest in a third entity, an accurate measure of the economic performance of the third entity is also likely to be an accurate measure of the economic performance of the holding company.
1.54 However, any measure adopted must be reasonable in the particular context. Hence, while some measures such as profit will often be appropriate, and others, such as the performance of financial indicies, are very unlikely to be appropriate, it is always necessary to consider how the economic performance of the business can reasonably be measured. For example, some research and development businesses may well not expect to make a profit for a considerable period after they start up, even if they are extremely successful. For these businesses, during this period in their operations, short-term profit may not necessarily be a good measure of their economic performance.
1.55 In considering this, it is important to distinguish between economic performance and the discovery of further information about an existing asset. Many assets are sold subject to a warranty that a financial benefit will be provided if the asset is found not to meet certain standards. This is a right to a contingent financial benefit. However, it cannot qualify as a look-through earnout right as the payment is not linked to the economic performance of the asset - the value generated by its use. Rather, the benefit is contingent on a discovery about the nature of the asset - the asset not actually meeting the promised standards. Such rights are not intended to benefit from the concessions provided for look-through earnout rights.
1.56 That said, while this divide is clear in the case of warranties and other similar specific agreements relating to information and valuation, economic performance and measures of economic performance can be affected by such valuation issues. The fact that a measure of performance may be affected by income and valuation issues does not necessarily mean that the measure is inappropriate. Often, even the best measures of the economic performance of a business or asset can potentially be affected by valuation issues.
1.57 For example, a right to future financial benefits in relation to a potential mineral resource based on the value of any ore reserves once identified would likely not be contingent on economic performance - rather it is solely contingent on obtaining further information about an existing asset. However, a right to financial benefits based on the profit of the entity owning the resource may well be contingent on economic performance, despite the fact that this profitability may be very significantly affected by what is found out about the value of the mineral rights.
Reasonably related to economic performance
1.58 For a right to be a look-through earnout right, in addition to the financial benefits being contingent on the future economic performance of the asset or the business in which it is used the value of the benefits must also reasonably relate to this performance. [Schedule 1, item 4, paragraph 118-565(1)(g) of the ITAA 1997]
1.59 This means that, for example, a right to future financial benefits provided as part of the sale of a business where the financial benefits are contingent on the business meeting certain profit targets would generally not qualify as a look-through earnout right if the value of the financial benefits to be provided clearly exceeded the amount of the profits themselves.
1.60 This requirement does not entail a precise or mathematical link between performance and payment - a lump sum payment may well be as appropriate as a percentage of profits if it appears in the circumstances a reasonable estimate of economic performance. Further, in the context of commercial arrangements it is generally for the parties, not the Commissioner to determine what value they place on a particular benefit. However, the value of the contingent financial benefits provided under the right must neither be out of all proportion to the benefits that could have been reasonably expected to result from performance nor otherwise wholly unrelated to the contingency to which they are linked. For example, a right under which the same benefit would be provided if either a contingency occurs or does not occur would likely be considered to fail this requirement.
1.61 To the extent financial benefits provided under a right may not reasonably relate to economic performance, they are for some other purpose than resolving this uncertainty and are outside the intended scope of this concession.
Example 1.2 Cake Co has acquired a number of businesses including Cupcake Ltd and Muffin Ltd as part of a plan to expand from the wholesale to retail baking sector.As part of the purchase of Cupcake Ltd and Muffin Ltd, Cake Co agreed to provide a right to future payments to the former owners of these businesses if certain conditions are met.For Cupcake Ltd, Cake Co has agreed to provide payments of fixed amounts if the number of customers making purchases from Cupcake Ltd exceeds a specified number. These payments may be contingent on economic performance - the number of purchases can be a reasonable measure of economic performance of a business, especially a retail business.For Muffin Ltd, Cake Co has agreed to provide payments based on the outcome of certain litigation being undertaken by Muffin Ltd and based on an independent valuation of the performance of the business two years after the purchase.The payment based on the outcomes of litigation is not contingent on economic performance. It does not relate to the performance of Muffin Ltd or any of its assets but to clarification by a court of legal obligations - while this may affect the value of Muffin Ltd or its assets it has nothing to do with their economic performance.The payment based on the independent valuation of Muffin Ltd may be contingent on economic performance. The value of a business at a time may be a reasonable measure of its performance up to that time. In this context, it is unlikely to matter that the value of Muffin Ltd may well have been affected by the outcome of the litigation.
1.62 For a right to be a look-through earnout right, the financial benefits provided must also be not be reasonably ascertainable at the time the right is created. [Schedule 1, item 4, paragraph 118-565(1)(a) of the ITAA 1997]
1.63 In most cases, the fact that financial benefits are contingent will mean that they are also reasonably unascertainable. However, in some cases a benefit may be contingent on future events where there is little or no doubt that these events will transpire and the quantum of the payment is fixed or can reasonably be determined given what is known. In this case, the benefit can reasonably be ascertained and the right cannot be a look-through earnout right.
Five year payment limitation
1.64 For a right to be a look-through earnout right, the right must not require financial benefits to be provided more than five years after the end of the income year in which the relevant CGT event occurs in relation to the disposal of the relevant active asset. [Schedule 1, item 4, paragraph 118-565(1)(e) of the ITAA 1997]
1.65 The requirement only applies to payments under the look-through earnout right - other payments, such as the payment of instalments may be made in relation to the disposal without affecting the character of the right.
1.66 The purpose of this requirement is twofold.
1.67 First, this requirement ensures concessions for look-through earnout rights are not available to long-term profit sharing arrangements. Such arrangements are in substance the transfer of equity and should be treated similarly to other such transfers, such as the issuing of shares.
1.68 Secondly, the requirement places a reasonable limit on the period of deferral to avoid providing excessive and distorting benefit to look-through earnout rights. The intention of the measure is to address the potential difficulties created by valuing earnout rights for tax purposes, not to create tax incentives for the use of earnout rights.
1.69 This requirement is not breached simply because one party or another may be late in providing a financial benefit under the look-through right, even if the other party tolerates this lateness.
1.70 It will also not be breached if the agreement includes provisions that allow for a delay in payment contingent on events, such as a dispute over the terms of the agreement being subject to a binding arbitration process. However, the relevant contingency must be outside the control of either party and not a contingency that a reasonable person would consider likely at the time of the agreement. Further, while this process may involve a delay in when payment is required, it must not result in any change in the amount payable under the agreement. [Schedule 1, item 4, subsection 118-565(3) of the ITAA 1997]
1.71 However, the five year requirement will be breached if the agreement includes an option for the parties to extend the period over which financial benefits are provided or to enter into a new agreement providing for the continuation of substantially similar financial benefit in relation to the asset.
1.72 Further, if the parties vary the right to extend the period over which financial benefits are provided beyond five years or enter into a new agreement to create an equivalent right to further future financial benefits after this time then the right will be taken to have never been a look-through earnout right. [Schedule 1, item 4, section 118-565(2) of the ITAA 1997]
Example 1.3 David has purchased Wine Ltd from Adam. Under the arrangement, David undertook to make a number of further payments to Adam based on the profits earned by Wine Ltd, the last of which was due one month before the 5 year anniversary of the sale. The right to these further payments met the requirement to be a look-through earnout right.The conditions for this final payment to be made are satisfied, but, due to a series of administrative errors, David is 12 months late in providing the payment.As a result, the final payment under the look-through earnout right occurs more than 5 years after the end of the income year in which the sale occurred. However, this does not affect the character of the right as a look-through earnout right - the late payment by David does not alter the fact that the right still only provided for financial benefits over five years from the end of the relevant income year.
Example 1.4 Judy has sold her business, Pharma Co, to Vanessa.Under the arrangement, Vanessa agrees to provide Judy with 5 per cent of the annual profit of Pharma Co over the next three years if the profits for the year exceed a fixed threshold. This right qualifies as a look-through earnout right.In the third year of the arrangement, Judy and Vanessa agree that the payments will continue for a further five years in exchange for Judy making a lump sum payment to Vanessa.As a result of this extension, Judy is now entitled to receive future financial benefits that are contingent on economic performance more than five years after the income year in which she disposed of the business.Due to this, the right is now not a look-through earnout right and is taken to have never been a look-through earnout right. Judy and Vanessa may now need to request that the Commissioner make appropriate changes to their income tax assessments.
1.73 Finally, all look-through earnout rights must be created as part of arrangements entered into on an arm's-length basis. [Schedule 1, item 4, paragraph 118-565(1)(h) of the ITAA 1997]
1.74 The concessions provided to look-through earnout rights are only intended to be available for commercial transactions. Allowing the concessions to be available for non-commercial arrangements is inappropriate and would create scope for abuse.
Rights to receive financial benefits for ending a look-through earnout right
1.75 A right will also be a look-through earnout right if it is a right to receive financial benefits provided in exchange for ending a right that is a look through earnout right under the general rules. [Schedule 1, item 4, subsection 118-565(4) of the ITAA 1997]
1.76 A right to receive payment for ending an earnout right generally includes a right to receive a payment for transferring the entitlement to payment to another, as the original entitlement has been lost.
1.77 Payments to end a look-through earnout rights are in effect a replacement for the payments that would have been made under the right. By providing the same tax treatment even where the financial benefit may be provided by a third party, these amendments avoid inconsistent tax treatment and unnecessary complexity.
Consequences of a right being a look-through earnout right
1.78 Broadly, if a right is a look-through earnout right, two consequences arise:
- the value of the right is disregarded for the purposes of CGT; and
- the value of any financial benefits made or received under the right is included in either the capital proceeds arising from the disposal (for the seller) or the cost base of the acquisition (for the buyer).
Disregarding the right
1.79 Generally, when a taxpayer creates or disposes of a CGT asset, the taxpayer must take into account any money and property received when determining the capital proceeds arising from the CGT event or events. Similarly, when acquiring a CGT asset, a taxpayer takes into account the full value of any money and other property provided to acquire the asset in determining the cost base of the asset.
1.80 However, as was identified previously, in the case of earnout rights this can pose difficulties. The purpose of providing the right to future financial benefits under such arrangement is often to resolve difficulty in agreeing a valuation. In this context, requiring a valuation goes against the rationale for the concession.
1.81 To address this, any capital gain or loss arising in respect of the creation or cessation of a look-through earnout right will be disregarded. [Schedule 1, item 4, section 118-575 of the ITAA 1997]
1.82 Similarly, the value of a look-through earnout right will not be taken into account in determining the capital proceeds of the disposal of the active asset for the seller nor the cost base and reduced cost base of the asset acquired by the buyer. [Schedule 1, items 1 and 3, paragraphs 112-36(1)(a) and 116-120(1)(a) of the ITAA 1997]
Adjusting the capital proceeds and the cost base for subsequent financial benefits
1.83 In the place of taxing the value of the look-through earnout rights, Schedule 1 amends the income tax law to include the value of any financial benefits subsequently provided or received under or in relation to such a right in the original capital proceeds of the disposal for the related asset for the seller, or the initial cost base and reduced cost base of the asset for the buyer as at the date of the original acquisition. [Schedule 1, items 1 and 3, paragraphs 112-36(1)(b) and (c) and 116-120(1)(b) and (c) of the ITAA 1997]
1.84 This ensures that the amounts received under a look-through earnout right is appropriately recognised in the tax system, without requiring the right itself to be valued.
Example 1.5 Anna sells all of the shares in her business, ABC Co, to Purple Ltd in March 2016.Under the sale arrangement, Anna receives an upfront payment of $1 million at the time of sale and a right to two future payments of up to $100,000 in March 2017 and March 2018 provided the turnover of ABC Co exceeds an agreed threshold during 2016 and 2017 respectively. This right is a look-through earnout right.At this time Anna's capital proceeds for the sale of the business are $1 million - the total of the upfront payment she has received. Anna has also received the right to future payments which she would generally need to include in the capital proceeds, but as this is a look-through earnout right, the value of the right is disregarded when working out the capital proceeds.As Anna has a cost base of for ABC Co of $600,000, at this time Anna has a capital gain of $400,000 (capital proceeds of $1 million less the cost base of $600,000) as a result of the sale.ABC Co's turnover exceeds the agreed threshold in 2016 and so Purple Ltd pays Anna a further $100,000.As a result of this payment, the capital proceeds from the sale of ABC Co at the time of the original CGT event are now considered to be $1.1 million - made up of the $1 million initial payment and the $100,000 payment she received in March 2017. She has now made a capital gain of $500,000 (capital proceeds of $1.1 million less the cost base of $600,000) as a result of the sale.Finally, in July 2017, Purple Ltd decides it would prefer to end the arrangement immediately. It offers to pay Anna $50,000 if she will agree to forgo her right to further payments under the look-through earnout right and Anna agrees to this offer.This financial benefit provided to terminate a look-through earnout right is treated in the same way as a financial benefits provided under the right.As a result, Anna's total capital proceeds for the sale are $1.15 million, made up of the $1 million initial payment, the subsequent $100,000 payment under the earnout right and the $50,000 payment to end the earnout right.Anna's final capital gain from the sale is $550,000 (capital proceeds of $1.15 million less the cost base of $600,000), which is considered to have arisen in March 2016 at the time of the original CGT event.
1.85 In circumstances where a taxpayer subsequently disposes of an asset that is subject to an ongoing look-through earnout right before their obligations or entitlements in relation to financial benefits under the right are exhausted, their cost base for the asset may change as a result of any subsequent financial benefits they pay or receive. In this situation, the taxpayer will need to adjust the capital gain or loss on that subsequent disposal.
Choices and timing
1.86 This approach results in the amount of a capital gain or loss changing as a result of financial benefits provided or received in subsequent income years. A number of special rules are required to ensure that this does not disadvantage taxpayers or impose unnecessary compliance and administrative costs.
1.87 The first difficulty that could arise relates to the gap between the CGT event and the financial benefits provided under an earnout right.
1.88 As the financial benefits may be provided up to five years after the end of the income year in which the CGT event occurred, for some taxpayers, the period of review for the income year in which the CGT event occurred may have passed before the taxpayer has provided or received the financial benefits requiring the amendment.
1.89 To address this, these amendments extend the period of review for all of a taxpayer's tax-related liabilities that can be affected by the character of the look-through earnout right. The amendments also extend the period of review in respect of tax-related liabilities that can be affected by the character of rights that are treated as never having been a look-through earnout right (see paragraph 1.72). [Schedule 1, items 1 and 3, subsections 112-36(3) and 116-120(3) of the ITAA 1997]
1.90 For these tax-related liabilities, the period of review is the later of the period of review that would normally apply and four years after the end of the final income year in which financial benefits could be provided under the look-through earnout right.
1.91 This extension applies to all tax-related liabilities that can be affected by the change to a capital gain or loss as a result of financial benefits provided under a look-through earnout right. This includes liabilities in subsequent years and tax-related liabilities for taxes other than income tax. For example, the small business CGT retirement concessions provide, broadly, that certain contributions to superannuation linked to capital gains arising from the sale of business asset are not counted towards non-concessional superannuation contribution caps. If the amount of the relevant gain for a taxpayer changes as a result of the financial benefits provided under an earnout right, the extended amendment period would apply to the assessment of the taxpayer's non-concessional contributions.
1.92 In certain limited cases, changing the capital proceeds or cost base of a CGT asset held by one taxpayer may impact upon the tax-related liabilities of another taxpayer. For example, certain small business CGT concessions provide benefits for CGT concession stakeholders in a company. This extension will also apply to the tax-related liabilities of these related entities if they can be affected by the character of a right as look-through earnout right.
1.93 The extension also applies to a taxpayer's right to object where they are dissatisfied with an assessment. Where the Commissioner amends a taxpayer's assessment because of a financial benefit provided or received under an earnout right or a right that is taken to never have been an earnout right, the taxpayer may object in the same way the taxpayer may object to any other amendments to an assessment. Where a taxpayer is dissatisfied with an assessment as the Commissioner has not made an amendment due to a financial benefit provided or received under an earnout right, these amendments will allow the taxpayer to object within 60 days of receiving notice of the Commissioner's decision not to amend the assessment, even if they would otherwise be out of time. [Schedule 1, items 1, 3 and 33, subsections 112-36(5) and 116-120(5) of the ITAA 1997 and paragraph 14ZW(1)(aaaa) of the Taxation Administration Act 1953 (TAA 1953)]
1.94 The second difficulty is that, under the general CGT law, a taxpayer is not able to change a choice that they have previously made.
1.95 In this situation, where the amount of a gain or loss may substantially vary from the amount of the gain or loss identified in the year in a way that is uncertain, it would not be reasonable to require taxpayers to adhere to their initial choice (indeed in some situation a taxpayer may not have been eligible to make the choice they now wish to make based on the gain or loss in that initial year).
1.96 These amendments will permit taxpayers to amend a choice made previously where the choice relates to a capital gain or loss that can be affected by financial benefits provided under a look-through earnout right. The decision to vary a choice must be made by the time the taxpayer is required to lodge a tax return for the period in which the financial benefits under the look-through earnout right is received. [Schedule 1, items 1 and 3, subsections 112-36(2) and 116-120(2) of the ITAA 1997]
1.97 Thirdly, taxpayers must generally pay interest on the amount of any income tax due for an income year that is not paid by the due date for payment. Similarly, but in more limited circumstances, the Commissioner may pay taxpayers interest on overpayments of tax.
1.98 As financial benefits provided or received under look-through earnout rights modify the capital proceeds of a disposal and the cost base of the asset acquired in an earlier year, underpayments and overpayments will unavoidably arise in this year for affected taxpayers. The imposition of interest on these amounts would not be appropriate.
1.99 Instead, the Schedule provides that:
- taxpayers are not be subject to interest on any shortfall that arises as a consequence of financial benefits provided or received under a look-through earnout right, as long as the taxpayer requests an amendment to their relevant income tax assessment within the period they must lodge their income return for the income year in which the financial benefit was provided or received; and
- the Commissioner is not be liable to pay interest on any overpayment of tax that arises as a result of financial benefits provided or received under a look-through earnout right.
[Schedule 1, items 34 to 37, subsections 280-100(5), 280-102A(4) and 280-102B(4) in Schedule 1 to the TAAct 1953 and subsection 9(1B) of the Taxation (Interest of Overpayments and Early Payments) Act 1983]
1.100 Effectively, neither taxpayers nor the Commissioner need to pay interest solely because a financial benefit is provided or received under a look-through earnout right.
1.101 The final difficulty is that this measure may result in changes to the capital loss available to taxpayers back over five years. This means that in some cases where entities dispose of assets and receive a look-through earnout right, they will initially be in a capital loss position. However, they will have a strong expectation that this will change as a result of subsequent financial benefits they will receive under the right.
1.102 Under the normal rules governing the income tax treatment of capital losses, this notional loss could affect tax positions in each year until the year in which the last potential payment under the earnout right is due to be paid. This could potentially result in financial benefits that reduce this loss requiring amendments to assessments not just to the year in which the disposal occurred, but to every subsequent year in which part of the loss was applied. Over a five year period, this could potentially involve 15 separate amendments (that is, assuming one financial benefit was received in each income year, one amendment would be made in the first year to the assessment of the original year, two in the second year to the assessments for both the original year and the first year and so forth, up to the fifth year where five amendments would be needed, resulting in a total of 15 amendments).
1.103 Further, in this situation the taxpayer would also receive an excessive tax benefit. By being able to make use of the 'loss' they have incurred on the disposal until subsequent financial benefits are received under the earnout right, they have been able to defer not just the payment of any tax on the eventual capital gain from the disposal, but also in respect of other capital gains arising in subsequent years.
1.104 To avoid these concerns, 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. [Schedule 1, item 4, section 118-580 of the ITAA 1997]
1.105 Once such losses become certain, they are available from the year in which the loss was originally incurred, not when the amount became certain.
Example 1.6 In June 2016, Lucas sold his business, Software Enterprises Ltd (a small business entity with only active assets) to Buyer Co.Lucas receives a fixed upfront payment of $750,000 and has a number of additional entitlements to future payments under several look-through earnout rights contingent on a variety of profit and performance targets being met by Software Enterprises. As he has a cost base of $800,000 for Software Enterprises, at this stage Lucas has made a capital loss of $50,000. However, as Lucas may potentially receive further payments of an amount greater than $50,000 under the look-through earnout rights, he must disregard this loss in both the current year and subsequent years.In the 2016-17 financial year, Lucas receives further payments totalling $250,000 under the look-through earnout rights. This payment is included in the capital proceeds of the sale of Software Enterprises, meaning that Lucas has now received a total of $1 million and has a capital gain of $200,000. This gain results in an increase in his income tax liability for that year.At the same time as Lucas lodges his tax return for the 2016-17 year, he also requests an amendment to his assessment for the 2015-16 income year to include the additional capital gain resulting from the payment under the rights. As a result he would not be subject to shortfall interest charge on any amount of additional tax he must pay for the 2015-16 year as a result of this amendment - in effect he is in the same position as if the payment had been taxed in the income year in which it was received.In June 2020, Lucas receives a final payment of $100,000 under the look-through earnout rights. Consistent with the previous payments this amount is included in the capital proceeds of the sale and Lucas requests an amendment to his income tax assessment for 2015-16 to reflect the increased capital gain of $300,000.As an individual who did not satisfy any of the conditions for a longer amendment period, Lucas's assessment for 2015-16 would normally only be able to be amended by the Commissioner for two years from the date of the original assessment. By June 2020, this period would have passed.However, in this case, the Commissioner may still amend Lucas's assessment in respect of the payment as it is a financial benefit under a look-through earnout right that affects the amount of Lucas's income tax liabilities for the year in which the sale occurred and the amendment is sought within four years of the end of the income year in which the final potential financial benefit under the right was to be provided.
Access to CGT concessions
1.106 The changes to the treatment of look-through earnout rights are only intended to affect a taxpayer's entitlement to CGT concessions insofar as this may occur as a result of the value of the underlying disposal now including all of the amounts provided for and under the earnout right.
1.107 In general, this is achieved without the need for additional special rules. Taxpayers are entitled to remake choices relating to the disposal or the asset they received as a result of the disposal. As a result, taxpayers may reconsider any choices and their entitlement to concessions in light of subsequent receipts and payments to ensure that the resulting gain, loss or cost base reflects any concessions that are available and only those concessions that are available.
1.108 Likewise, in some cases, a taxpayer may not initially be in a position to elect that a concession to apply to a CGT event. Alternatively, a taxpayer may be concerned that anticipated future financial benefits in respect of a look-through earnout right may mean that they cease to be eligible for a concession to apply after they have taken irrevocable actions based on this concession (such as making contributions to superannuation). In these cases, as the taxpayer can remake choices they can simply wait until it is clear whether or not they will be finally eligible for the concession before making any choice.
1.109 However, some of the CGT small business concessions require things to be done or decisions to be made within a fixed period of the time the relevant CGT event occurs. Specifically:
- the CGT small business retirement exemption in Subdivision 152-D of the ITAA 1997 allows a taxpayer to disregard all or part of a capital gain, if, relevantly, the taxpayer contributes an equivalent amount to their superannuation, or if the taxpayer is a company or trust, the superannuation of the CGT concession stakeholder of the company or trust, either when the proceeds are received or at the time the choice is made for an individual, or seven days after these times for a trust or company;
- the CGT small business 15 year exemption in Subdivision 152-B of the ITAA 1997 permits a company or trust may disregard an amount in determining its taxable income if, amongst other things, the amount is paid to a CGT concessional stakeholder within two years after the relevant CGT event;
- additionally, section 292-100 of the ITAA 1997 provides, amongst other things, that if the taxpayer receives a payment from a trust or company of the sort described in the second dot point above within two years of the relevant CGT event and subsequently contributes this amount to superannuation, the amount of this contribution does not count towards the non-concessional contributions cap; and
- the CGT small business 'rollover' allows the taxpayer to disregard a capital gain, but may result in a capital gain arising for the taxpayer under certain other CGT events (CGT events J2, J4, J5 and J6) if the taxpayer does not acquire an appropriate asset or undertake suitable expenditure within a the replacement asset period, which ends two years after the last CGT event in the year in which the 'rollover' is accessed.
1.110 These concessions would be problematic in the context of look-through earnout rights as actions may need to occur before the final amount of the relevant capital gain or loss is known.
1.111 To address this, the period for accessing these concessions is extended.
1.112 For the CGT small business retirement exemption, special rules already exist for instalment payments that allow the concession to apply where amounts are contributed as payments are received. However, there may be doubts about whether financial benefits under an earnout right are instalments. The amendments would specifically apply the same rules to financial benefits received under or in respect of earnout rights. [Schedule 1, items 14 and 17, paragraphs 152-125(1)(b) and 292-100(4)(b) of the ITAA 1997]
1.113 For the CGT small business 15 year exemption, and the related concession under section 292-100 in relation to non-concessional contributions, the two year period is extended to last until two years after the final potential financial benefit under the look-through earnout right is concluded. [Schedule 1, items 15 and 16, subsections 152-305(1B) and 152-335(2A) of the ITAA 1997]
1.114 Further, the Government proposes to make separate consequential changes to the regulations regarding acceptance of superannuation contributions to ensure that any forced delay in making contributions does not affect a taxpayer's entitlement to make the contribution.
1.115 Finally, for the CGT small business 'rollover', the replacement asset period would similarly be extended until two years after the final potential financial benefit under the look-through earnout right could have been provided. [Schedule 1, items 6, 8 to 12 and 18, paragraph 104-185(1)(a), subsections 104-190(1A) to (3) and (5), paragraph 104-198(1)(a), subsections 104-198(2) and (4) and the definition of replacement asset period in subsection 995-1(1) of the ITAA 1997]
: Access to CGT concessions
Returning to Example 1.6, upon receiving the final payment under the look-through earnout right, Lucas chooses to access the small business rollover in relation to the gain.Broadly, the small business rollover provides that, amongst other things a taxpayer may disregard a capital gain if:
Access to CGT concessions - the maximum net asset value test
1.116 A particular problem would also arise in respect to the maximum net asset value test.
1.117 This test, found in section 152-15, is one of the tests that can make taxpayers eligible to access the small business CGT concessions. To satisfy the test, the value of the CGT assets of the taxpayer and any entities that they control or are controlled by must not exceed $6 million at the time of the relevant CGT event.
1.118 As this valuation is separate from the determination of cost base or capital proceeds, it could require the taxpayer to value an asset that is subject to a look-through earnout right.
1.119 Consistent with the overall purpose of the amendments, Schedule 1 revises the maximum net asset value test to provide that when working out the value of an entity's CGT assets just before the time of a CGT event, taxpayers should be able to elect not to include the value of any look-through earnout right the entity may hold, but instead take into account any financial benefits that the entity may have provided or received under the look-through earnout right after that time. [Schedule 1, item 134, section 152-20]
1.120 Special rules are also included to make sure that the value of these financial benefits is not taken into account multiple times where the look-through earnout right relates to an asset that the entity holds at the time of the valuation. [Schedule 1, item 134, subsection 152-20(5) of the ITAA 1997]
1.121 The election to use this method may only be made once no further financial benefits can be provided under the look-through earnout right.
CGT concessions and the implications of changes to capital proceeds
1.122 The availability of some CGT concessions is linked to the capital proceeds of the CGT event or the income or turnover of a taxpayer in the relevant income year. Similarly, some CGT concession apply only where the taxpayer has a capital gain but not where the taxpayer has a capital loss or vice versa.
1.123 These characteristics in the past income year can change based on financial benefits that the taxpayer provides or receives in relation to a look-through earnout right.
1.124 As a result, a taxpayer may become eligible or cease to be eligible for a CGT concession as a result of these financial benefits. Such changes will require an alteration to the taxpayer's assessment or assessments reflecting the availability or loss of the concession in addition to the changes required as a direct result of the financial benefits under the look-through earnout right.
1.125 As previously outlined, a taxpayer will not be subject to shortfall interest charge on additional tax that they must pay as a result of providing or receiving financial benefits under a look-through earnout right. However, to the extent a taxpayer has accessed a concession for which they are ultimately not eligible due to these financial benefits, any additional tax that arises falls outside the scope of that exception and the taxpayer will be subject to shortfall interest charge.
1.126 Additionally, while the receipt of financial benefits under a look-through earnout right may allow the taxpayer to remake choices and often extends the period in which a choice can be made, it does not entitle the taxpayer to undo the actions they have taken in that period. For example, if a taxpayer has made contributions to superannuation in order to access a concession, they cannot withdraw these contributions now they are no longer available.
Foreign resident CGT withholding and transactions involving look-through earnout rights
1.127 Schedule 2 of this Bill, introduces a new regime that imposes withholding obligations on, broadly, the purchasers of certain types of taxable Australian property (see Chapter 2 for more information on Schedule 2).
1.128 Where the relevant taxable Australian property is an active asset of a business (for example if it is land used for the purposes of a business and not for generating rent) it may also potentially be subject to a look-through earnout right as part of the sale.
1.129 However, under the general rules for look-through earnout arrangements any future financial benefits linked to the economic performance of the asset may well only be included in the capital proceeds of the underlying asset after the time the initial withholding tax is calculated and paid. Therefore, an additional rule is necessary to ensure a portion of the future financial benefit payment is paid to the Commissioner.
1.130 If a transaction to which foreign resident capital gains withholding applies involves a look-through earnout right, the taxpayer does not need to include any amount referable to the future financial benefits under the look-through earnout right. [Schedule 1, item 40, subparagraph 14-200(3)(a)(i) in Schedule 1 to the TAA 1953]
1.131 Instead, if the original transaction required a purchaser to pay an amount to the Commissioner, the purchaser must also pay an amount to the Commissioner with respect to any financial benefits provided under look-through earnout rights at such time as the benefit are received. [Schedule 1, item 41, section 14-205 in Schedule 1 to the TAA 1953]
1.132 The purchaser must pay 10 per cent of the financial benefit to the Commissioner. The Commissioner may vary the required amount (see paragraphs 2.95 to 2.103 in Chapter 2). [Schedule 1, item 41, subsection 14-205(4) in Schedule 1 to the TAA 1953]
Example 1.8 : Withholding and look-through earnout rights Patrick acquires farm land from a vendor he knows to be a foreign resident. The purchase price for the premises is $3 million.Because the parties are uncertain as to the value of the farm land, Patrick also agrees to pay, to the vendor, a future amount calculated on the profits that Patrick is able to generate from the farm land. The right to receive this payment is, in the hands of the vendor, a look-through earnout right.Patrick withholds $300,000 from the purchase price and pays this amount the Commissioner.Two years later, Patrick's business farm has been very successful. He is required to pay $50,000 to the vendor under the terms of the sale contract. Patrick is required to pay $5,000 to the Commissioner and may withhold this amount from the payment to the foreign resident vendor.
1.133 Generally, if the purchaser was required to withhold with respect to the original transaction, financial benefits will be subject to these additional rules. However, the latter obligation may be relieved where there is a change in circumstances relating to the residency of the person ultimately receiving the financial benefit.
1.134 This may arise because the residency of the original foreign resident changes. Alternatively, the financial benefit may be directed towards a person who was not a part of the original transaction. In either case, the question, of whether the person receiving the benefit is a relevant foreign resident, is reassessed at the time the financial benefit is provided or received.
Example 1.9 : Look-through earnout rights and changes in circumstance Further to Example 1.8, assume that, before the payment of the $50,000, the vendor provided Patrick with a declaration that the vendor was now an Australian resident for income tax purposes. Patrick is not required to pay any amount to the Commissioner.
1.135 Subsection 705-65(5B) of the ITAA 1997 was inserted into the law to create special rules to deal with earnout arrangements in the context of consolidated groups.
1.136 Broadly, it requires consolidated groups to revise the allocated cost 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 allocated cost amount when the entity joined the group.
1.137 Prior to these amendments, there were concerns about the effectiveness of this section. As the provision only applies where amounts were not taken into account in determining the initial cost base, if the value of the right to future money or property is taken into account at that time, subsection 705-65(5B) of the ITAA 1997 would not apply.
1.138 However, as this measure will now mean that the value of the right is explicitly disregarded when determining the initial cost base, subsection 705-65(5B) of the ITAA 1997 will now operate as originally intended.
Contingent on economic performance
1.139 Contingent on economic performance is a defined term in the ITAA 1997. It generally bears its ordinary meaning, but specifically provides that the ability or willingness of an entity to meet obligations and the receipts or turnover of an entity or activity are to be disregarded in determining if a right is contingent on economic performance.
1.140 The first matter, disregarding the ability or willingness of an entity to meet an obligation to satisfy the right or provide the return is included for avoidance of doubt - a financial benefit contingent on the choice or capacity of another is not contingent on economic performance.
1.141 However, the second matter, disregarding receipts and turnover is a modification of the ordinary meaning. While there are many cases in which receipts or turnover may not link to economic performance, there are many other cases in which it can be an appropriate measure. This exclusion reflects the context of the use of the term within the ITAA 1997.
1.142 This restriction presents a problem for the current amendments, where the exclusion of measures of economic performance based on receipts and turnover would unduly limit the scope of the concession. At the same time, it would be problematic to create another term with the same meaning as the ordinary meaning of 'contingent on economic performance'.
1.143 To address this, a consequential amendment has been made to remove the existing definition of 'contingent on economic performance' so that the term now bears its ordinary meaning. Existing references to 'contingent on economic performance' have been replaced by the new defined term 'contingent on aspects of economic performance', which is defined in exactly the same way as 'contingent on economic performance' was previously. No change to the outcomes under the existing law results from the change in terminology, [Schedule 1, item 26, subsection 974-85(1) of the ITAA 1997]
1.144 The power under the present law to modify the meaning of 'contingent on economic performance' by regulation will be retained in relation to the new term 'contingent on aspects of economic performance'. [Schedule 1, items 18 to 25 and 27 to 31, paragraphs 25-85(2)(a) and 230-15(4)(a), subsection 230-460(13), table items 2 in subsections 820-930(2) and 974-75(1), paragraph 974-80(2)(a), the example in subsection 974-80(2), the heading to subsection 974-85(1), subsection 974-85(2), paragraph 974-85(4)(c), subsection 974-140(1) and the definitions of 'contingent on the economic performance' and 'contingent on aspects of the economic performance' in subsection 995-1(1) of the ITAA 1997]
Other consequential amendments
1.145 A number of minor consequential amendments have been made to headings and guidance materials to reflect the consequences of the principal amendments made by this Schedule. [Schedule 1, items 2, 5, 7 and 42, item A1 in the table in section 116-25, the heading to section 104-190, the definition of look-through earnout right in subsection 995-1(1) of the ITAA 1997 and item 101 of the table in subsection 250-10(2) in Schedule 1 to the TAA 1953]
Application and transitional provisions
1.146 Most of the amendments made by Schedule 1 will apply to all earnout arrangements entered into on or after 24 April 2015, the first working day on which draft legislation to give effect to this measure was made public. [Schedule 1, item 37]
1.147 The amendments relating to the interaction of these amendments and the foreign resident capital gains withholding regime will apply to acquisitions made on or after the later of 1 July 2016 and first day both these amendments and the foreign resident capital gains withholding regime have commenced. [Schedule 1, item 43]
1.148 This ensures that the changes to deal with the interactions of the two sets of rules only apply if both sets of rules are in place. See Chapter 2 for more information on the foreign resident capital gains withholding regime.
Protection for taxpayer anticipation
1.149 These amendments do not apply prior to 24 April 2015. However, taxpayers that have reasonably and in good faith anticipated changes to the tax law in this area as a result of the announcement by the former Government will have their current income tax treatment preserved. [Schedule 1, item 38]
1.150 This protection measure introduced by this Schedule operates by reference to the protection measure introduced in relation to certain tax measures announced by former Governments that did not proceed in section 170B of the Income Tax Assessment Act 1936.
1.151 This approach protects taxpayers that have reasonably anticipated changes without requiring complex retrospective changes or requiring taxpayers to make amendments to comply with the specific provisions of the final law the detail of which could not have been anticipated.
1.152 As with this earlier measure, the protection will operate by placing a statutory bar on the Commissioner amending an income tax assessment in relation to a particular contained in a statement, to the extent that the particular represents the taxpayer's reasonable anticipation of the announced changes to the law and satisfies the timing conditions.
1.153 Amongst other things, the timing conditions for the earlier protection measure applied differently to events before and after 14 December 2013 (see subsection 170B(3) of the ITAA 1997). For the purposes of this measure, the timing conditions will apply differently based on whether events happened before, or on or after 24 April 2015. Broadly, this means that the conditions will be satisfied if either:
- the statement is made between the date of the announcement and 23 April 2015 and if the statement was made in a return, the return was not required to be lodged before 24 April 2015; or
- the statement is made in a return lodged on or after 24 April 2015, the return was not required to be lodged before that date, no prior return had been lodged or assessment made for that income year, and the statement relates to the application of the taxation law to events prior to 24 April 2015 or to which the taxpayer was committed prior to 24 April 2015.
1.154 Also consistent with the prior measure, any protection under the measure will be lost if the taxpayer makes a statement for a later year of income that is not consistent with the anticipated amendments reflected in the taxpayer's original statement in a way that is to the taxpayer's benefit. Assessments may be amended at any time to give effect to the loss of protection.
Example 1.10 On 14 February 2014, Lauren enters into an arrangement to sell her business, Trapeze Services, to Circus Ltd. As part of the sale, Circus Ltd agrees to provide two annual payments of up to $100,000 contingent on ticket sales and profitability of Trapeze Ltd over those two years.Lauren lodges her 2013-14 tax return on 30 July 2015. In this return, she anticipates, that the announced measure relating to CGT treatment for earnout arrangements will apply this transaction, based on the original announcement on 11 May 2010 and the discussion paper issued on 12 May 2010.As a result of this anticipation, Lauren does not include the value of the two future payments contingent on performance when determining her capital gains from the sale of Trapeze Services. Provided her anticipation is reasonable, Lauren will receive the benefit of the protection rule and the Commissioner will not be able to amend this assessment, even though the amendments made by this Schedule will not apply at this time.In February 2015, Lauren receives the full $100,000 payment available under the earnout right for that year.Lauren's return for the 2014-15 income year will be lodged after 23 April 2015. However, the timing rule means that Lauren will be protected if she lodges her return on the basis of the law as she has anticipated it in her prior return and this anticipation was reasonable, as this will be a statement relating to circumstances prior to 24 April 2015.Subsequently, in February 2016, Lauren again receives the full $100,000 available for that year.In this case both the payment and the lodgement of the return occur well after 23 April 2015. However, again, Lauren will be protected against subsequent amendments by the Commissioner if she prepares her return on the basis of the law as she had previously anticipated. The statements in the return relate to the circumstances of her original transaction and the rights created under the transaction, to which Lauren was committed prior to 24 April 2015.It is open to Lauren to prepare either or both of these subsequent returns on a basis that is not consistent with the law as she had anticipated in her original return. However, if she does and this is not to her detriment, the protection measure will no longer apply in respect of the statements in any of Lauren's returns and the Commissioner will apply the law as it stood at those times.
1.155 This protection measure affects how the Commissioner will apply the law in relation to earlier periods but does not actually change the law in these periods and so does not strictly speaking have retrospective effect. Additional, while the measure may affect past liabilities, it does so only to the benefit of the taxpayer.
Statement of Compatibility of Human Rights
Prepared in accordance with Part 3 of the Human Rights (Parliamentary Scrutiny) Act 2011
Capital gains tax treatment of earnout rights
1.156 This Schedule is compatible with the human rights and freedoms recognised or declared in the international instruments listed in section 3 of the Human Rights (Parliamentary Scrutiny) Act 2011.
1.157 This Schedule amends the Income Tax Assessment Act 1997 to change the capital gains tax treatment of the sale and purchase of businesses involving certain earnout arrangements - rights to future payments linked to the performance of an asset or assets after sale.
1.158 As a result of these amendments, capital gains and losses arising in respect of look-through earnout arrangements will be disregarded. Instead, payments received under the earnout arrangements will affect the capital proceeds and cost base of the underlying asset or assets to which the earnout arrangement relates.
1.159 There amendments can apply to transactions entered into as far back as 17 October 2007. However, the application is generally beneficial and optional for all parties. As a result, no taxpayer will be disadvantaged as a result of the retrospective application of these provisions.
Human rights implications
1.160 This Schedule does not engage any of the applicable rights or freedoms.
1.161 In substance, these amendments only alters the time at which capital gains or losses are recognised for tax purposes, and addresses technical issues.
1.162 This Schedule is compatible with human rights as it does not raise any human rights issues.