Edited version of your private ruling

Authorisation Number: 1012564308603

Ruling

Subject: CGT - earnout arrangements

Questions and answers

1. Will a Capital Gains Tax event A1 occur at the time you enter into the contract for disposal of the shares?

Yes

2. Will you be required to include the capital proceeds for the A1 event, being the sum of the cash (50% of the Base Purchase Price) and market values of the earnout payments, from the sale of the shares in the company in the one financial year?

Yes.

3. Will a Capital Gains Tax event C2 occur as the rights to the earnouts end at the time Tranche 2 and Tranche 3 is paid?

Yes.

This ruling applies for the following period(s)

1 July 2013 to 30 June 2014

1 July 2014 to 30 June 2015

1 July 2015 to 30 June 2016

1 July 2016 to 30 June 2017

1 July 2017 to 30 June 2018

Relevant facts and circumstances

You hold shares in the company.

You are one of a number of entities referred to in the Share Sale and purchase deed (the deed) as 'Sellers'.

Under the deed you receive a portion of the Base Purchase Price.

Under of the deed, The Base Purchase Price, plus, any amounts payable (Performance Payment), which shall be adjusted by the Adjustments and is payable by the company in the following tranches;

(a) The amount that is equal to Tranche 1 Unadjusted Amount (50% of the Base Purchase Price) as adjusted by the Tranche 1 Adjustment (Tranche 1 Amount); plus

(b) Subject to the relevant clause, the amount that is equal to 30% of the Base Purchase Price as adjusted by the Tranche 2 Adjustment (Tranche 2 Amount); plus

(c) Subject to the relevant clause, the amount that is equal to 20% of the Base Purchase Price as adjusted by the Tranche 3 Adjustment (Tranche 3 Amount); plus

(d) Subject to the relevant clause, a Performance Payment Amount as adjusted in the relevant clause.

Under the deed the Base Purchase Price is payable as follows;

(a) On the completion date, the company must pay 50% of the Base Purchase Price to you.

(b) Subject to relevant clause, on the date that is the later of:

(i) 90 days after the first anniversary of completion; and

(ii) 10 Business Days after the Representative Earnings Before Income Tax (EBIT) Accounts are finally determined in accordance with the relevant clause,

The company must pay you the Tranche 2 Amount (if any); and

(c) Subject to the relevant claue, on the date that is the later of:

(i) 90 days after the second anniversary of completion; and

(ii) 10 Business Days after the Representative EBIT Accounts are finally determined in accordance with the relevant clause,

The company must pay you the Tranche 3 Amount (if any).

(d) For the avoidance of doubt, the Base Purchase Price includes the earnout arrangements in Tranches 1,2 and 3 amounts assuming that they are eventually paid, and the trust is not entitled to receive the Tranches 1,2 and 3 amounts unless the conditions in the relevant clauses are satisfied. The trust is not entitled to receive the Performance Payment amount unless a relevant clause is satisfied.

Tranche 1 Adjustment - the amount set out in the relevant schedule.

Payment of the Tranche 1 Adjustment - the parties agree that no Tranche 1 Adjustment will be required.

Tranche 2 Adjustment

(a) if the Representative EBIT of the Company for the First Year is equal to or greater than the Base EBIT Amount, the Tranche 2 Amount will be equal to 30% of the Base Purchase Price.

(b) if the Representative EBIT of the Company for the First Year is less than the Base EBIT Amount, the Tranche 2 Amount will be calculated by applying the following formula:

Tranche 2 Amount = ((5.0 x Representative EBIT for the First Year) - (Tranche 1 Unadjusted Amount)) x 30%

(c) if the formula in paragraph (b) produces a negative amount, the Tranche 2 Amount will be zero.

(d) To the extent that the Tranche 2 Adjustment decreases the Tranche 2 Amount, then the relative cash amount set out in the relevant schedule will decrease proportionately and such amount shall be applied to each Seller in accordance with their Respective Proportions.

Tranche 3 Adjustment

(a) If the Representative EBIT of the Company for the Second Year is equal to or greater than the Base EBIT Amount, the Tranche 3 Amount will be calculated by applying the following formula:

Tranche 3 Amount = Base Purchase Price - (Tranche I

Unadjusted Amount + Tranche 2 Amount)

(b) If the Representative EBIT of the Company for the Second Year is less than the Base EBIT Amount, the Tranche 3 Amount will be calculated by applying the following formula:

Tranche 3 Amount = 50 x Representative EBIT for the Second Year - (Tranche 1 Unadjusted Amount + the Tranche 2 Amount)

(c) If the formula in paragraph (b) produces a negative amount, the Tranche 3 Amount will be zero.

(d) To the extent that the Tranche 3 Adjustment decreases the Tranche 3 Amount, then the cash amount set out in the relevant schedule will increase or decrease proportionately and such amount shall be applied to each Seller in accordance with their Respective Proportions.

Representative EBIT Accounts

(a) For the purpose of calculating the Tranche 2 Adjustment and the Tranche 3 Adjustment, no later than 30 days after the end of the First Year and the Second Year, as applicable, the company must provide to the Sellers the Representative EBIT Accounts.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 104-10

Income Tax Assessment Act 1997 subsection104-25(2)(a)

Income Tax Assessment Act 1997 subsection 104-25(2)(b)

Income Tax Assessment Act 1997 Section 109-5

Income Tax Assessment Act 1997 subsection 112-30(1)

Income Tax Assessment Act 1997 subsection 112-30(3)

Income Tax Assessment Act 1997 subsection 112-30(4)

Income Tax Assessment Act 1997 Section 116-20

Income Tax Assessment Act 1997 subsection116-20(1)(a)

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 1936 is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable.

We have not considered the application of Part IVA to the arrangement you asked us to rule on.

Reasons for decision

Under section 104-10 of the Income Tax Assessment Act 1997 (ITAA 1997) event A1 happens if you dispose of a capital gains tax (CGT) asset to another entity. The time of the event is when you enter into the contract for disposal. You make a capital gain if the capital proceeds from the disposal are more than the assets cost base.

Earnout Arrangement

A standard earnout arrangement is any transaction in which an income earning asset is sold for consideration that includes the creation of an earnout right in the seller of the asset.

An earnout right is a right to an amount calculated by reference to the earnings generated by the asset for a defined period following the sale. It is to be distinguished from a right to a sum in respect of that sale which is certain as to amount and as to receipt as this '…money you…are entitled to receive…' in terms of subsection 116-20(1)(a) of the ITAA 1997 regarding capital proceeds.

Under section 116-20 of the ITAA 1997, the earnout right is not an entitlement to money for the purposes of calculating the seller's capital proceeds from CGT event A1.

An earnout right is considered 'other property….received' by the seller in respect of the disposal of the original asset. Accordingly the seller's capital proceeds from that event includes the market value of that right. It is not possible for the seller to 'look through' the earnout right and treat any payments made in relation to it as capital proceeds in respect of the disposal of the of the original asset.

The earnout right is property, and a CGT asset, in the hands of the seller. It commences to be owned and is acquired for the purpose of section 109-5 of the ITAA 1997 at the time the contract for the sale of the original asset is made.

Ending of an earnout right

Generally, the seller's ownership of an earnout right will come to an end when satisfied by the payment of an amount or amounts by the buyer, or by expiring without any amounts becoming payable. In each of these situations, CGT event C2 (about cancellation, surrender and similar endings) happens.

The contract for the sale of the original asset for an earnout right is not a 'contract that results in the asset ending' under subsection 104-25(2)(a) of the ITAA 1997. Accordingly, under subsection 104-25(2)(b) of the ITAA 1997, the time of the CGT event is when the right ends and not before.

CGT event C2 will occur as the rights end. Generally, the seller's ownership of the right will come to an end when satisfied by the payment of an amount or amounts by the buyer, or by expiring without any amounts becoming payable. In each of these situations, CGT event C2 happens.

Where an earnout is discharged progressively in instalments, the CGT treatment will differ depending on the circumstances of the payments. In some circumstances, it will be appropriate to regard each right to an instalment as a separate CGT asset. In others, it may be more appropriately characterised as part of a single CGT asset comprising the totality of rights under a contract covering both the sale of the original asset and of the earnout arrangement.

The totality of rights under a contract is generally regarded as a single for CGT purposes. However, this is ultimately a question of fact to be determined on a case by case basis.

Where the rights to progressive payments are part of a single CGT asset comprising the totality of the rights under a single contract, CGT event C2 happens to part of it at the time specified for each payment (other than the final payment). The seller's cost base for the part of the right to which the event happens is apportioned according to the formula in subsection 112-30(3) of the ITAA 1997. Under subsection 112-30(4) of the ITAA 1997, the remainder of the cost base after each payment is made is attributed to the part of the asset that remains.

Where each right to progressive payments under the earnout arrangement is a separate CGT asset, the seller is required to determine the cost base of each separate right as it is acquired. Under subsection 112-30(1) of the ITAA 1997, the first element of the cost base of each right is part of the expenditure that relates to its acquisition.

Application to your circumstances

At the time you enter into the contract for disposal of the shares an A1 event will happen under section 104-10 of the ITAA 1997. Therefore the capital gain on the disposal of your shares is assessed in one year; the year the A1 event occurs.

Under the deed there are three payments; the initial payment, Tranche 2 and Tranche 3. Tranche 2 and Tranche 3 are earnout payments.

The capital proceeds for the A1 event are the sum of the cash (50% of the Base Purchase Price) and market values of the earnout payments.

The additional CGT events (CGT event C2) will occur as the rights to the earnouts end at the time each Tranche is paid. This could allow capital losses to be made and claimed against future capital gains.

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