Edited version of your written advice

Authorisation Number: 1013126376144

Date of advice: 21 November 2017

Ruling

Subject: Earnout arrangement

Question 1

If the capital gain from the sale of your assets increases by you receiving additional capital amounts under the earnout right in a future financial year, should the increased capital gain be included as assessable income in the 201X-1X financial year?

Answer

Yes

Question 2

Will the Commissioner of Taxation exercise his discretion under sections 8AAG, 280-160 and 298-20 of Schedule 1 to the Taxation Administration Act 1953 (TAA) to remit GIC, SIC or any penalty that may arise as a consequence of an amendment in relation to an earnout payment which will be received after the 201X-1X financial year which is referable to a CGT event which occurred in the 201X-1X financial year from the sale of your assets?

Answer

Yes

This ruling applies for the following periods

Year ended 30 June 201X

Year ended 30 June 201X

Year ended 30 June 201X

Year ending 30 June 201X

Year ending 30 June 201X

The scheme commenced on

1 July 201X

Relevant facts and circumstances

You held CGT assets.

You sold the assets and entered into an earnout arrangement with the buyer.

You, reasonably and in good faith entered into the earnout arrangement on the basis of the content of the Assistant Treasurer's press release on 12 May 2010 regarding the tax treatment of earnout arrangements.

Under the earnout agreement, the amount payable by the buyer to you as consideration for the sale of your assets comprised:

a) a proportion of the “initial payment” (initial payment) which was payable to you at completion of the sale of the assets to the buyer, and

b) certain future payments that are contingent upon milestones being achieved (earnout right) in relation to activities of the entity.

The buyer subsequently distributed the net proceeds from the asset sale to you.

You included the capital gain from the sale of the assets in your 201X-1X tax return.

To date you haven't received any proceeds from your earnout right under the agreement. However, you expect that one or more milestones set out in the agreement will be achieved in a future financial year, in which case you will be eligible to receive additional consideration from the sale of the assets.

Relevant legislative provisions

Income Tax Assessment Act 1936 Section 170B

Taxation Administration Act 1953 Section 8AAG of Schedule 1

Taxation Administration Act 1953 Section 280-160 of Schedule 1

Taxation Administration Act 1953 Section 298-20 of Schedule 1

Income Tax Assessment Act 1997 Subdivision 118-I

Reasons for decision

Question 1

On 12 May 2010, the Assistant Treasurer, the Hon Nick Sherry MP, announced that the Government would provide 'look-through' treatment for qualifying earnout arrangements. Earnout arrangements are a common and efficient way of structuring the sale of an asset to deal with uncertainty about the value of the asset, for example the goodwill attached to a business. The proceeds from the sale of the business (or assets of the business) typically include a lump sum payment plus a right to further payments that are contingent on the performance of the business — an 'earnout right'. The proposed measure will treat additional payments made under a 'standard' earnout arrangement as capital proceeds for the original asset for the seller and add to the asset's cost base for the buyer. It will treat payments made under a 'reverse' earnout arrangement as effectively a repayment of part of the capital proceeds for the disposal of the business asset.

On 25 February 2016, legislation was enacted to provide look-through capital gains tax (CGT) treatment for look-through earnout rights created on or after 24 April 2015.

Broadly, under the look-through CGT treatment:

● capital gains and losses arising in respect of look-through earnout rights are disregarded;

● for the buyer, any financial benefit provided (or received) under a look-through earnout right increases (or decreases) part of the cost base or reduced cost base of the underlying asset; and

● for the seller, any financial benefit received (or provided) under the look-through earnout right increases (or decreases) the capital proceeds for the underlying asset.

This new legislation does not apply prior to 24 April 2015. However, transitional protection is provided to taxpayers that have reasonably and in good faith anticipated the changes to the tax law in this area as a result of the announcement by the former Government.

The protection operates 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.

Any protection 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.

Transitional protection

Transitional protection is provided to taxpayers who have reasonably and in good faith anticipated the changes to the tax law in this area as a result of the government's announcement in May 2010.

The government announced as part of its 2010-11 Federal Budget that a look-through treatment would be applied to earnout arrangements for CGT purposes.

Treasury released the draft legislation measure on 23 April 2015. According to the draft Bill, a subsequent payment received by the seller would be treated as part of the original capital proceeds (with interest and penalties suspended). This approach, Treasury argues, is consistent with the application of the existing CGT concession framework. Recognising this change, combined with the lack of detail available to taxpayers at the time, might mean that the draft laws differed from what might had been anticipated by taxpayers. Accordingly, the law applies from 23 April 2015 which was the date the draft legislation was released and taxpayers who reasonably anticipated the announced measure before the release of draft legislation receive transitional protection.

The protection operates 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. Broadly, the conditions will be satisfied if either:

● the statement was made between the date of the announcement (i.e. 11 May 2010 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 was 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.

Such protection will be lost if the taxpayer makes a statement for a later income year that is inconsistent 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. The protection is provided under s 170B of ITAA 1936 (see item 39 in Schedule 1 of the Tax and Superannuation Laws Amendment (2015 Measures No 6) Act 2016
(Act No 10 of 2016)).

Example

The following example which shows how the transitional measures work was taken from the Explanatory Memorandum to Act No 10 of 2016:

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 to this transaction, based on the original announcement 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 2014-15 tax return 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.

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.

In your case you sold your assets to the buyer and also entered into an earnout agreement with the buyer. In your 201X-1X income tax return you included the capital gain made on the sale of the assets in relation to the initial payment received in the 201X-1X financial year. You anticipated that the announced measure relating to CGT treatment for earnout arrangements would apply to this transaction based on the original announcement on 12 May 2010. You now anticipate that you may receive payment of the earnout right in a future financial year.

Your tax return in the year or years in which you anticipate you will receive the payment of the earnout right will be lodged after 23 April 2015, the return was not required to be lodged before that date, no prior return was lodged or assessment made for that income year and the statement relates to the application of taxation law to events prior to or to which you were committed to prior to 24 April 2015.

The Commissioner considers that potential payments of the earnout right in the future financial year which will be received by you should be treated as part of the original capital proceeds which were returned in the 201X-1X financial year (assessable income).

Question 2

The Commissioner's power to amend, impose and remit General Interest Charge (GIC), Shortfall Interest Charge (SIC) and Penalties

Taxpayers who have reasonably and in good faith anticipated these changes as a result of the announcement on 12 May 2010 proposing this CGT look-through treatment, will be protected in accordance with section 170B of Income Tax Assessment Act 1936 (ITAA 1936). Section 170B provides protection to taxpayers in relation to proposed retrospective amendments to the tax law which have not been implemented (a discontinued anticipated amendment). Section 170B operates by preventing the Commissioner from amending assessments in relation to protected positions in a way that would produce a less favourable result for the taxpayer. The protection is limited to the particulars of an assessment that reflect the taxpayer's anticipation of the impact of a relevant announcement. All other particulars of the assessment are subject to the usual rules governing amendment of assessments and any protection will be lost if the taxpayer makes a statement for a later income year that is not consistent with the anticipated amendments reflected in the taxpayer's original statement.

Treasury released the draft legislation measure on 23 April 2015. According to the draft Bill, a subsequent payment received by the seller would be treated as part of the original capital proceeds (with interest and penalties suspended).

The following sets out our administrative approach to lodgment and payment obligations and related charging of interest and penalties where taxpayers may be affected by the introduction of a new tax measure.

If you self-assess by anticipating an announced law change and you lodge a return or activity statement, anticipating an announced law change and the retrospective law changes:

● are as anticipated, your self-assessment will not be affected

● are not as anticipated (for instance, because amendments were made to the relevant legislation during the parliamentary process), you'll need to make an amendment or revision.

If you make an amendment or revision and it:

● reduces your liability, we will pay appropriate interest on any overpayment

● increases your liability

● no tax shortfall penalties will apply, on the basis that it is reasonable for a taxpayer to follow an announced government proposal to change the law and that the existence of such an announcement represents special circumstances

● any interest accrued will be remitted to the base interest rate up to the date of enactment of the relevant law change

● any interest in excess of the base rate accruing after the date of enactment will be remitted if you actively seek to amend assessments or revise activity statements within a reasonable time after enactment of the law change ('a reasonable time' to be determined on a case-by-case basis).

In your case you lodged your 201X-1X tax return on the basis of the media release on 12 May 2010 which was issued, by the then, Assistant Treasurer, Mr Nick Sherry.

When you receive the earnout payment you will need to amend your 201X-1X income tax return to include the earnout amount as a capital gain.

As the inclusion of the earnout payment in your amendment will increase your liability:

● no tax shortfall penalties will apply, on the basis that it is reasonable for you to follow an announced government proposal to change the law and that the existence of such an announcement represents special circumstances

● any interest accrued will be remitted to the base interest rate up to the date of enactment of the relevant law change

● any interest in excess of the base rate accruing after the date of enactment will be remitted if you actively seek to amend your assessment within a reasonable time after enactment of the law change ('a reasonable time' to be determined on a case-by-case basis).

Copyright notice

© Australian Taxation Office for the Commonwealth of Australia

You are free to copy, adapt, modify, transmit and distribute material on this website as you wish (but not in any way that suggests the ATO or the Commonwealth endorses you or any of your services or products).