Edited version of private advice

Authorisation Number: 1051844680389

Date of advice: 1 June 2021

Ruling

Subject: Deferred consideration payment

Question 1

Do the look-through earnout right provisions contained in Subdivision 118-I of the Income Tax Assessment Act 1997 (ITAA 1997) apply to the Deferred Consideration 1 payment?

Answer

No

Question 2

Did XYZ Limited start to have a financial arrangement under section 230-45 of ITAA 1997 when it received the assets pursuant to the Sale and Purchase Agreement (SPA)?

Answer

Yes

Question 3

If the answer to question 2 is yes, does the proceeds from business sale exception under subsection 230-460(13) of ITAA 1997 apply in respect of the financial arrangement?

Answer

No

Question 4

If the answer to question 3 is no, did XYZ Limited make a loss under a financial arrangement in respect of the Deferred Consideration 1 payment made under the SPA, which is deductible under subsection 230-15(2) of ITAA 1997 in the income year ended 31 December 20YY?

Answer

Yes

This ruling applies for the following period:

1 January 20YY to 31 December 20YY

The scheme commences on:

1 January 20YY

Relevant facts and circumstances

XYZ Limited (XYZ) was incorporated in Australia and is a resident of Australia for income tax purposes.

XYZ has an income year ending 31 December.

Division 230 of ITAA 1997 has applied to XYZ since the income year that commenced on 1 January 20XX.

XYZ has not made any tax timing elections under the Taxation of Financial Arrangements (TOFA) rules in Division 230 of the ITAA 1997.

In 20XX, XYZ acquired assets under a Sale and Purchase Agreement (SPA). The SPA was entered into prior to the introduction of Division 118-I of ITAA 1997.

XYZ paid $XXXm cash consideration for the acquisition.

In addition to the $XXXm, XYZ agreed to pay Deferred Consideration 1 of $XXYm and Deferred Consideration 2 of $XXZm on the occurrence of certain contingencies that were defined in the SPA.

There was no time constraint attached to the Deferred Consideration 1 and the Deferred Consideration 2 obligations. Each payment obligation is structured as a single payment.

During the year ended 31 December 20YY, a contingency event was triggered which led to the payment of the Deferred Consideration 1 obligation.

The Deferred Consideration 2 payment has not been made as the relevant contingency events have not occurred.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subdivision 118-I

Income Tax Assessment Act 1997 Division 230

Income Tax Assessment Act 1997 subsection 974-160

Income Tax Assessment Act 1997 subsection 995-1(1)

All legislative references in these reasons for decision are to ITAA 1997 unless otherwise stated.

Question 1

Do the look-through earnout right provisions contained in Subdivision 118-I of ITAA 1997 apply to the Deferred Consideration 1 payment?

Summary

The look-through earnout provisions in Subdivision 118-I do not apply to the Deferred Consideration 1 payment.

Detailed reasoning

A look-through earnout right is a right to future financial benefits which are not reasonably ascertainable at the time the right is created.

Subdivision 118-I applies to look-through earnout rights (as defined) created on or after 24 April 2015.

The vendors' right to the Deferred Consideration 1 payment was created under the SPA that was signed in 20XX.

Therefore, Subdivision 118-I does not apply to the Deferred Consideration 1 payment as the right was created prior to 24 April 2015.

Question 2

Did XYZ Limited start to have a financial arrangement under section 230-45 of ITAA 1997 when it received the assets pursuant to the SPA?

Summary

XYZ started to have a financial arrangement under section 230-45 when it received the assets pursuant to the SPA.

Detailed reasoning

Division 230 deals with the tax treatment of gains and losses from financial arrangements. The Division provides for the recognition of gains and losses, as appropriate, over the life of a financial arrangement.

Division 230 has applied to XYZ since the income year that commenced on 1 January 20XX.

For Division 230 to apply to the arrangement under the SPA, the arrangement must satisfy the definition of financial arrangement. Section 230-45 is the general test to determine whether you have a financial arrangement.

Is there an arrangement for the purposes of Division 230?

To determine whether there is a financial arrangement for the purposes of Division 230, it is first necessary to identify the relevant arrangement under section 230-55.

Subsection 230-55(4) sets out factors that need to be considered when determining whether rights and/or obligations form a single arrangement or two or more separate arrangements for the purposes of Division 230. Whether a number of rights and/or obligations constitute one or more arrangements is a question of fact and degree.

Subsection 230-55(4) provides:

For the purposes of Division 230, whether a number of rights and/or obligations are themselves an *arrangement or are 2 or more separate arrangements is a question of fact and degree determined having regard to the following:

(a)       the nature of the rights and/or obligations

(b)       their terms and conditions (including those relating to any payment or other consideration for them)

(c)       the circumstances surrounding their creation and their proposed exercise or performance (including what can reasonably be seen as the purposes of one or more of the entities involved)

(d)       whether they can be dealt with separately or must be dealt with together

(e)       normal commercial understandings and practices in relation to them (including whether they are regarded commercially as separate things or as a group or series that forms a whole), and

(f)        the objects of this Division.

An 'arrangement' is defined in subsection 995-1(1) as meaning any arrangement, agreement, understanding, promise or undertaking, whether express or implied, and whether or not enforceable (or intended to be enforceable) by legal proceedings.

This is a broad definition covering a broad range of possible circumstances.

In applying subsection 230-55(4), regard must be had to all of the matters referred to in paragraphs (a) to (f) both in relation to the rights and/or obligations separately and in relation to the rights and/or obligations in combination with each other.

Taxation Ruling TR 2012/4 Income tax: the operation of subsection 230-55(4) of the Income Tax Assessment Act 1997 in determining what is an 'arrangement' for the purposes of the taxation of financial arrangements under Division 230 (TR 2012/4) provides the Commissioner's view on the application of subsection 230-55(4) in determining whether a number of rights and/or obligations are themselves an arrangement or are two or more separate arrangements for the purposes of Division 230.

TR 2012/4 provides (at paragraph 6) that it will often be the case that the arrangement is consistent with the legal form of the arrangement, though subsection 230-55(4) can operate to identify as an arrangement something other than the rights and/or obligations under a particular contract.

In applying the factors at subsection 230-55(4) to the SPA, the matters considered include:

•         The SPA provided for consideration in the form of an upfront payment of $XXXm cash and deferred consideration of $XXYm (Deferred Consideration 1) and $XXZm (Deferred Consideration 2). The deferred consideration payments were contingent on the occurrence of specified events as defined in the SPA.

•         The $XXXm cash consideration was paid in the income year ended 31 December 20XX. The Deferred Consideration 1 payment of $XXYm arose in the income year ended 31 December 20YY as that was when the relevant contingency under the relevant clause occurred.

•         Cash consideration of $XXXm was payable at the time of the acquisition in 20XX. The deferred consideration was only payable in the event that certain contingencies eventuated. Both forms of payment (i.e. upfront and contingent) were consideration for the acquisition of the assets.

•         The obligations to pay cash consideration at acquisition and deferred consideration on the occurrence of future events were covered by a single legal agreement, the SPA.

•         Normal commercial understanding and practice suggests that the obligations should be treated in combination since they make up the total of the acquisition consideration for the assets which were acquired in 20XX. The obligation to pay deferred consideration would not have existed if the assets had not been acquired.

•         Treating the SPA as a single arrangement would not defeat the objects of Division 230.

Having regard to the factors in subsection 230-55(4), on balance it is considered that the SPA is the arrangement for the purposes of Division 230.

Did XYZ start to have a financial arrangement under section 230-45?

Subsection 230-45(1) provides:

(1)       You have a financial arrangement if you have, under an *arrangement:

(a)       a *cash settlable legal or equitable right to receive a *financial benefit; or

(b)       a cash settlable legal or equitable obligation to provide a financial benefit; or

(c)       a combination of one or more such rights and/or one or more such obligations;

unless:

(d)       you also have under the arrangement one or more legal or equitable rights to receive something and/or one or more legal or equitable obligations to provide something; and

(e)       for one or more of the rights and/or obligations covered by paragraph (d):

                                                  (i)          the thing that you have the right to receive, or the obligation to provide, is not a financial benefit; or

                                                (ii)          the right or obligation is not cash settlable; and

(f)        the one or more rights and/or obligations covered by paragraph (e) are not insignificant in comparison with the right, obligation or combination covered by paragraph (a), (b) or (c).

The right, obligation or combination covered by paragraph (a), (b) or (c) constitutes the financial arrangement.

Are there cash-settlable legal or equitable rights to receive or obligations to provide financial benefits under the arrangement?

Subsection 230-45(2) specifies the circumstances in which a right to receive or obligation to provide a financial benefit that you have is cash settlable.

Under the SPA, the relevant rights and obligations that XYZ, as the buyer, had are:

•         the right to receive the assets,

•         an obligation to pay $XXXm consideration upon acquisition,

•         an obligation to pay deferred consideration of $XXYm (Deferred Consideration 1) in the future in the event of certain contingencies occurring, and

•         an obligation to pay deferred consideration of $XXZm (Deferred Consideration 2) in the future in the event of certain contingencies occurring.

Paragraph 974-160(1)(a) provides that a 'financial benefit' means anything of economic value.

Subsection 230-45(2) provides that:

A right you have to receive, or an obligation you have to provide, a *financial benefit is cash settlable if, and only if:

(a)  The benefit is money or a *money equivalent; ...

XYZ's right to receive the assets from the vendors on acquisition was not cash settlable. The $XXXm payment was made at the time of acquisition in 20XX.

XYZ's obligation to pay the $XXXm cash consideration on acquisition was a cash settlable obligation to provide a financial benefit.

After receiving the assets, XYZ's only subsisting obligations under the SPA were the obligations to pay Deferred Consideration 1 and Deferred Consideration 2 in the event of the contingencies occurring. These obligations were in respect of monetary amounts and cash-settlable obligations to provide financial benefits.

Pursuant to section 230-85, an obligation that is subject to a contingency is an obligation for the purposes of Division 230.

Are there any non-insignificant non-cash settlable rights or obligations?

Paragraphs 230-45(1)(e) and (f) would not apply as there are no non-insignificant non-cash settlable obligations under the financial arrangement.

Conclusion on whether there is a financial arrangement under section 230-45

XYZ's obligations under the SPA in respect of Deferred Consideration 1 and Deferred Consideration 2 are cash-settlable obligations to provide financial benefits. Accordingly, XYZ started to have a financial arrangement under section 230-45 when it received the assets pursuant to the SPA.

Is there a financial arrangement under section 230-50?

Section 230-50 provides two further tests for determining a financial arrangement. These tests should not apply in the circumstances on the basis that there is no equity interest as defined in Subdivision 974-C and the financial arrangement falls within subsection 230-45(1).

Question 3

If the answer to question 2 is yes, does the proceeds from business sale exception under subsection 230-460(13) of ITAA 1997 apply in respect of the financial arrangement?

Summary

The proceeds from business sale exception under subsection 230-460(13) of ITAA 1997 does not apply in respect of the financial arrangement.

Detailed reasoning

XYZ started to have a financial arrangement under section 230-45 when it received the assets pursuant to the SPA.

The notes to subsections 230-15(1) and 230-15(2) indicate that Division 230 does not apply to gains and losses respectively from certain financial arrangements that are subject to exceptions under Subdivision 230-H.

Proceeds from certain business sales exception

Division 230 will not apply to gains or losses from a financial arrangement for any income year to the extent that the rights and/obligations under the arrangement are the subject of the proceeds from certain business sales exception in subsection 230-460(13). Under subsection 230-460(13), an obligation to provide financial benefits arising from the sale of a business is subject to an exception if the amounts or values of the financial benefits are:

•         only 'contingent on aspects of the economic performance' of the business, as that term is defined in section 974-85 (if the earnout right is a look-through earnout right created on or after 24 April 2015) or

•         contingent only on the economic performance of the business (if the earnout right is not a look-through earnout right created on or after 24 April 2015).

The vendors' right to deferred consideration was created under the SPA, which was entered into before 24 April 2015. It is therefore necessary to consider whether the amounts or values of the financial benefits are contingent only on the economic performance of the business.

Are the obligations contingent only on the economic performance of the business after the sale?

The terms 'contingent' and 'economic performance' in subsection 230-460(13) of the ITAA 1997 are not defined. Therefore, consideration is required to be given to the ordinary meaning of this phrase.

The most basic measure of the economic performance of a business is profitability.

The Deferred Consideration 1 was specified as a fixed amount of $XXY million in the SPA. The obligation to pay this amount arose on the occurrence of a trigger event. This event was not determined by the economic performance of the XYZ business. Once the contingency event occurred, the $XXYm was payable regardless of the profitability of XYZ.

Conclusion

The obligation to pay Deferred Consideration 1 is not contingent only on the economic performance of the business after the sale of the assets to XYZ. As such, the exception provided within subsection 230-460(13) will not apply.

For completeness, it is considered that none of the other exceptions in Subdivision 230-H will apply to the financial arrangement under the SPA.

Question 4

If the answer to question 3 is no, did XYZ Limited make a loss under a financial arrangement in respect of the Deferred Consideration 1 payment made under the SPA, which is deductible under subsection 230-15(2) in the income year ended 31 December 20YY?

Summary

XYZ made a loss under a financial arrangement in respect of the Deferred Consideration 1 payment made under the SPA, which is deductible under subsection 230-15(2) in the income year ended 31 December 20YY.

Detailed reasoning

To determine whether a loss made from the Deferred Consideration 1 payment is deductible under Division 230, the loss must satisfy the requirements of subsection 230-15(2).

Pursuant to section 230-20, a loss that is deductible under Division 230 is not deductible to any extent under any other provision.

Subsection 230-15(2) provides a deduction for a loss an entity makes from a financial arrangement, to the extent that the loss is made in gaining or producing its assessable income or is necessarily incurred in carrying on a business for the purposes of gaining or producing such income.

The obligation in respect of the Deferred Consideration 1 arose under the financial arrangement identified at question 2.

The Explanatory Memorandum to Taxation Laws Amendment (Taxation of Financial Arrangements) Bill 2008 (the TOFA EM) provides (at paragraph 3.72) that the rule in subsection 230-15(2) reflects the general deduction rule in section 8-1, in particular the nexus aspects. This means that case law in respect of the nexus aspects of section 8-1 is also relevant when determining whether losses made from a financial arrangement satisfy subsection 230-15(2).

It is considered that the Deferred Consideration 1 payment was made by XYZ in carrying on a business for the purpose of gaining or producing assessable income. As such, XYZ will be entitled to a deduction pursuant to subsection 230-15(2). The quantum and timing of the loss for TOFA purposes is considered below.

Methods for taking loss into account

Pursuant to section 230-40, the accruals and the realisation methods under Subdivision 230-B are the default methods which apply to financial arrangements that are not subject to any of the elective tax timing methods of Division 230.

XYZ has not made any tax timing elections under Subdivisions 230-C, 230-D, 230-E or 230-F. As a result, the default methods in Subdivision 230-B will apply.

The accruals method under subsection 230-100(2) (the overall gain or loss approach) or subsection 230-100(3) (the particular gain or loss approach) will apply where there is a sufficiently certain gain or loss from the financial arrangement. Where gains or losses are not sufficiently certain, the realisation method under subsection 230-100(5) will apply.

To the extent that the balancing adjustment in Subdivision 230-G applies, neither the accruals method nor the realisation method will apply.

The particular gain or loss approach (subsection 230-100(3)) is the default approach when applying the accruals method unless the taxpayer, if eligible, makes a choice to apply the accruals method to the overall gain or loss pursuant to paragraph 230-100(2)(c).

In deciding whether XYZ's gain or loss is sufficiently certain for the purposes of section 230-110, XYZ can only have regard to those financial benefits under the financial arrangement that are sufficiently certain.

Are there sufficiently certain financial benefits?

Whether a financial benefit is sufficiently certain is determined pursuant to section 230-115.

As provided in the TOFA EM at paragraph 4.104, the term 'reasonably expected' is not defined in the legislation, although its meaning has been contemplated in a number of tax law cases. In FC of T v. Peabody (1994) 181 CLR 359 the court stated that a reasonable expectation requires more than a possibility.

The TOFA EM provides guidance regarding section 230-115 at paragraphs 4.99 and 4.100. There must be more than a mere expectation that the estimated gain or loss will actually be made.

In this case, the amount of the financial benefit is fixed and determinable with reasonable accuracy as required by paragraph 230-115(2)(b). The fixed amount of $XXYm was specified in the SPA under which the assets was acquired. However, there was no reasonable expectation that XYZ would provide this financial benefit.

The Deferred Consideration 1 payment was no more than a possibility or mere expectation.

The Deferred Consideration 1 payment was not a sufficiently certain financial benefit pursuant to section 230-115. As a loss was not sufficiently certain at the time when the assets were acquired, the accruals method under subsection 230-100 cannot apply.

Does the realisation method apply?

Subsection 230-100(5) provides that the realisation method provided for in Subdivision 230-B applies to a gain or loss that you have from a financial arrangement if the accruals method does not apply to that gain or loss.

Since the accruals method does not apply, the realisation method applies to the gain or loss XYZ makes from the financial arrangement in respect of the Deferred Consideration 1 payment made under the SPA.

Balancing adjustment under Subdivision 230-G

The balancing adjustment under Subdivision 230-G applies to any gains or losses that arise when the taxpayer either transfers some or all of the rights and obligations under the arrangement to another person, or all of the taxpayer's rights or obligations under the arrangement otherwise cease.

Since all of XYZ's obligations under the financial arrangement have not ceased, Subdivision 230-G does not apply.

What is the gain or loss?

Subsection 230-180(1) states that if a gain or loss is to be taken into account using the realisation method, you are taken to make the gain or loss for the income year in which the gain or loss occurs.

Paragraph 230-180(2)(a) provides that, for these purposes, if the last of the financial benefits, rights and obligations taken into account in determining the amount of the gain or loss is a financial benefit, the gain or loss from a financial arrangement is taken to occur at the time the financial benefit is provided. The relevant time in this case is when the $XXYm is provided by XYZ, which occurs during the income year ended 31 December 20YY.

Paragraph 3.33 of the TOFA EM makes the following comments regarding the gain or loss:

In recognising that a gain or loss is a net concept, it is important to note that the gain or loss is generally determined by making a reasonable allocation of:

•         the costs of the financial arrangement (financial benefits provided or to be provided, either under the financial arrangement or which are integral to the calculation of a gain or loss from the arrangement); and

•         the proceeds from the financial arrangement (financial benefits received or to be received, either under the financial arrangement or which are integral to the calculation of a gain or loss from the arrangement or the amount of such gain or loss).

Section 230-60 determines when a financial arrangement has been provided or received under a financial arrangement for the purpose of working out any gain or loss from that financial arrangement. In particular, financial benefits that you receive (or have a right to receive) which play an integral role in determining whether a gain or loss is made from the financial arrangement, are also taken to be relevant financial benefits under that financial arrangement (subsection 230-60(2)).

The financial benefit provided by XYZ to the vendors was the $XXYm it paid during the income year ended 31 December 20YY.

XYZ makes a loss when it pays Deferred Consideration 1 to the vendors. This loss is calculated by comparing the $XXYm paid to the vendors on 29 August 20YY with the financial benefit received in respect of granting the obligation to pay Deferred Consideration 1.

As the financial benefit provided is greater than the financial benefit received in respect of granting the obligation to pay Deferred Consideration 1, XYZ made a loss equal to the difference between the $XXYm and the financial benefit received in respect of granting the obligation to pay Deferred Consideration 1.

This loss is deductible under subsection 230-15(2) in the income year ended 31 December 20YY as it is made under a financial arrangement and has a sufficient nexus with the earning of assessable income.

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