Edited version of private ruling

Authorisation Number: 1011861652410

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Ruling

Subject: Earnout arrangement

Question 1

In relation to the disposal of the business, will the receipt of (i) a lump sum payment consisting of cash, (ii) shares in the Buyer, and (iii) the market value of an earnout right (as worked out at the time of the disposal) constitute an A1 capital gains tax (CGT) event under section 104-10 of the Income Tax Assessment Act 1997 (ITAA 1997) for the Rulee?

Answer

Yes.

Question 2

Will future annual receipts over Z years of A% up to $XM and B% over $XM constitute separate C2 CGT events under section 104-25 of the ITAA 1997 relating to the creation and disposal of rights created in your favour arising under a standard earnout arrangement in accordance with Taxation Ruling TR 2007/D10?

Answer

Yes.

Question 3

Can the annual market value of the rights under the earnout arrangement be calculated on the basis of current income data?

Answer

No.

This ruling applies for the following periods:

Year ended 30 June 2012

Year ended 30 June 2013

Year ended 30 June 2014

Year ended 30 June 2015

Year ended 30 June 2016

Relevant facts and circumstances

You have been practicing under the business structure of a company, the Rulee.

The Rulee is selling the business to the Buyer. The terms of the agreement provide for a lump sum payment of $YM and future payments of A% of the revenue generated by the buyer up to $XM and B% over $XM for the following Z years.

Of the $YM, a percentage will be in cash and a percentage will be shares in the Buyer.

Relevant legislative provisions

Income Tax Assessment Act 1997, section 104-10

Income Tax Assessment Act 1997, section 104-25

Income Tax Assessment Act 1997, section 108-5

Income Tax Assessment Act 1997, section 109-5

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

Income Tax Assessment Act 1997, section 116-20

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 1936 (ITAA 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 fully considered the application of Part IVA of the ITAA 1936 to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

If you want us to rule on whether Part IVA of the ITAA 1936 applies we will first need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

For more information on Part IVA of the ITAA 1936, go to our website www.ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select: Part IVA: the general anti-avoidance rule for income tax.
Reasons for decision

Note, all subsequent legislative references are to the ITAA 1997 unless otherwise stated.

Question 1

Under section 104-10 CGT event A1 happens if you dispose of a 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 asset's cost base.

Under section 116-20 the capital proceeds from a CGT event are the sum of the money you receive and the market value of any other property you receive.

Application to your circumstances

The assets and goodwill associated with the Rulee's business are all considered CGT assets under section 108-5.

When the Rulee enters into a contract for disposal an A1 CGT event will happen under section 104-10.

Under section 116-20 the proceeds from this event will include the cash received and the market value of the shares transferred to the Rulee from the Buyer. In accordance with paragraph 13 of TR 2007/D10, the proceeds will also include the market value of the earnout right, as worked out at the time of the original A1 CGT event.

Question's 2 & 3

Treatment of earnout rights under Taxation Ruling TR 2007/D10

TR 2007/D10 addresses the CGT consequences of earnout arrangements. Paragraphs 2 and 3 define what a standard earnout arrangement is:

2. A standard earnout arrangement is any transaction in which an income-earning asset (often a business asset) is sold for consideration that includes the creation of an 'earnout right' in the seller of the asset.

3. 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 (generally a period of between one and five years). 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 is '...money you...are entitled to receive...' in terms of paragraph 116-20(1)(a).

The earnout right is a CGT asset which is acquired by the seller for the purposes of section 109-5 at the time the contract for sale of the original asset is signed. Under subsection 112-30(1) the first element of the cost base is that part of the market value of the original asset given by the seller in exchange for the earnout right as is reasonably attributable to its acquisition.

TR 2007/D10 cites section 116-20 and provides that the earnout right is not an entitlement to money for the purpose of calculating the seller's capital proceeds from CGT event A1. An earnout right is 'other property' received by the seller in respect of the disposal of the original asset. The 'look-through' approach is also discounted under TR 2007/D10 which provides that any payment made in relation to the earnout right cannot be treated as being in respect of the original asset.
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. In each of these situations CGT event C2 (about cancellation, surrender and similar endings) under section 104-25 will happen.

Application of TR 2007/D10 to Rulee's circumstance

The nature of the arrangement described in this ruling application is such that taxation on the additional payments the Rulee will receive over the Z year period may be calculated in accordance with the standard earnout arrangement as described in TR 2007/D10.

The earnout rights will be acquired by the Rulee at the time the contract for sale of the business is signed. At this time the cost base will be calculated on a reasonable basis.

The Z payments will not be subject to a 'look through' approach in relation to the original A1 disposal. Instead, the proceeds will be in respect of the newly created earnout rights and will be assessed each year upon receipt. A C2 event under section 104-25 will be the relevant CGT event that takes place.

Refer to TR 2007/D10 for examples of the calculation methodology in relation to standard earnout right receipts.

Note that this method precludes your suggested option of calculating the value of future earnings up front on the basis of current income data.

Additional information

Important: Proposed changes to legislation & transitional arrangements

The 'Guide to capital gains tax 2010-11' is an ATO view document which includes a section on changes and proposed changes. The proposed change entitled 'Look-through treatment for earnout arrangements' reads as follows:

On 12 May 2010, the Government announced it would amend the tax law to treat additional payments made under a 'standard' earnout arrangement as related to the original asset for the seller and adding to the 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.

This change will apply to earnout arrangements entered into on or after royal assent of the amending legislation. Optional transitional relief will be provided, in certain cases, back to 17 October 2007, which was the date of release of a relevant ATO draft ruling.

At the time of publishing these instructions this change had not become law.

For more information the above mentioned CGT guide provides the following link back to the ATO website:

http://www.ato.gov.au/taxprofessionals/content.aspx?doc=/content/00243365.htm

The above web site provides links to 'Media release No. 098' of 12 May 2010 and the associated 'Treasury discussion paper':

Media release No. 098:

http://assistant.treasurer.gov.au/DisplayDocs.aspx?doc=pressreleases/2010/098.htm&pageID=003&min=njsa&Year=&DocType=0

Treasury discussion paper:

http://www.treasury.gov.au/documents/1801/RTF/CGT_treatment_of_earnout_arrangements.rtf?bcsi_scan_42A418D6AC94B6B0=iTeKzWZIcTwWDovJhiZyBi3azksHAAAAOyvACw==&bcsi_scan_filename=CGT_treatment_of_earnout_arrangements.rtf

The above documents contain worked examples of how the new measures will operate. In summary, the proposed legislation will allow the 'look through' approach back to the original asset which, in relation to earnout arrangements, will have the effect of deferring the tax liability to later years and also permitting access to the CGT small business concessions.

The transitional arrangements will allow taxpayers to adopt the new measures prior to royal assent. If the amending law is not enacted taxpayers may need to request amendments to affect a return to the TR 2007/D10 treatment.

If amendments are necessary the ATO will not apply any tax shortfall penalties and will remit any interest accrued at the base interest rate up to the date the amending law was enacted. We will remit any interest that accrues in excess of the base rate after that date if taxpayers actively seek to amend their assessments within a reasonable timeframe.