Edited version of your private ruling

Authorisation Number: 1012457472969

Ruling

Subject: Income Tax: Capital Gains Tax: Small Business Concession

Question 1

Will the Commissioner exercise his discretion under subsection 152-125(4) of the Income Tax Assessment Act 1997 (ITAA 1997) to extend the 2-year time limit imposed by paragraph 152-125(1)(b) of the ITAA 1997 in relation to the payment of an exempt amount under section 152-110 of the ITAA 1997?

Answer

The Commissioner will exercise his discretion under subsection 152-125(4) of the ITAA 1997 to grant an extension of time till 30 June 20XX for the market value of the earnout right in relation to the payment of exempt amount under section 152-110 of the ITAA 1997.

The Commissioner will not exercise his discretion under subsection 152-125(4) of the ITAA 1997 to grant an extension of time for any gain or loss made from the earnout right to be treated as relating to the original asset.

This ruling applies for the following periods

Year ended 30 June 20XX

Year ended 30 June 20XX

Year ended 30 June 20XX

The scheme commences on

1 July 20XX

Relevant facts and circumstances

X Pty Ltd (the taxpayer) sold its' business assets to a third party.

The taxpayer satisfies the basic conditions for Small Business CGT relief under Division 152 of the ITAA 1997and in particular, the 15-year exemption for companies under section 152-110 of the ITAA 1997.

The taxpayer entered into a Business Sale and Purchase Agreement with the buyer.

There are two components of consideration:

· 80% base amount; and

· 20% balance amount.

The balance amount is payable on the Determination Date as per of the agreement.

The Determination Date is defined in the agreement as the fifth Business Day after the Average EBITA (earnings before interest taxation and amortization expenses) becomes final and binding.

As per the Agreement the balance amount is adjusted in accordance with the average EBITA for the years 20xx and 20xx follows:

The buyer must calculate and notify the Seller of the average of the 20xx EBITA and the 20xx EBITA (Average EBITA) and otherwise procure the production of 20XX and 20XX financial statements.

As per the agreement based on the EBITA the balance amount can be one of the following:

· market value of the earnout right; or

· less than market value of the earn out right; or

· and additional amount will be paid with the market value of the earn out right

Relevant legislative provisions

Income Tax Assessment Act 1997 section 109-5

Income Tax Assessment Act 1997 section 112-30

Income Tax Assessment Act 1997 section 116-20

Income Tax Assessment Act 1997 Division 152

Income Tax Assessment Act 1997 section 152-110

Income Tax Assessment Act 1997 paragraph 152-125(1)(b)

Income Tax Assessment Act 1997 subsection 152-125(4)

Reasons for decision

Question 1

Detailed reasoning

Subdivision 152-B of the ITAA 1997 provides a small business 15-year exemption as part of the CGT small business relief provisions.

To qualify for the CGT small business concessions, an entity must satisfy the three major basic conditions as follows:

1. the entity must be a small business entity or a partner in a partnership that is a small business entity, or the net value of assets that the entity and related entities own must not exceed $6,000,000:

2. the CGT asset must be an active asset;

3. If the asset is a share or interest in a trust, there must be a CGT concession stakeholder just before the CGT event, and the entity claiming the concession must be a CGT concession stakeholder in the company or trust or CGT concession stakeholders in the company or trust must have a small business participation percentage in the entity of at least 90%.

In your case, you have advised that you meet all the basic conditions for the small business concession and the 15-year exemption.

Pursuant to section 152-125 of the ITAA 1997, if a capital gain made by a company is disregarded under the small business 15-year exemption, distributions made by the company of that exempt amount to a CGT concession stakeholder is not included in the assessable income of the CGT concession stakeholder if the company makes the payment within two years after the CGT event.

The Commissioner may exercise his discretion under subsection 152-125(4) of the ITAA 1997 and allow further time to make payments to the concessional stakeholder. Factors to be considered include:

§ there should be evidence of an acceptable explanation for the period of time requested and it would be fair and equitable in the circumstances to provide such an extension;

§ account must be had to any prejudice to the Commissioner which may result from the additional time being allowed;

§ account must be had of any unsettling of people, other than the Commissioner, or of established practices;

§ there must be consideration of fairness between you and other people in like positions and the wider public interest;

§ whether there was any mischief involved; and

§ consideration of the consequences.

Earnout Right

Earnout right is a right to an amount calculated by reference to 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 the amount.

Draft Taxation Ruling TR 2007/D10 (TR 2007/D10) rule on the tax treatment of 'earnout arrangement' where on the sale of the business/asset some part of the agreed price is contingent on future economic performance that includes the creation of an earnout right. The earnout rights are assets for capital gains tax purposes acquired by the seller and the cost base of the rights is their market value.

The tax treatment in relation to the seller under an earnout arrangement is explained at paragraphs 12 to 14 of the Daft Ruling TR 2007/D10 as follows:

12. Under section 116-20, 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 'other property ... received' by the seller in respect of the disposal of the original asset.

13. Accordingly, the seller's capital proceeds from that event includes the market value of that right (worked out at the time of the CGT event).

14. It is not possible for the seller to 'look-through' the earnout right and to treat any payments made in relation to it as the capital proceeds in respect of the disposal of the original asset.

Separate CGT asset

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

Under subsection 112-30(1) of the ITAA 1997, the first element of cost base of the earnout right is that part (which may be all) 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.

Where the original assets provided by the seller under an earnout arrangement satisfy the conditions in Division 152 of the ITAA 1997 (small business relief), capital gains tax made by the seller may be reduced by one or more of the concessions contained in that Division. Relief under this Division is only available for gains made in respect of active assets as defined in section 152-40 of the ITAA 1997.

There are two CGT events which occur, the first is the disposal of the business, which will be a CGT event A1. Consideration received will be the market value of the earnout right at that date.

The business will satisfy the definition of active asset and provided all the conditions under Subdivision 152-B of the ITAA 1997 are satisfied the capital gain can be disregarded under small business 15 year exemption.

In this case the market value of the earnout right is part of the consideration from the sale of the business of the taxpayer.

As per the agreement if the Average EBITA calculated is equal to or greater than a certain amount, the balance amount is payable in full.

Therefore, the Commissioner will exercise his discretion under subsection 152-125(4) of the ITAA 1997 to grant an extension of time till 30 June 20xx for the market value of the earnout right.

CGT EVENT C2

However, the second CGT event occurs at a future point in time, that is, when a payment is received in relation to the earnout right, CGT event C2 under section 104-25 of the ITAA 1997 will occur. Unlike the original asset, an earnout right will not satisfy the definition of active asset under section 152-40 of the ITAA 1997. This is because

(a) an earnout right is not used, or held ready for use, by the seller in the course of carrying on a business by the seller or by a small business affiliate thereof: paragraph 152-40(1)(a) of the ITAA 1997;

(b) an earnout right is not an intangible asset inherently connected with a business carried on by the seller or a small business affiliate thereof: paragraph 152-40(1)(b) of the ITAA 1997;

(c) an earnout right is in the nature of a financial instrument and is excluded from the definition of active asset by the exception in: paragraph 152-40(4)(d) of the ITAA 1997.

As the earnout arrangement is not considered to be an active asset for the purpose of small business concession. The taxpayer is not eligible to claim the small business capital gain tax concession for the additional payment received under the agreement.

Further, the taxpayer will not revert back the capital loss if the payment from the earnout right is less than the market value.

Accordingly, the Commissioner will not extend the time limit for the additional amount which will be payable under clause 3.2.3 or any loss be made under clause 3.2.2 to be treated as relating the original asset. As explained above any loss or gain made from the earnout right will dot satisfy the basic conditions for the small business concession under the current law.

CGT Look - through treatment for earnout arrangements

On 12 May 2010, the Assistant Treasurer announced 'Look-through treatment for earnout arrangements' to simplify sale of business assets as part of the 2010-11 Budget announcements.

Under this measure:

· additional payments made under a 'standard' earnout arrangement will be treated as relating to the original asset for the seller and will be added to the cost base for the buyer

· payments made under a 'reverse' earnout arrangement will be treated effectively as a repayment of part of the capital proceeds.

This change will apply to earnout arrangements any taxpayer enters into on or after royal assent of the amending legislation. Optional transitional relief will be provided, in certain cases, back to 17 October 2007 - the date of release of TR 2007/D10

Generally, changes that are made to the laws administered by the Commissioner of Taxation have a future application. That is they only create rights and obligations after the changes are enacted by Parliament.

Accordingly, the look-through approach for earnout arrangement is only a proposed change to the law. The Commissioner cannot exercise his discretion under subsection 152-125(4) of the ITAA 1997 to grant an extension of time for the small business 15 year exemption under Subdivision 152-B of the ITAA 1997.

If the taxpayer wishes to apply the look-through treatment for the additional payment of earnout right the following administrative treatment that was announced by the ATO on 4 May 2011 will apply.

Administrative treatment

This measure will take effect on the day of royal assent. However, the following transitional arrangements will be available:

1. Taxpayers will have the choice to apply the proposed look-through treatment for earnout arrangements entered into between 12 May 2010 and the date of royal assent (inclusive).

1. In addition, the buyer in a standard earnout arrangement will have the choice to apply the proposed look-through treatment for earnout arrangements entered into on or after 17 October 2007.

We will accept returns as lodged during the period up until the amending law is enacted. We will not review assessments until the outcome of the proposed amendment is known.

If a taxpayer chooses to apply the first transitional arrangement explained above and the amending law is enacted, no further action is required. If the amending law is not enacted, taxpayers will need to review their positions and seek amendments accordingly.

Taxpayers who wish to apply the second transitional arrangement should review their positions once the amending law is enacted and then seek amendments to take advantage of the transitional arrangement. If the amendment reduces the amount of tax they are liable to pay, they will be entitled to interest on any overpayments.

In both cases, we will not apply any tax shortfall penalties and we 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.