Edited version of your private ruling

Authorisation Number: 1012590323936

Ruling

Subject: CGT - earnout arrangements

Question

Will you be able to apply the small business concessions to any capital gain that arises as a result of the payment of the earnout amount?

Answer

No

This ruling applies for the following period:

Year ending 30 June 2013

The scheme commenced on:

1 July 2012

Relevant facts and circumstances

The trust sold a business and made a capital gain.

The contract for the sale of the business provided that the purchase price of the business was the initial purchase price of $X plus an earnout amount.

The earnout amount was to be calculated with reference to the business earnings before interest and taxes (EBIT) for a specified period.

The earnout amount was paid to the trust by the purchaser during the 2012-13 financial year.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Paragraph 110-25(2)(b)

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

Income Tax Assessment Act 1997 Paragraph 116-20(1)(a)

Income Tax Assessment Act 1997 Division 152

Income Tax Assessment Act 1997 Section 152-40

Reasons for decision

Draft Taxation Ruling TR 2007/D10 addresses the consequences of earnout arrangements. 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.

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. 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, in terms of paragraph 116-20(1)(a) of the Income Tax Assessment Act 1997 (ITAA 1997).

TR 2007/D10 provides that the earnout right is not an entitlement to money for the purpose of calculating the seller's capital proceeds from capital gains tax (CGT) event A1. An earnout right is '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 (worked out at the time of the CGT event).

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 under section 104-25 of the ITAA 1997 will happen.

Where the original assets provided by the seller under an earnout arrangement satisfy the conditions for the small business concessions in Division 152 of the ITAA 1997, capital gains made by the seller in relation to the CGT A1 event may be reduced by one or more of the concessions contained in that Division. However, relief under Division 152 of the ITAA 1997 is only available for gains made in respect of 'active assets' as defined in section 152-40 of the ITAA 1997.

Unlike the original asset, an earnout right can not satisfy the definition of 'active asset' under section 152-40 of the ITAA 1997. This is because:

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

· 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); and

· 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).

Application to your circumstances

In this case, the trust disposed of the business and made a capital gain. The nature of the arrangement is such that the taxation of the additional payment received by the trust during the 2012-13 financial year may be calculated in accordance with the standard earnout arrangement as described in TR 2007/D10.

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

The earnout payment will not be subject to a 'look through' approach in relation to the original disposal of the business. Instead, these proceeds will be in respect of the newly created earnout rights and will be assessed in the year of receipt; CGT event C2 being the relevant event.

As the earnout right is not an active asset, the trust cannot apply the small business concessions in relation to the C2 event.