Edited version of your written advice

Authorisation Number: 1012668471214

Ruling

Subject: CGT - earnout arrangement

Questions and Answers

1. In calculating your capital proceeds as a result of the acquisition of shares by Company B, do you include the market value of the earn-out right calculated at the time of entering into the contract?

Yes

2. Are you entitled to the 50% CGT discount on the sale of shares to the Company B, where you are the shareholder of the holding company?

Yes

3. Are you entitled to the CGT discount on the contingent consideration for the earnout period?

Yes

This ruling applies for the following period

Year ended 30 June 2013

Year ended 30 June 2014

Year ended 30 June 2015

Year ended 30 June 2016

The scheme commenced on

1 July 2012

Relevant facts and circumstances

X Trust and Y Trust were the two shareholders of Company A each having a 50% shareholding.

On date M in the 200X income year, you entered into a contract with Company A which provided for the transfer of p% of the shares held by X Trust and p% of the shares held by Y Trust in return of services rendered in the past and for the future. After the contract you held a q% shareholding in Company A for no consideration.

In the 20XX income year, Company A restructured and established a new holding company and the shareholders of Company A exchanged their shares for shares in the new holding company.

Scrip for scrip rollover was available as a result of shareholders acquiring shares in the new holding company in exchange for shares in Company A.

You would have made a capital gain from CGT event A1 regarding your Company A shares if the rollover option had not been available at the time Company A was taken over by the holding company.

You elected for the scrip for scrip rollover option.

The new holding company and Company A became a consolidated group, whereby group transactions were treated as a single entity for income tax purposes and intra group transactions were ignored for income tax purposes. More than 50% of the assets of Company A were transferred to the new holding company.

A few months later, during the 20XX income year the holding company was acquired by another company (Company B).

The total consideration is to be paid as follows:

1. Initial consideration: r% of the agreed value paid as initial consideration out of which s% to be paid in cash and the remainder after 12 months

2. Contingent consideration:- t% (balance) of the agreed value based on the earnings and will be paid after v years.

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 109-5

Income Tax Assessment Act 1997 Section 115-25

Income Tax Assessment Act 1997 Section 115-30

Income Tax Assessment Act 1997 Section 116-20

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 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 considered the application of Part IVA to the arrangement you asked us to rule on.

Reasons for decision

1. Earnout arrangement

You make a capital gain or loss as a result of a CGT event. The most common event is CGT event A1, which happens when there is a change of ownership of a CGT asset. Shares are CGT assets.

Capital proceeds

A capital gain arises on the sale of shares if the capital proceeds from the disposal of that share are more than its original cost base. A capital loss arises if the capital proceeds from the disposal are less than the shares reduced cost base.

Capital proceeds from a CGT event are the total of the money and the market value of any property received or entitled to be received in respect of the event happening.

Under an earnout arrangement, the capital proceeds from the sale of a CGT asset include a right to an amount calculated by reference to the earnings generated by the asset for a defined period following the sale. The right is other property received in terms of section 116-20 of the Income Tax Assessment Act 1997 (ITAA 1997).

Earnout arrangements

A standard earnout arrangement is any transaction in which an income earning asset is sold for consideration that includes the creation of an earnout right in the seller of the asset. Draft Taxation Ruling TR 2007/D10, Capital gains: capital gains tax consequences of earnout arrangements, addresses the consequences of earnout arrangements.

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, in terms of paragraph 116-20(1)(a) of the 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 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 include the market value of that right (worked out at the time of the CGT event).

Under TR 2007/D10, 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.

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.

Your circumstances

In your case, you were a shareholder of the holding company. The holding company was acquired by Company B. The total consideration (capital proceeds) is to be paid as follows:

1. Initial consideration: r% of the agreed value paid as initial consideration out of which s% to be paid in cash and the remainder after 12 months

2. Contingent consideration:- t% of the agreed value based on the earnings and will be paid after t years.

In working out your capital proceeds, you use the market value of the earnout right calculated at the time of entering into the contract - ie the date when the holding company was acquired by Company B. Whilst it is acknowledged that the proceeds (excluding the initial capital proceeds) are contingent being dependent on future earning, and may not ever be received, TR 2007D10 states that the capital proceeds from the sale of the shares includes the market value of the earnout right, which is worked out at the time of the CGT event.

We shall now consider the CGT discount with respect to the acquisition of Company A by Company B.

2. CGT discount on sale of shares to Company B

Takeovers and mergers

If a company in which you own shares is taken over or merges with another company, you may have a CGT obligation if you are required to dispose of your existing shares. As stated, a CGT event A1 happens if when there is a change of ownership of shares from one entity to another.

The time of the CGT event A1 is when the contract for the disposal is entered into, or if there is no contract, when the change of ownership occurs.

Scrip for scrip rollover

Scrip for scrip rollover is a CGT concession relating to shares that is available under certain conditions. Where the conditions for scrip for scrip rollover are met, the capital gain made on the exchange of shares in one company for shares in another company, is deferred until you dispose of the new shares (subdivision 124-M of the ITAA 1997). 

In your case, you held a q% shareholding in Company A for no consideration in the 200X income year. In the 20XX income year, Company A restructured and established a new holding company and the shareholders of Company A exchanged their shares for shares in the new holding company.

Scrip for scrip rollover was available as a result of shareholders acquiring shares in the new holding company in exchange for shares in Company A.

On acquiring the shares in the new holding company in exchange of shares in Company A, you satisfied the conditions for scrip for scrip roll-over under subdivision 124-M of the ITAA 1997 as:

a.  you acquired shares in Company A on or after 20 September 1985;

b.  you made a capital gain from CGT event A1 happening to your Company A shares; and

c.  any capital gain that may be made upon a future CGT event happening in relation to the new holding company shares would not be disregarded (except because of a roll-over).

In your case, you have chosen scrip for scrip roll-over, therefore the capital gain arising from the disposal of your Company A shares is disregarded.

CGT discount:

Generally, you can use the discount method to calculate your capital gain if:

• you are an individual,

• a CGT event happens to an asset you own,

• the CGT event happened after 21 September 1999,

• you owned the asset for 12 months, and

• you did not choose to use the indexation method.

For shareholders in the company that was the subject of the takeover who choose scrip-for-scrip rollover, the acquisition date of their new shares for CGT discount purposes is the date they acquired the corresponding shares that are disposed of under the takeover (item 2 of the table in subsection 115-30(1) of the ITAA 1997).

As you are taken to have acquired your shares in the holding company at the date you acquired your shares in Company A (date M in the 200X income year), you are entitled to the 50% CGT discount on the sale of shares to Company B as you were a shareholder of the holding company and held the shares for greater than 12 months..

3. CGT discount on the contingent consideration for the earnout period

As a result of the holding company being acquired by the Company B, part of the total consideration consisted of:

Contingent consideration:- t% of the agreed value based on the earnings to be paid after v years.

The right to receive contingent consideration is an asset for CGT purposes. 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.

In this case as the contingent consideration will be paid after v years, the CGT discount will apply as the right will have been held for greater than 12 months.