Edited version of private advice

Authorisation Number: 1051659115719

Date of advice: 14 May 2020

Ruling

Subject: Look-through earnout right qualification

Question 1

Will the look-through earnout provisions in subdivision 118-565 of the Income Tax Assessment Act 1997 (ITAA97) apply to the earnout payments payable under the purchase agreement (PA) entered into by the first taxpayer, the second taxpayer and the third taxpayer to the extent that they relate to the sale of shares in the Australian resident company?

Answer

Yes

Question 2

Will the look-through earnout provisions in subdivision 118-1 of the ITAA97 apply to the earnout payments payable under the purchase agreement (PA) entered into by the first taxpayer, the second taxpayer and the third taxpayer to the extent that they relate to the sale of shares in the non- Australian resident company?

Answer

No

Question 3

Is the proportion of the earnout payments under the PA attributable to the sale of shares in XXXX?

Answer

Yes

Question 4

If the look-through earnout provisions in subdivision 118-1 of the ITAA97 do not apply to the proportion of the earnout payments payable for disposal of shares in the non- Australian resident company under the PA entered into by the first taxpayer, the second taxpayer and the third taxpayer, will the subsequent provisions of those earnout payments result in a capital gains tax event C2 under section 104-25 of the ITAA97 for each of the first taxpayer, the second taxpayer and the third taxpayer?

Answer

Yes

This ruling applies for the following periods:

30 June 20XX

30 June 20XX

30 June 20XX

30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

You advised that all three shareholders entered into a purchase agreement (PA) on XXXX 20XX where you disposed of all of their shares in Australian and New Zealand companies to an Australian company (Buyer). The sale of shares in the both companies are 100%.

Your companies conducted XXXX business in Australia and New Zealand.

Both the buyer and the sellers are unrelated and received their own legal and accounting advice in relation to the PA. The deal was made at arm's length.

Two shareholders owned 40% shares both Australian and NZ companies. The third shareholder owned the reminder of 20% shares in both companies.

The total of the active assets in the Australian company has been 80% (market values of financial instruments and cash on hand) with shares and interests owned for 71/2 years as active assets.

Under the PA, initial sale proceeds were paid to respective taxpayers in their proportion of around $XXXX. An escrow amount of $XXXX was paid in escrow account on completion on potential warranty claims. A tax retention amount was retained by the buyer for any tax liabilities in accordance with the PA. $XXXX was also retained by buyer in accordance with the PA.

In addition to the consideration amounts there are certain conditions must be satisfied over a period of 3 years to qualify for all or some of the earnout payments totalling maximum of $XXXX with first, second and third earnout period payout of $XXXX each paid on the first, second and third anniversary after completion date as per their shares respectively.

The condition of the sale as per PA is that each company carries on the business as a going concern, follow its ordinary and usual practice, preserve the current relationships and goodwill and maintain the profitability of the business.

As advised by your agent, all three of you receive a salary and wages from the buyer for your services. This is paid in addition to the earnout payments that will be received as part of the sale.

You further advised that the first and second period earnout amounts are calculated by reference to the attrition rate of general employees. The third period amount of $XXXX is attributable to relevant employees of the seller either being employed by the buyer throughout the earnout period or having a managed termination service.

Relevant legislative provisions

Income Tax Assessment Act 1997, s118-1

Income Tax Assessment Act 1997, s118-560

Income Tax Assessment Act 1997, s118-565

Income Tax Assessment Act 1997, s947-160

Income Tax Assessment Act 1997, s104-25

Income Tax Assessment Act 1997, s112-30

Reasons for Decision

Summary

Look-through earnout right qualification

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. Under sections 118-560 and 118-565 of the ITAA 1997, the right must be created under an arrangement involving the disposal of a CGT asset that is an active asset of the seller, and the financial benefits under the right must be contingent on and reasonably related to the future economic performance of the asset (or a related business). To be a look-through earnout right, a right must be created as part of an arrangement for a disposal of the business or its assets - that is, the disposal must cause CGT event A1 to happen. (s118-565(1)(b) and (c) of the ITAA 1997)

Furthermore, under the CGT provisions, where a disposal occurs, CGT event A1 will happen, either on its own or, in some cases, in addition to one or more other CGT events. Sometimes, when CGT event A1 happens in addition to another CGT event, it will not be the most specific CGT event that happens in that situation. In this situation, the gain or loss that arises may be determined under the rules applying to the other CGT event (s102-25 of the ITAA 1997). However, in this situation, CGT event A1 still happens in addition to the other event and so the relevant right may still be a look-through earnout right.

In some cases, a right may relate to the disposal of more than one CGT asset. In this case, the financial benefits provided under the right will need to be reasonably apportioned between the various assets, consistent with the general apportionment rules for CGT (s112-30 and 116-40 of the ITAA 1997). Additionally, what is disposed of must be an active asset of the business before it is sold. (s118-565(1)(d) of the ITAA 1997).

Active asset is defined in s152-40 of the ITAA 1997. Broadly, and subject to certain exclusions, an active asset is an asset of the taxpayer that is used in the business of the taxpayer in a connected or affiliated entity. A membership interest in an Australian resident company or trust will also be an active asset if at least 80 per cent of the assets of the company or trust (by value) are active assets (rather than passive investments).

When this happens then:

·         any capital gains and losses in respect of a look-through earnout right are disregarded.

·         financial benefits under or in respect of a 'look-through' earnout right are included when determining the capital proceeds or cost base of the underlying business assets to which the arrangement relates.

·         a taxpayer's assessment for a tax related liability that can be affected by financial benefits provided or received under a 'look-through' earnout right may be amended for up to four income years after the end of the income year in which the last potential financial benefit under the right was due to be paid.

·         capital losses arising from a CGT event related to an earnout right may not be considered in determining tax liabilities until such time as they cannot be reduced by future financial benefits received under a relevant look-through earnout right.

Broadly, if a right is a look-through earnout right, two consequences arise:

·         the value of the right is disregarded for the purposes of CGT; and

·         the value of any financial benefits made or received under the right is included in either the capital proceeds arising from the disposal (for the seller) or the cost base of the acquisition (for the buyer).

Look-through CGT treatment under s118-565(1) of ITAA97, applies to 'look-through earnout rights' created on or after 24 April 2015, if:

• the right is a right to future financial benefits that are not reasonably ascertainable at the time the right is created
• the right was created under an arrangement involving the disposal of a CGT asset
• the disposal caused CGT event A1 to happen
• just before the CGT event, the CGT asset was an active asset of the entity which disposed of the asset
• all of the financial benefits under the rights are to be provided within five years after the end of the income year in which the CGT event happened
• the financial benefits must be contingent on the economic performance of the CGT asset or a business for which it is expected that the CGT asset be an active asset for the period to which those financial benefits relate
• the value of those financial benefits reasonably relates to that economic performance, and
• the parties to the arrangement deal with each other at arm's length in making the arrangement.

Under the look-through CGT treatment:

• the capital gains or losses in respect of look-through earnout rights are disregarded
• for the buyer, any financial benefit provided (or received) under a look-through earnout right increased (or decreased) the cost base and the reduced cost base of the underlying asset
• for the seller, any financial benefit received (or provided) under the look-through earnout right increased (or decreased) the capital proceeds from the disposal of the underlying asset
• capital losses arising from the disposal of assets to which look-through earnout rights relate are temporarily disregarded until and to the extent that they become certain, that is, the capital losses could not be further reduced by you receiving one or more financial benefits. Once the losses become certain, they are available from the income year in which they were originally incurred, and not when the amount of the losses became certain.

The criteria for qualifying earnout arrangements are important in determining the look through treatment. Not all earnout arrangements will qualify for the look through treatment. In order for the look-through treatment to apply, earnout arrangements must meet the following broad criteria:

• the earnout right must be created as part of an arrangement for the disposal of a business or its assets;
• the asset being sold must be an 'active asset' of the business. There are a number of aspects to this criterion:

-         the 'active asset' concept takes its general meaning from the small business CGT concessions, although for earnout purposes, the definition is extended to interests in foreign entities;

-         if the asset is shares in a company or units in a trust, at least 80% of the assets (by value) in the entity need to be active assets (and not passive investment-type assets);

• future financial benefits provided under the right must be linked to the future economic performance of the asset or business in which the asset is used. This is assessed on a case-by-case basis. While an earnout that is only triggered on the business meeting certain profit targets is likely to meet this requirement, an earnout that is only conditional on key employees employed on a certain date shall have;
• the financial benefits provided must not be capable of being reasonably ascertained at the time the right is created
• the arrangement must be on an arm's-length basis; and
• the right must not involve payments that span for more than five years from the end of the increase year in which the relevant CGT event occurs and must not include an option allowing the parties to extend. Subsequent financial benefits provided under the right can result in a capital gain or loss for the holder of the right as a result of CGT event C2 occurring (s104-25 of the ITAA 1997). However, there are no CGT consequences for the entity obliged to provide financial benefits under the right. As a result, the costs of providing these financial benefits are generally not recognised in the CGT provisions.

Generally, in the case of earnout rights the purpose of providing the right to future financial benefits under arrangement is often to resolve difficulty in agreeing a valuation. To address this, any capital gain or loss arising in respect of the creation or cessation of a look-through earnout right will be disregarded (s118-575 of the ITAA 1997). Similarly, the value of a look-through earnout right will not be taken into account in determining the capital proceeds of the disposal of the active asset for the seller nor the cost base and reduced cost base of the asset acquired by the buyer (s112-36(1)(a) and 116-120(1)(a) of the ITAA 1997).

In the place of taxing the value of the look-through earnout rights, the value of any financial benefits subsequently provided or received under or in relation to such a right in the original capital proceeds of the disposal for the related asset for the seller, or the initial cost base and reduced cost base of the asset for the buyer as at the date of the original acquisition ensures that the amounts received is appropriately recognised in the tax system, without requiring the right itself to be valued. (s112-36(1)(b) and (c) and s116-120(1)(b) and (c) of ITAA 1997).

Application to your circumstances

Under the PA, the taxpayers will be entitled to all or some of the earnout payments if certain conditions are met. The conditions are based on the attrition rate of general employees and certain named key employees. This is measured every 12 months for the 3 years period. As there is doubt as to whether the contingent or future events will transpire, the earnout payments will use financial benefits that are not reasonably determinable and are contingent on future events. Therefore, the earnout payments are not reasonably ascertainable and the conditions under s118-565(1)(a) of ITAA97 is satisfied.

Due to the earnout rights were created to dispose of the CGT assets, s118-565(1)(b) of the ITAA97 is satisfied. The CGT event A1 (s104-10) happened in respect of the CGT asset sold, satisfying the s118-565(1)(c) of the ITAA97. Furthermore, the sale of shares in the Australian company are active assets therefore, the disposal satisfies the conditions in s118-565(1)(d) of the ITAA97.

The financial benefits under the earnout arrangements provided will end on 30 June 2023, three years from the CGT event. This meets the requirements under s118-565(1)(e) of the ITAA97 where the earnout payments must be completed within five years after the CGT even occurred.

The business sold provides XXXX services and is entirely dependent upon skilled employees who can provide those services. Therefore, the retention of the specialised employees will have a direct impact on the productivity, serviceability and survival of the business. The entitlement to the financial benefits is contingent to the employee retention. Therefore, under s118-565(1)(f) of the ITAA97, the financial benefits are contingent on the economic performance and satisfy the conditions for the business with CGT assets being active assets.

S118-565(1)(g) of the ITAA97 states that the financial benefit must be reasonable estimate of economic performance and the value must not be out of proportion to the benefits that could have been reasonably expected to result from the performance. The value must also be related to the contingency to which the financial benefits are linked. The sellers will only be entitled to their respective shares of the earnout payments when certain conditions, especially the specialist employees critical to the economic performance remain employed, thus satisfying s118-565(1)(g) of the ITAA97.Also the sale being at arm's length the does not seem out of proportion to the benefits that could have been reasonably expected to result from the performance.

Furthermore, under s118-565(1)(h) of the ITAA97, the parties must deal at arm's length. The sale was negotiated in an open market. Also, the sellers and buyers have no connection and have their own independent legal and accounting consultants, satisfying the conditions in s118-565(1)(h) of the ITAA97.

Where the earnout right comes to an end when all payments are satisfied, CGT event C2 under s104-25 of the ITAA97 happens. The PA being a contract for sale as a going concern does not end the asset contract under s104-25(2)(a) of the ITAA97. Pursuant to s104-25(2)(b) of the ITAA97, the time of CGT event is when the right of the assets end.

The rights to progressive payments attributable to the non-resident company are part of the single CGT asset with rights under the single contract, therefore as the earnout payments are made, the CGT event C2 will happen at the time of each payment. Each taxpayer's cost base for their right to which the event happens will be apportioned according to s112-30(3). The remainder of the cost base under s112-30(4) of the ITAA97 will be attributed to remaining asset after each payment is made.