Edited version of private advice

Authorisation Number: 1051812284788

Ruling

Subject: CGT - share sale arrangement

Question 1

Is the earnout right in relation to the sale of the shares considered by the Commissioner to be on revenue account?

Answer

No.

Question 2

Is the earnout right in relation to the sale of the shares considered by the Commissioner to be on capital account?

Answer

Yes

Question 3

Is the earnout right a look-through earnout right for the purposes of Subdivision 118-I of the Income Tax Assessment Act 1997 (Cth) and associated provisions?

Answer

Yes

Question 4

Is the sale of the shares in the company considered to be "in connection with the retirement" of the taxpayer for the purposes of Subdivision 152-B of the Income Tax Assessment Act 1997 (Cth)?

Answer: Yes

This ruling applies for the following periods:

Year ending 30 June 20XX

Year ending 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

Mr A (the Applicant) was the Operational Director and CEO of ABC Pty Ltd (the Company).

The applicant held XXX of the XXX issued ordinary shares in the Company.

The taxpayer and the other shareholders in the Company entered into a share sale agreement (the Agreement) to sell their shares in the Company to Buyer Pty Ltd (the Buyer).

The Company carried on, and will continue to carry on, a manufacturing and distribution business.

99.98% of the Company's income in the 20XX income year was derived from carrying on a business. None of this 99.98% was derived from financial instruments or assets used to derive interest, annuities, rent, royalties or foreign exchange gains.

Completion of the Agreement was effected on XX December 20XX.

The Agreement was a result of a joint sales process, which was presented to XX potential investors identified as appropriate by the Company. Throughout this process, approximately 20 proceeded through initial negotiations.

The Buyer and all of the previous shareholders of the Company had independent advisors with respect to the sale of the shares under the Agreement.

The Buyer is an unrelated party to the previous shareholders of the Company.

In accordance with the Agreement, the applicant retired from his role as a director and the CEO of the Company.

In accordance with the Agreement, the applicant and the other shareholders in the Company transferred their shares in the Company to the Buyer.

In accordance with the Agreement, the Buyer paid the applicant the Initial Purchase Price multiplied by his Seller Percentage.

In accordance with the Agreement, the applicant is entitled to an earnout. That earnout is calculated by reference to clause 6 of the Agreement.

Subclause 6.8 provides:

If the Final EBITDA Amount is greater than the Target EBITDA Amount, the Buyer will pay to [Mr A] the difference between the Final EBITDA Amount and the Target EBITDA Amount up to but not exceeding the Earn-Out Amount Cap (Earn-Out Amount) on the later of:

a.            30 November 2021; and

b.            5 Business Days after the Earn-Out Amount is finally determined in accordance with this agreement.

The Agreement provides that the Target EBITDA Amount is $XXXX and the Earn-Out Amount Cap is $XXX.

The Agreement provides that the Earn-Out Period is the 12 months ending on 30 September 20XX.

In accordance with the Agreement, the applicant entered into a Consultancy agreement with Consultant Pty Ltd and the Company.

Under subclause 2(b) the Consultancy Agreement, the applicant must be available to provide the Services for the Company at such locations as is agreed.

Commencement Date of the Consultancy Agreement is the day after the Completion Date of the Agreement. The Term of the Consultancy Agreement is 12 months.

The Services are prescribed at Item 5 of Schedule 1 of the Consultancy Agreement as:

a.     transitional operation support and strategic advice in respect of the business of the manufacture of glass-fibre reinforced concrete products as conducted by the Company (Business);

b.     assisting Company management with general managerial and support services and day-to-day sales and operations matters that occur in the Business

c.     assisting Company management with the induction and training of any new management or other senior personnel engaged or employed by the Company and assisting with the transition of any such new personnel into the Business; and

d.     such other similar services as reasonably required by the Company from time to time.

Prior to entering into the Agreement, the Applicant's responsibilities included:

•         the development of the company's short- and long-term strategies;

•         the execution and vision of the long-term strategies of the company;

•         personnel decisions, such as hiring, firing and determining remuneration packages;

•         communicating on behalf of the company to government entities and the public;

•         evaluation of the company's team leaders;

•         maintaining awareness over the market landscape, for example looking to expansion opportunities and industry developments;

•         assessing risks to the company, and the monitoring and minimisation thereof.

Prior to entering into the Agreement, the Applicant worked in excess of XX hours per week.

After entering into the Agreement, it is expected that the Applicant will commit approximately XX.X hours per week to providing the services.

Subclause 6(c) provides for a reduction in the amount of time (hours and/or days) that the Applicant will be required to provide the services once a new general manager is trained in the position.

The applicant has been advised a candidate has been selected for the general manager position. That person has already relocated to commence the required transitional training to assume that responsibility.

The applicant intends to contribute the proceeds of the transaction, to the extent permissible by cap amounts, into superannuation as part of his retirement planning.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subdivision 118-I

Income Tax Assessment Act 1997 Subdivision 152-B

Income Tax Assessment Act 1997 Subsection 104-10(1)

Income Tax Assessment Act 1997 Section 108-5

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

Income Tax Assessment Act 1997 Subsection 118-565(1)

Income Tax Assessment Act 1997 Subsection 118-570(1)

Income Tax Assessment Act 1997 Section 152-40

Income Tax Assessment Act 1997 Section152-60

Income Tax Assessment Act 1997 Section 152-55

Income Tax Assessment Act 1997 Section 152-65

Income Tax Assessment Act 1997 Section 152-105

Income Tax Assessment Act 1997 Section 974-160

Reasons for decision

All legislative references are to the Income Tax Assessment Act 1997 (Cth) (ITAA 1997).

Question 1

Is the earnout right in relation to the sale of the shares considered by the Commissioner to be on revenue account?

Summary

The earnout right is not considered to be on revenue account.

Detailed reasoning

Taxation Ruling TR 2007/D10 Income Tax: capital gains tax consequences of earnout arrangements provided guidance on the treatment of earnout arrangements. It is noted that while TR 2007/D10 was withdrawn because of the introduction of look-through earnout rights under subdivision 118-I, its commentary regarding the classification of earnout amounts as capital or revenue is still relevant.

Paragraph 10 of TR 2007/D10 provides that:

only be in extreme circumstances where an earnout of between one to five years on the sale of a business asset might conceivably generate ordinary income (Chadwick v. Pearl Life Insurance [1905] 2 KB 507).

Under the Agreement, the earnout will be one year in length.

The value of the earnout is based on the performance of the Company (measured here based on EBITDA). The earnout is capped at $XXXX.

It is considered that the earnout payable under the Agreement does not give rise to an extreme circumstance. Therefore, the earnout right is not considered to be on revenue account.

Question 2

Is the earnout right in relation to the sale of the shares considered by the Commissioner to be on capital account?

Summary

The earnout right is considered to be on capital account.

Detailed reasoning

As outlined in paragraphs 27 - 31, the earnout is not considered to be on revenue account.

Note 1 to section 108-5 provides that shares in a company are considered to be a CGT asset.

Subsection 104-10(1) provides that the disposal of a CGT asset will give rise to a CGT event A1.

Paragraph 116-20(1)(a) provides that the capital proceeds from a CGT event include:

the money you have received, or are entitled to receive, in respect of the event happening.

The sale of shares in the Company under the agreement will result in a CGT event A1 happening.

The earnout amount is received in respect of the sale of the shares under the Agreement, and therefore will be treated as capital proceeds of that sale.

Question 3

Is the earnout right a look-through earnout right for the purposes of Subdivision 118-I of the Income Tax Assessment Act 1997 (Cth) and associated provisions?

Summary

The earnout is considered to be a look-through earnout right in accordance with Subdivision 118-I.

Detailed reasoning

A right will be a look-through earnout right if all of the requirements in subsection 118-565(1) are satisfied.

Future financial benefits that are not reasonably ascertainable

Paragraph 118-565(1)(a) requires that:

the right is a right to future * financial benefits that are not reasonably ascertainable at the time the right is created

Section 974-160 provides that 'financial benefit' means anything of economic value, and includes property and services.

The payment of the earnout under the Agreement has economic value and is therefore a financial benefit.

In accordance with subclause 6.8 of the Agreement, the earnout is payable on the later of:

a.     30 November 2021; and

b.     5 Business Days after the Earn-Out Amount is finally determined in accordance with this agreement.

The payment of the earnout is therefore a future financial benefit.

The Explanatory Memorandum to the Tax and Superannuation Laws Amendment (2015 Measures No. 6) Bill 2015 (the EM), which was enacted as Tax and Superannuation Laws Amendment (2015 Measures No. 6) Act 2016, and inserted Subdivision 118-I into the ITAA 1997, states:

'in most cases, the fact that financial benefits are contingent will mean that they are also reasonably unascertainable'.

The amount of the earnout will depend on the EBITDA of the company throughout the Earn-Out Period. In effect, the full amount of the earnout will only be paid if the Company has an EBITDA of at least $XXXX through the Earn-Out period.

The Company has not reached this EBITDA amount in any of the last four financial years.

The financial benefit to the Applicant here is contingent and there is sufficient doubt as to whether the full amount of the earnout will be paid.

Therefore, the future financial benefit is not reasonably ascertainable.

Right arises from CGT asset disposal

Paragraph 118-565(1)(b) requires that:

the right is created under an * arrangement that involves the * disposal of a * CGT asset

Shares in a company are specifically provided to be a CGT asset per note 1 to section 108-5.

The right arises from the disposal of shares in the Company, and therefore arises from the disposal of a CGT asset.

Disposal causes CGT event A1

Paragraph 118-565(1)(c) requires that:

the disposal causes * CGT event A1 to happen

Subsection 104-10(1) provides that the disposal of a CGT asset will give rise to a CGT event A1.

The shares will be disposed under the Agreement, resulting in a CGT event A1 happening.

The CGT asset was an active asset

Paragraph 118-565(1)(d) requires that:

just before the CGT event, the CGT asset was an * active asset of the entity who disposed of the asset

Subsection 118-570(1) provides an additional way that a CGT asset can be an active asset for the purpose of Subdivision 118-I.

Paragraph 118-570(1)(a) requires that 'the entity owns it at that time'. The Applicant owned the shares at the time they were sold under the agreement.

Paragraph 118-570(1)(b) requires that the asset 'is either a * share in a company, or an interest in a trust'. The assets here are shares in a company.

Paragraph 118-570(1)(c) requires that:

at that time, the entity:

(i) is a * CGT concession stakeholder of the company or trust; or

(ii) if the entity is not an individual--has a * small business participation percentage in the company or trust of at least 20%

Section 152-60 provides that:

An individual is a CGT concession stakeholder of a company or trust at a time if the individual is:

(a) a * significant individual in the company or trust; or

(b) a spouse of a significant individual in the company or trust, if the spouse has a * small business participation percentage in the company or trust at that time that is greater than zero.

Section 152-55 provides that:

An individual is a significant individual in a company or a trust at a time if, at that time, the individual has a * small business participation percentage in the company or trust of at least 20%.

Section 152-65 provides that:

An entity's small business participation percentage in another entity at a time is the percentage that is the sum of:

(a) the entity's * direct small business participation percentage in the other entity at that time; and

(b) the entity's * indirect small business participation percentage in the other entity at that time.

Item 1 to the table in section 152-70 provides that an entity's direct small business participation percentage in a company is:

This percentage that the entity has because of holding the legal and equitable interests in * shares in the company:

(a) the percentage of the voting power in the company; or

(b) the percentage of any * dividend that the company may pay; or

(c) the percentage of any distribution of capital that the company may make;

or, if they are different, the smaller or smallest.

The issued capital of the Company consists of 4,000 ordinary shares. The applicant held 25% of these shares.

2.            Voting, dividend and capital rights in the Company are proportional to the number of ordinary shares that a shareholder holds. As the Applicant held 25% of the ordinary shares in the Company, his direct small business participation percentage in the Company was 25%.

The Applicant was therefore a CGT concession stakeholder in the Company at and just before the shares were disposed under the Agreement.

Paragraph 118-570(1)(d) requires that the company:

(i) is carrying on a * business, and has been carrying on a business since the start of the most recent income year ending before that time; and

(ii) is not a * subsidiary member of a * consolidated group

The Company carried on its manufacturing and distribution business throughout the entirety of the 2019 income year and is not a subsidiary member of a consolidated group.

Paragraph 118-570(1)(e) requires that:

the assessable income of the company or trust for that most recent income year was greater than nil, and at least 80% of that assessable income was:

(i) from the carrying on of one or more businesses; but

(ii) not * derived (directly or indirectly) from an asset of a kind to which paragraph 152-40(4)(d) or (e) applies.

Note: Paragraphs 152-40(4)(d) and (e) refer to financial instruments and assets used to derive interest, annuities, rent, royalties or foreign exchange gains.

99.98% of the Company's income in the 2020 income year was derived from carrying on a business and was not derived from the assets to which paragraph 152-40(4)(d) or (e) applies.

Therefore, the shares in the Company sold by the Applicant were an active asset of the Applicant just before the CGT event.

Financial benefits provided in a 5 year period

Paragraph 118-565(1)(e) requires that:

all of the financial benefits that can be provided under the right are to be provided over a period ending no later than 5 years after the end of the income year in which the CGT event happens

The entirety of the financial benefits available under the Agreement will be provided over 1 year.

Financial benefits are contingent on economic performance

Paragraph 118-565(1)(f) requires that the financial benefits be:

contingent on the economic performance of:

(i) the CGT asset; or

(ii) a business for which it is reasonably expected that the CGT asset will be an active asset for the period to which those financial benefits relate

The earnout to be paid to the Applicant under the Agreement is contingent on the EBITDA of the business of the Company during the Earn-Out Period. Therefore, the financial benefits are not contingent on the economic performance of the relevant CGT asset, but is contingent on the economic performance of the business.

It is therefore necessary to determine if the shares in the Company, being the relevant CGT asset, would be reasonably expected to continue to be an active asset of the business of the Company throughout the Earn-Out Period.

The requirement of subparagraph 118-565(1)(f)(ii) is within Subdivision 118-I, so the alternative test in subsection 118-570(1) can apply.

The requirements of paragraphs 118-570(1)(a), 118-570(1)(b) and 118-570(1)(d) will continue to be met on the same rationale as under the heading 'The CGT asset was an active asset' above.

The Buyer is a company, therefore paragraph 118-570(1)(c) will require them to have a small business participation percentage in the company or trust of at least 20%.

The Buyer is acquiring 100% of the shares. They will therefore have a small business participation percentage in excess of 20%. This is not expected to change before the end of the Earn-Out Period, therefore the requirement of paragraph 118-570(1)(c) is met.

The 0.02% of income referred to in paragraph 63 was attributable to interest. It is not expected that this will increase to an amount greater than 20% during the Earn-Out Period, therefore the requirement of paragraph 118-570(1)(e) is met.

Therefore, it is reasonable to expect that the shares in Company will continue to be an active asset for the business of Company for the purposes of Subdivision 118-I.

Therefore, the requirement of paragraph 118-565(1)(f) is met.

Value of financial benefits relates to that economic performance

Paragraph 118-565(1)(g) requires that 'the value of those financial benefits reasonably relates to that economic performance'.

The EM provides:

For a right to be a look-through earnout right, in addition to the financial benefits being contingent on the future economic performance of the asset or the business in which it is used the value of the benefits must also reasonably relate to this performance...

... in the context of commercial arrangements it is generally for the parties, not the Commissioner to determine what value they place on a particular benefit. However, the value of the contingent financial benefits provided under the right must neither be out of all proportion to the benefits that could have been reasonably expected to result from performance nor otherwise wholly unrelated to the contingency to which they are linked.

There is a direct connection between economic performance of the business in which the shares are reasonably expected to continue to be an active asset.

The earnout amount relates to the economic performance of the business for a single 12-month period, only becomes payable after a certain threshold of EBITDA is met, and is capped at a maximum amount.

It is considered that the value of the financial benefits under the Agreement reasonably relates to the economic performance of the business of the Company.

Arm's length transaction

Paragraph 118-565(1)(h) requires that 'the parties to the arrangement deal with each other at * arm's length in making the arrangement'.

The Agreement was a result of a joint sales process, which was presented to numerous parties.

The Buyer and all of the previous shareholders of the Company had independent advisors with respect to the sale of the shares under the Agreement, and the Buyer was unrelated to the previous shareholders of the Company.

It is considered that the parties to the arrangement dealt with each other at arm's length in making the arrangement.

Conclusion

The earnout payable to the applicant under the Agreement is a look-through earnout right in accordance with subdivision 118-I.

Question 4

Is the sale of the shares in the company considered to be "in connection with the retirement" of the taxpayer for the purposes of Subdivision 152-B of the Income Tax Assessment Act 1997 (Cth)?

Summary

The sale of shares is considered to be "in connection with retirement" of the Applicant for the purposes of Subdivision 152-B.

Detailed reasoning

The small business 15-year exemption is contained in Subdivision 152-B.

Section 152-105 provides the requirements for an individual to access the exemption. One of these requirements is that the individual:

(d) either:

(i) you are 55 or over at the time of the CGT event and the event happens in connection with your retirement; or

(ii) you are permanently incapacitated at the time of the CGT event.

The courts consider that the words 'in connection with' have a wide meaning but are to be interpreted in the context of the statute in which they are contained (Burswood Management Ltd & Ors v Attorney-General (Cth) & Anor (1990) 20 ALD 357, Hatfield v. Health Insurance Commission (1987) 15 FCR 487; 77 ALR 103).

The legislation does not provide a specific definition of the word 'retirement' for the purpose of the ITAA 1997 and therefore takes its ordinary meaning. The Macquarie Dictionary (online version) defines 'retirement' to mean 'removal or retiring from service, office, or business, especially in reaching the end of one's working life'.

Whether a CGT event happens in connection with an individual's retirement depends on the particular circumstances of each case. There must be at least a significant reduction in the number of hours the individual works or a significant change in the nature of their present activities to be regarded as a retirement. However, it is not necessary for there to be a permanent and everlasting retirement from the workforce.

A CGT event may be 'in connection with your retirement' even if it occurs at some time before retirement. If it can be shown that the earlier CGT event was integral to the individual's plan to cease activities and retire, the CGT event may be accepted as happening in connection with retirement.

It was the Applicant's intention to retire from the business activities of the Company following the its sale. This stemmed from the fact that the Applicant turned 66 years of age in November 2020.

Subject to cap amounts, the Applicant will contribute the proceeds of the sale into superannuation for retirement planning purposes.

Prior to entering into the Agreement, the Applicant's role went to the strategic focus of the Company, being responsibilities for things such as personnel, communication on behalf of the Company, and assessing and addressing risks to the Company.

The Applicant is now only required to be available to provide the prescribed Services under the Consultancy Agreement.

The change in the Applicant's responsibilities after entering into the Agreement and Consultancy Agreement, has reduced the number of hours he works in a week from in excess of 55 to approximately 37.5.

The Consultancy Agreement allows for a reduction in the hours worked by the Applicant once a suitable general manager has undergone training. The Applicant has been informed that a Candidate has been selected for this role.

The Consultancy Agreement has a duration of 12 months and commenced on 23 December 2020.

It is accepted that the Applicant's responsibilities has reduced as a result of entering into the Agreement and Consultancy Agreement, both in terms of hours worked and scope of responsibilities. This reduction will increase once the training of the new general manager has been completed.

It is considered that the duration of the Consultancy Agreement is not so lengthy as to suggest that his continued involvement in the Company after the sale of shares is not in connection his retirement.

The Applicant's intention to contribute the proceeds of the sale into superannuation also supports that the sale of the shares happened in connection with his retirement.

Conclusion

The sale of shares in the Company by the Applicant, is in connection with the retirement of the Applicant for the purposes of subdivision 152-B.