Edited version of private advice

Authorisation Number: 1052020105622

Date of advice: 11 August 2022

Ruling

Subject: Look-through earnout rights

Question 1

Did CGT event A1 happen under section 104-10 of the Income Tax Assessment Act 1997 (ITAA 1997) when the Trust entered into a Share Sale Agreement (SSA) to dispose of its shares in Company 1 to Company 2?

Answer

Yes.

Question 2

Will the amount the Trust is entitled to receive in accordance with the terms of the Earnout Deed be a 'look-through earnout right' under subsection 118-565(1) of the ITAA 1997?

Answer

No.

Question 3

Will the amount the Trust is entitled to receive in accordance with the terms of the Earnout Deed be included as capital proceeds under subsection 116-20(1) of the ITAA 1997?

Answer

Yes.

Question 4

Will any capital gain made by the Trust from the disposal of shares be a discount capital gain for the purposes of section 115-5 of the ITAA 1997?

Answer

Yes.

Question 5

If the conditions contained in Clause 2.2 of the Earnout Deed are not satisfied and the Trust does not receive one or more amounts in accordance with the terms of the Earnout Deed, will the capital proceeds from the CGT event be reduced by the unpaid amount under section 116-45 of the ITAA 1997?

Answer

Yes.

Question 6

Will any portion of the amounts to be paid in accordance with the terms of the Earnout Deed to the Trust be treated as ordinary income under section 6-5 of the ITAA 1997?

Answer

No.

This ruling applies for the following period:

Year ended 30 June YYYY

The scheme commences on:

1 July YYYY

Relevant facts and circumstances

1.             Company 1 was incorporated after 21 September 1999.

2.             There were more than X shareholders as of DD MM YYYY.

3.             As of DD MM YYYY, the Trustee for the Trust held a portion of shares in the Company.

4.             In the YYYY income year, all other shareholders in the Company entered into a Share Sale Agreement (SSA) with Company 2 to sell Company 1 to Company 2. Completion under the SSA occurred in YYYY. The Trust had held its Company 1 shares for longer than 12 months when the SSA was entered into.

5.             The Trust is named as X of X Key Stockholders in the SSA.

6.             Clause 1.1 of the SSA sets out that the Sale Shares comprise all of the issued share capital in Company 1.

7.             The SSA sets out that the purchase price for all shareholders and stipulates that part of the payment amounts for Key Stockholders will be held in escrow and subject to an Earnout Deed.

8.             Clause 2.2 of the Earnout Deed between the Trust and Company 2 sets out when the payments of the Key Stockholder Earnout Amount will occur. Broadly, under the terms of the Earnout Deed:

(a) if, as at the last day of any calendar month between the Completion Date (as defined in the SSA) and the Earnout Period End Date (being the date that is 60 months after the Completion Date), certain business targets have been met,

the Buyer and the Key Stockholder are required to jointly instruct the Escrow Agent to pay the Key Stockholder an amount equal to the Key Stockholder Earnout Amount, less any amount that has already been paid under (b) and (c) below, plus Net Interest

(b) if, as at the Key Stockholder Earnout Amount Payment Date 1 (being, 24 months after the Completion Date):

(i) no payment has been made to the Key Stockholder under (a)

(ii) the Key Individual is and has at all times between the Completion Date and the payment date been continuously employed on a full time basis by Company 2 (or a Buyer Group Member), or is a Good Leaver, and

(iii) neither the Key Stockholder nor the Key Individual has breached their obligations under the Non-Competition and Non-Solicitation Deed or repudiated their obligations under any Relevant Agreement,

the Buyer and the Key Stockholder are required to jointly instruct the Escrow Agent to pay the Key Stockholder an amount equal to the Key Stockholder Earnout Amount Part A plus Net Interest, and

(c) if, as at the Key Stockholder Earnout Amount Payment Date 2 (being, 36 months after the Completion Date), the conditions in (b)(i), (ii) and (iii) are satisfied, the Buyer and the Key Stockholder are required to jointly instruct the Escrow Agent to pay the Key Stockholder an amount equal to the Key Stockholder Earnout Amount Part B plus Net Interest.[1]

9.             A 'Good Leaver' is defined at Clause 1.1 of the Earnout Deed as follows:

in relation to the Key Individual means that the Key Individual has ceased employment with Company 2 or Buyer Group Member as a result of:

1              death;

2 permanent incapacity of the Key Individual through ill health as verified by an independent doctor appointed by the Buyer (if the Buyer so requires);

3 the employment of the Key Individual with Company 2 or a Buyer Group Member having been terminated by Company 2 or Buyer Group Member (as applicable) without Cause; or

4 the employment of the Key Individual having been terminated by the Key Individual for Good Reason.

10.          Clause 1.1 of the Earnout Deed defines the Key Individual as the founder of Company 1 (the Founder). The Founder is a beneficiary of the Trust.

11.          In purchasing Company 1, Company 2's view was that a significant portion of Company 1's value rested with the engagement of the Founder. Consequently, the consideration for the sale was structured in part based on either business outcomes or the retention of the Founder. Their salary package was increased to ensure he was appropriately remunerated following the transaction.

12.          It was confirmed that:

(a) the targets listed at Clause 2.2(a) of the Earnout Deeds are not fanciful and do not require the presence of the Founder. The targets are 'ambitious but plausible'.

(b) Company is still in the process of integrating the software with Company 2's software (i.e. it hasn't finished). All of the source code is fully documented and owned by Company 2. The Founder's continued employment is not critical in order to satisfy the condition in Clause 2.2(a).

(c) Clause 2.2(a) is the 'fundamental or main' clause in obtaining the deferred payment. That is, if the requirement in Clause 2.2(a) is met, the requirements in Clauses 2.2(b) and (c) are not triggered. Conversely, if the requirements in Clauses 2.2(b) or (c) are not met, the requirement in Clause 2.2(a) can still be met in order to receive the deferred payment.

13.          Clause 2.5 of the Earnout Deed states:

Tax effect of payments

Any payment made by the Buyer to the Key Stockholder under this deed will be payment of the Purchase Price under the SSA.

14.          You have stated the transaction was negotiated between the parties at arm's length.

Relevant legislative provisions

Income Tax Assessment Act 1936 section 170

Income Tax Assessment Act 1936 subsection 170(10AA)

Income Tax Assessment Act 1936 subsection 318(3)

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 104-10

Income Tax Assessment Act 1997 section 108-5

Income Tax Assessment Act 1997 section 115-5

Income Tax Assessment Act 1997 section 115-10

Income Tax Assessment Act 1997 section 115-15

Income Tax Assessment Act 1997 section 115-20

Income Tax Assessment Act 1997 section 115-25

Income Tax Assessment Act 1997 subsection 116-20(1)

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

Income Tax Assessment Act 1997 section 116-25

Income Tax Assessment Act 1997 section 116-45

Income Tax Assessment Act 1997 subsection 118-560(2)

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

Income Tax Assessment Act 1997 paragraph 118-565(1)(a)

Income Tax Assessment Act 1997 paragraph 118-565(1)(f)

Income Tax Assessment Act 1997 paragraph 118-565(1)(g)

Reasons for decision

All legislative references are to the Income Tax Assessment Act 1997 unless otherwise noted.

Question 1

Did CGT event A1 happen under section 104-10 when the Trust entered into a Share Sale Agreement to dispose of its shares in Company 1 to Company 2?

Summary

CGT event A1 happened when the Trust entered into a SSA to dispose of its shares in Company 1 to Company 2.

Detailed reasoning

1.            Under section 104-10, CGT event A1 happens if you dispose of a CGT asset to another entity. The time of the event is when you enter into the contract for disposal. You make a capital gain if the capital proceeds from the disposal are more than the asset's cost base.

2.            The Trust entered into the SSA for disposal of the shares it held in Company 1, in DD MM YYYY. As the shares are CGT assets[2] and the SSA constitutes a contract for disposal, CGT event A1 happened in DD MM YYYY, under section 104-10.

Question 2

Will the amount the Trust is entitled to receive in accordance with the terms of the Earnout Deed be a 'look-through earnout right' under subsection 118-565(1)?

Summary

The amounts that the Trust are entitled to receive in accordance with the terms of the Earnout Deed are not earnout payments, since they are deferred payments for the disposal of the shares in Company 1. In any event, the requirements under subsection 118-565(1) would not have all been satisfied.

Detailed reasoning

3.            An earnout arrangement is an arrangement whereby as part of the sale of a business or the assets of a business, the buyer and seller are not able to agree on a fixed payment and instead agree that subsequent financial benefits may be provided based on the future performance of the business or a related business in which the assets are used. 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, as this is money you are entitled to receive under paragraph 116-20(1)(a).

4.            An earnout arrangement is not merely a mechanism by which the parties agree to set an appropriate amount of compensation for the assets delivered in the contract. The deferred payments should not be, as a matter of substance, made in respect of the acquisition of those assets. They are paid in respect of a separate obligation under which the seller stands to make a financial gain depending on the economic performance of an asset which the seller has ceased to own. In such circumstances, the CGT provisions recognise that what the buyer has given in respect of the acquisition of the original asset is property in the form of a promise to pay an indeterminate amount of money. Similarly, the CGT provisions recognise that the seller has received property in the form of a right to receive an indeterminate amount of money.

5.            In relation to look-through earnout rights specifically, 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 at paragraph 1.48:

The concession provided to look-through earnout rights is only intended to cover rights created to resolve uncertainty about the value of the business that is being sold due to difficulties determining future economic performance, not to all deferred payment arrangements.

6.            In this case, the Trust, as X of X Key Stockholders has agreed under the terms of the SSA and Earnout Deed to receive on Completion a portion its respective proportion of the Shareholder Completion Amount. The remaining shareholders who are not Key Stockholders were entitled to receive 100% of their respective proportion of the Shareholder Completion Amount on Completion.

7.            The amount of the Shareholder Completion Amount not immediately paid to the Trust on Completion has been held in escrow and is payable as a Key Stockholder Earnout Amount in accordance with the Earnout Deed.

8.            Under Clause 2.2(a) of the Earnout Deed, prior to the Earnout Period End Date (being the date that is 60 months after Completion Date) the Trust will be entitled to the Key Stockholder Earnout Amount (less any amounts already paid under Clauses 2.2(b) and (c)), if, certain business targets are met.

9.            Under Clause 2.2(b) of the Earnout Deed, the Trust is entitled to be paid the Key Stockholder Earnout Amount Part A 24 months from the Completion Date, so long as the Founder has continuously remained a full-time employee of Company 2 (or have been a Good Leaver).

10.          Similarly, under Clause 2.2(c), the Trust is entitled to be paid the Key Stockholder Earnout Amount Part B 36 months from the Completion Date, so long as the Founder has continuously remained a full-time employee of Company 2 (or have been a Good Leaver).

11.          None of the amounts payable under Clause 2.2 of the Earnout Deed can be described as indeterminate. They are fixed amounts that are calculated with reference to the agreed purchase price. They have been withheld from just X of the shareholders in order to incentivise the founders of Company 1 - who are beneficiaries of those X shareholder trusts - to remain employed with Company 2 for at least X years. It should be noted that there is provision for payment of the amounts based on the business targets.

12.          This is contrasted with earnout payments which occur when there is insufficient agreement on the value of an asset or business and therefore future payments to the seller are based around and calculated with reference to the economic performance of the assets or business. Whereas under the current transaction, the deferred payments will merely be made in respect of the acquisition of the shares in Company 1.

13.          In short, the Key Stockholder Earnout Amount is a deferred payment to the Trust for the disposal of its shares in Company 1 to Company 2 and is not a look-through earnout right.

14.          In any event, not all of the requirements in subsection 118-565(1) is likely to be satisfied to access the concessions at subsection 118-560(2).

15.          Subsection 118-565(1) states that a look-through earnout right is a right for which the following conditions are met:

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

(b)          the right is created under an arrangement that involves the disposal of a CGT asset;

(c)           the disposal causes CGT event A1 to happen;

(d)          just before the CGT event, the CGT asset was an active asset of the entity who disposed of the asset;

(e)          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;

(f)            those financial benefits are 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;

(g)          the value of those financial benefits reasonably relates to that economic performance;

(h)          the parties to the arrangement deal with each other at arm's length in making the arrangement.

16.          It is accepted the requirements in paragraphs (b), (c), (d), (e) and (h) is likely to be satisfied. The remaining requirements will now be considered.

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

17.          The EM states at paragraph 1.63:

In most cases, the fact that financial benefits are contingent will mean that they are also reasonably unascertainable. However, in some cases a benefit may be contingent on future events where there is little or no doubt that these events will transpire and the quantum of the payment is fixed or can reasonably be determined given what is known. In this case, the benefit can reasonably be ascertained and the right cannot be a look-through earnout right.

18.          The payments proposed to be made under Clauses 2.2(b) and (c) of the Earnout Deed are financial benefits whose quantum is known at the commencement of the arrangement. They are therefore considered to be reasonably ascertainable.

19.          Since the future financial benefits are reasonably ascertainable the requirement in paragraph

20.          118-565(1)(a) is not satisfied.

(f)            those financial benefits are 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

21.          For a right to be a look-through earnout right, future financial benefits provided under the right must be linked to the future economic performance of the asset. Measures that may be appropriate include both financial measures such as the profit, sales or turnover of the business (or the business in which the asset is used) and non-financial measures such as the number of clients retained or attracted.[3]

22.          Whilst Clause 2.2(a) of the Earnout Deed is an appropriate measure of economic performance, the financial benefit to be provided to the Trust is not wholly contingent on this metric. Clauses 2.2(b) and (c) may instead be satisfied.

23.          It is your view that Clauses 2.2(b) and (c) of the Earnout Deed are connected to the economic performance of Company 1. That is, the retention of Founder as an employee is critical to the productivity of the business. Whilst this may happen, the continued employ of the Founder is not a guarantee of future economic performance and therefore cannot be considered a metric of economic performance. Simply by remaining employed for a period of X months from Completion Date, the Founder effectively guarantees that the Trust becomes entitled to the Key Stockholder Earnout Amount, regardless of the economic performance of Company 1 over that period. It therefore is not the case that the financial benefit, being the Key Stockholder Earnout Amount is contingent on the economic performance of Company 1. Therefore, the requirement in paragraph 118-565(1)(f) is not satisfied.

(g)          the value of those financial benefits reasonably relates to that economic performance

24.          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.[4] Although this requirement does not entail a precise or mathematical link between performance and payment, a nexus must nonetheless exist.

25.          There is no link or nexus between the satisfaction of Clause 2.2 of the Earnout Deed and the quantum of the Key Stockholder Earnout Amount. Rather, the satisfaction of the requirements in Clause 2.2 merely brings the Trust into the same position in terms of capital receipts as the non-Key Stockholders who participated in the sale. Therefore, had the financial benefits been contingent upon economic performance, they would nonetheless not have been reasonably related to that economic performance. The requirement in paragraph 118-565(1)(g) is not satisfied.

Conclusion

26.          The arrangement involving payment of the Key Stockholder Amount is merely a mechanism by which the Trust, Company 1 and Company 2 agreed to set an appropriate amount of consideration under the SSA. It is a deferred payment made in respect of the acquisition of the shares. In any event, the requirements under subsection 118-565(1) would not have all been satisfied. Consequently, the amount the Trust is entitled to receive in accordance with the terms of the Earnout Deed is not a 'look-through earnout right' under subsection 118-565(1).

Question 3

Will the amount the Trust is entitled to receive in accordance with the terms of the Earnout Deed be included as capital proceeds under subsection 116-20(1)?

Summary

The amount the Trust is entitled to receive in accordance with the terms of the Earnout Deed is to be included as part of the total capital proceeds from a CGT event under subsection 116-20(1).

Detailed reasoning

27.          Paragraph 116-20(1)(a) states:

The capital proceeds from a *CGT event are the total of:

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

28.          The Trust received a portion of its proportion of the capital proceeds shortly after CGT event A1 happened in DD MM YYYY. The remaining capital proceeds is to be received by the Trust if the conditions set out in Clause 2.2 of the Earnout Deed are satisfied. Collectively, they are amounts that have been received, and are entitled to be received, by the Trust in respect of CGT event A1 happening.

29.          Therefore, the amount(s) the Trust is entitled to receive under Clause 2.2 of the Earnout Deed is to be included as part of the total capital proceeds received from CGT event A1 happening under subsection 116-20(1).

Question 4

Will any capital gain made by the Trust from the disposal of shares be a discount capital gain for the purposes of section 115-5?

Summary

The capital gain made by the Trust from the disposal of shares will be a discount capital gain.

Detailed reasoning

30.          Under section 115-5, for a capital gain to be a discount capital gain, the following requirements are to be satisfied:

•                     you are an individual, a trust or a complying superannuation entity[5]

•                     the capital gain must result from a CGT event happening after 11.45am (by legal time in the ACT) on 21 September 1999[6]

•                     the cost base must not have been calculated using the indexation method,[7] and

•                     you acquired the asset at least 12 months before the CGT event.[8]

31.          The Trust acquired the shares in Company 1 at least 12 months before CGT event A1 happened and is ineligible to use the indexation method as Company 1 was incorporated after 21 September 1999. As all the requirements under section 115-5 have been met, any capital gain made will be a discount capital gain.

Question 5

If the conditions contained in Clause 2.2 of the Earnout Deed are not satisfied and the Trust does not receive one or more amounts in accordance with the terms of the Earnout Deed, will the capital proceeds from the CGT event be reduced by the unpaid amount under section 116-45?

Summary

If the conditions contained in Clause 2.2 of the Earnout Deed are not satisfied the Trust will be entitled to reduce the capital proceeds from the CGT event by any unpaid amount under section 116-45.

Detailed reasoning

31. There are six modifications to the general rules set out in the table in section 116-25 that may be relevant where CGT event A1 happens. The most relevant is the 'non-receipt rule' in modification 3 in subsection 116-45(1), which states:

The *capital proceeds from a *CGT event are reduced if:

(a) you are not likely to receive some or all (the unpaid amount) of those proceeds; and

(b) this is not because of anything you (or your associate) have done or omitted to do; and

(c) you took all reasonable steps to get the unpaid amount paid.

The capital proceeds are reduced by the unpaid amount.

32.          This means that where a CGT event happens and a part or all of the proceeds are not received through no fault of the taxpayer and despite reasonable steps having been taken to have the amount recovered, capital proceeds can be reduced to the actual amount received.

33.          The Trust only received a portion of the capital proceeds on Completion of the SSA with the remaining capital proceeds payable in accordance with Clause 2.2 of the Earnout Deed. This is because the Founder is an associate of the Trust[9] and is a Key Individual referred to in Clause 2.2.

34.          To determine whether the non-receipt rule in paragraph 116-45(1)(b) can be applied to reduce the capital proceeds from the sale of the Trust's shares in Company 1 to Company 2, requires an examination of Clause 2.2 of the Earnout Deed.

35.          Clause 2.2(a) relates to targets being met by Company 1 by the Earnout Period End Date, being the date that is 60 months after the Completion Date in the SSA. The targets are not fanciful and do not require the presence of the Founder. The targets are 'ambitious but plausible' and do not require the continuing employment of the Founder in order to be achieved. Further, the software integration into Company 2's software is nearing completion and is fully documented. In short, if the targets are not achieved by 60 months from Completion Date, it cannot be said that it is because of anything that the Founder has done or omitted to do.

36.          Clause 2.2(b) and (c) of the Earnout Deed relate to the Founder's continued employment with Company 2 for a period of 24 months and 36 months from Completion Date of the SSA. In the event that he has not been continuously employed with Company 2 for these timeframes, or is not a Good Leaver, the remaining capital proceeds will not be paid unless or until Clause 2.2(a) has been satisfied. In other words, if the Founder has left employment with Company 2 within 24 or 36 months, or is not a Good Leaver, the remaining capital proceeds are still eligible to be paid if the condition in Clause 2.2(a) is satisfied.

37.          It is clear that Clause 2.2(a) is the fundamental clause of the Earnout Deed. That is, if the requirement in Clause 2.2(a) is satisfied, the requirements in Clauses 2.2(b) and (c) do not need to be satisfied. For Clauses 2.2(b) and (c) to be triggered, no payment has been made under Clause 2.2(a). Likewise, if the requirements in Clauses 2.2(b) or (c) are not satisfied, the requirement in Clause 2.2(a) can still be satisfied in order to receive the deferred payment of capital proceeds.

38.          If, as at the Earnout Period End Date, any part of the Key Stockholder's Earnout Amount has not been paid, and is not required to be paid, under Clauses 2.2(a), (b) or (c), the Buyer is to receive the amount that remains in the Escrow accounts. [10] Further, if the Key Stockholder and the Key Individual met the requirements for payment of the relevant part of its Key Stockholder Earnout Amount for part but not all of any period referred to in Clauses 2.2(a), (b) or (c), then the Key Stockholder will 'not be entitled to be paid any portion of such part of the Key Stockholder Earnout Amount'.[11]

39.          It is therefore the Commissioner's view that in the event that part or all of the remaining capital proceeds are not received by the Trust due to Clauses 2.2(a), (b) and/or (c) not being satisfied, it will not be due to anything that the Founder has done or omitted to do.

35. The Trust will be entitled to reduce the capital proceeds from the CGT event by any unpaid amount under section 116-45.

Question 6

Will any portion of the amounts to be paid in accordance with the terms of the Earnout Deed to the XXXX Trust be treated as ordinary income under section 6-5?

Summary

No portion of the amounts received in accordance with the terms of the Earnout Deed to the Trust be treated as ordinary income under section 6-5.

Detailed reasoning

37. Each of the shareholders in Company 1 was entitled to receive broadly the same maximum amount of consideration for the sale of their shares to Company 2. As X of the X Key Stockholders, the consideration received for the Trust is structured differently to the other shareholders, with a deferred payment under the terms of the Earnout Deed. Clause 2.5 of the Earnout Deed states that any payment made by the Buyer to the Key Stockholder will be payment of the Purchase Price under the SSA.

38. It is clear from the Earnout Deed the deferred payments represent capital proceeds that form part of the acquisition price of the shares disposed of by the Trust, as concluded at Question 3 of this ruling. Although the payments are in part contingent upon the Founder remaining employed by Company 2 for a period up to 36 months, they are not in respect of services rendered. The Founder has an employment contract and receives appropriate remuneration separate to the SSA and Earnout Deed, in respect of services rendered.

39. As concluded at Question 3, the amount the Trust is entitled to receive in accordance with the terms of the Earnout Deed will be included as capital proceeds under subsection 116-20(1). Consequently, these amounts will not be treated as ordinary income under section 6-5.

[1] Clause 2.2(c) of the Earnout Deed

[2] Section 108-5

[3] Paragraph 1.53 of the EM

[4] Paragraph 1.58 of the EM

[5] Section 115-10

[6] Section 115-15

[7] Section 115-20

[8] Section 115-25

[9] Subsection 318(3) of the Income Tax Assessment Act 1936

[10] Clause 2.2(d) of the Earnout Deed

[11] Clause 2.2(e) of the Earnout Deed