Edited version of private advice

Authorisation Number: 1052339236827

Date of advice: 13 December 2024

Ruling

Subject: Look-through earnout

Question 1

Is the earnout right (EOR) a "look-through earnout right" for the purposes of section 118-565 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer 1

Yes

Question 2

If the answer to Question 1 is 'yes', is the value of the EOR excluded from the Taxpayer's capital proceeds resulting from the CGT event that was triggered by the Taxpayer's disposal of the Shares?

Answer 2

Yes

Question 3

Is the EOR a CGT asset, with the first element of its cost base being its market value on the date of acquisition by the Taxpayer?

Answer 3

N/A. There has been no assignment of the EOR. Further, pursuant to subsection 116-120(1), the value of the EOR is not included in the taxpayer's capital proceeds from the disposal of the shares.

Question 4

Will the capital proceeds from the assignment of the EOR be its market value on the date of its assignment?

Answer 4

N/A. There has been no assignment of the EOR

Question 5

On assigning the EOR as contemplated under the arrangement, will the Taxpayer receive a financial benefit as that term is understood for the purposes of section 116-120(1)(b) of the ITAA 1997?

Answer 5

N/A. There has been no assignment of the EOR.

This ruling applies for the following periods:

Income year ended XX June 20XX

Income year ended XX June 20XX

Income year ended XX June 20XX

The scheme commenced on:

XX October 20XX

Relevant facts and circumstances

The taxpayer is a company registered in Australia and a tax resident of Australian for tax purposes, and owned shares in XXX.

XXX is engaged in the business of manufacturing and equipment.

XXX was not a member of a consolidated group at the time the Agreement was executed.

A sale agreement was entered into between the shareholders of XXX (as sellers) and the Buyer for the sale of the shares in XXX (share sale agreement).

The Taxpayer received cash consideration for the sale of the shares, together with rights to two 'Earn-Out Payments' for X years.

Deeds of Assignment were executed purporting to assign rights to the earnout payments to various individuals.

When the Earn-Out Payment was paid by the Buyer to the Taxpayer, the Taxpayer paid a total amount of $XXXX to the various assignees under the Deeds of Assignment.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 118-565

Income Tax Assessment Act 1997 section 118-560

Income Tax Assessment Act 1997 section 116-120

Income Tax Assessment Act 1997 section 116-30

Income Tax Assessment Act 1997 section 116-20

Income Tax Assessment Act 1997 section 104-10

Income Tax Assessment Act 1997 section 974-160

Income Tax Assessment Act 1997 subdivision 118-I

Does IVA apply to this private ruling?

Part IVA of the Income Tax Assessment Act 1936 contains anti-avoidance rules that can apply in certain circumstances where you or another taxpayer obtains a tax benefit, imputation benefit or diverted profits tax benefit in connection with an arrangement.

If Part IVA applies, the tax benefit or imputation benefit can be cancelled (for example, by disallowing a deduction that was otherwise allowable) or you or another taxpayer could be liable to the diverted profits tax.

We have not fully considered the application of Part IVA to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

If you want us to rule on whether Part IVA applies, we will need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

For more information on Part IVA, go to our website ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select 'Part IVA: the general anti-avoidance rule for income tax'.

Reasons for decision

Question 1

Is the earnout right (EOR) a "look-through earnout right" for the purposes of section 118-565 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Summary

Yes

Detailed reasoning

Subdivision 118-I of the Income Tax Assessment Act 1997 (ITAA 1997) provides the requirements which an earnout needs to satisfy in order to qualify as a look through earnout right.

Subsection 118-565(1) provides as follows:

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;

Note:

For extra ways to be an active asset, see section 118-570

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 relate to the economic performance;

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

Each of the above requirements has been met in this case.

Question 2

If the answer to Question 1 is 'yes', is the value of the EOR excluded from the Taxpayer's capital proceeds resulting from the CGT event that was triggered by the Taxpayer's disposal of the Shares?

Summary

Yes.

Detailed reasoning

Paragraph 116-120(1)(a) provides as follows:

116-120(1)

If CGT event A1 happens because you dispose of a CGT asset, your capital proceeds from the disposal:

(a) do not include the value of any look-through earnout right relating to the CGT asset and the disposal;

Therefore the value of the Earn-Out right is excluded from the taxpayer's capital proceeds from the CGT event A1 disposal of the Shares.

Question 3

Is the EOR a CGT asset, with the first element of its cost base being its market value on the date of acquisition by the Taxpayer?

Summary

N/A. There has been no assignment of the EOR. Further, subsection 116-120(1) applies such that the value of the EOR is not included in the taxpayer's capital proceeds from the disposal of the shares.

Detailed reasoning

The cost base of the Earn-Out right is immaterial to the tax outcomes for the taxpayer in this case for the following reasons:

•                The Earn-Out right has not been assigned.

•                Owing to the operation of 116-120(1), the value of the Earn-Out right is excluded from the taxpayer's capital proceeds from the CGT event A1 disposal of the Shares.

Question 4

Will the capital proceeds from the assignment of the EOR be its market value on the date of its assignment?

Summary

N/A. There has been no assignment of the EOR.

Detailed reasoning

On the construction of the Deeds of Assignments, no part of the underlying earnout right was assigned.

Question 5

On assigning the EOR as contemplated under the arrangement, will the Taxpayer receive a financial benefit as that term is understood for the purposes of section 116-120(1)(b) of the ITAA 1997?

Summary

There has been no assignment of the EOR.

For the reasons expressed in relation to question 4, there has been no assignment of the EOR.

Subsection 116-120(1) provides as follows:

If CGT event A1 happens because you dispose of a CGT asset, your capital proceeds from the disposal:

(a) do not include the value of any look-through earnout right relating to the CGT asset and the disposal; and

(b) are increased by any financial benefit that you receive under such a look-through earnout right; and

(c) are reduced by any financial benefit that you provide under such a look-through earnout right.

As the taxpayer did not assign the EOR, its CGT event A1 capital proceeds are increased by the financial benefits it received under the right.