Business sale earnout arrangements back in spotlight
In December last year the Government announced it would proceed with the long-standing proposal to provide 'look-through' treatment for qualifying earnout arrangements.
What is an earnout?
Earnout arrangements are a common way of structuring the sale of a business. Under a standard earnout arrangement, the business assets are sold for a lump sum plus a right to further payments that are contingent on the performance of the business over a defined period following the sale. The lump sum is normally calculated to ensure that the purchase price paid by the acquirer is not excessive. The lump sum will often assume a base or reasonable profit level and take into account assets that have a relatively certain value, like trading stock, plant and equipment, land and buildings. The earnout right typically reflects the uncertainty surrounding future profitability, the value of goodwill and future cash flow projections.
Changes on the Cards
The proposed amendment will treat additional payments made by a buyer under an earnout arrangement as an addition to the buyer's cost base for the original asset. The seller will be taken to have received additional capital proceeds for the original asset. Payments made by a seller under a reverse earnout arrangement will be treated as a repayment of part of the capital proceeds for the disposal of the original asset and will reduce the buyer's cost base for that asset.
The proposed amendment is a welcome improvement to the current taxation treatment of earnout arrangements. The current approach can be summarised as follows:
- For standard earnout arrangements, the proceeds from the sale of the relevant assets include the lump sum amount plus the estimated value of the earnout right. The problem with taxing the market value of the earnout right is that the seller must pay tax on an amount not yet received. A second problem is that valuing an earnout right at the time of sale is an imprecise and potentially costly exercise.
- When a standard earnout payment is subsequently received by the seller, a second CGT event is triggered because a payment is taken to be received for the cessation of the earnout right (i.e. a CGT event C2). This is where a third problem presents, because any capital gain under this second CGT event will not qualify for the small business CGT concessions. A fourth problem will arise if this second CGT event gives rise to a loss for the seller, because the seller cannot carry the loss back and offset it against any gain that may have arisen on the initial sale of the business if the sale occurred in a previous income year.
The proposed amendments will apply to all earnout arrangements entered into after the date of Royal Assent for the enacting Bill, with transitional provisions to be made available in certain cases with effect from 17 October 2007.
The ATO has made available the following transitional administrative arrangements:
- Taxpayers will have the choice to apply the proposed 'look-through' treatment for earnout arrangements entered into between 12 May 2010 and the date that the enacting Bill receives Royal Assent.
- In addition, the buyer in a standard earnout arrangement will have the choice to apply the lookthrough treatment for arrangements entered into on or after 17 October 2007.
- However, the ATO will require any taxpayers who use the transitional arrangements to review their tax positions once the outcome of the proposed amendments is known.
The proposed changes are a simple and equitable alternative that will remove the current tax impediment to the operation of an efficient market for the sale of businesses or business assets. Now that the Coalition Government has subscribed to the proposed new approach, it is hoped they will move quickly to pass the enabling legislation in order to eliminate the uncertainty that has surrounded this matter for so long. The Government has expressed an intention to introduce the changes this year.
To discuss how these proposed changes could impact you, contact our Taxation team in Sydney on (02) 8346 6000 or Newcastle on (02) 4962 2688.