It is common in the sale of a business for there to be some type of earn out arrangement, whereby some of the sale consideration is held back by the buyer and only paid to the seller after certain economic performance is achieved by the business after the sale agreement has been signed. There are some complex tax ramifications around arrangements like this which need to be taken into account when drafting up sale agreements.
Where there is an earn out arrangement on a sale the question to be asked is whether the right qualifies as a “look through” earn out right. This will determine how the earn out is treated. The conditions that need to be satisfied to be seen as a “look through” earn out right are set out in Section 118-565(1) of the Income Tax Assessment Act. In essence the conditions to be satisfied to be seen as a qualifying arrangement and be treated as “look through” are as follows:
- the contractual right was created on or after 24 April 2015
- the contractual 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 right are to be provided within 5 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.
Most of these conditions are reasonably straight forward and satisfying them is easy enough to determine. However, the complexity to be considered in relation to the qualification is whether the value of the consideration to be received is contingent on the economic performance of the business and that the proceeds are not reasonably ascertainable at the time of sale of the business. This can be more complex than it would seem.
Economic performance would tend to suggest the earn out payment is dependent on achieving some type of profit or revenue aim. This would seem quite clear but there is always some uncertainty where the profit or revenue aim could be seen as “reasonably ascertainable”. As an example, in regards to future payments, if there is mention of set earn out figures, or minimum earn out amounts, in the sale agreement the ATO could argue the is reasonably ascertainable and not treat it as “look through”.
Similarly, as was the case with a client of ours a few years ago, there was a requirement to meet revenue targets to receive the earn out. In this case, the client already had existing long term annuity revenue contracts that really meant that the revenue target would be achieved easily based on the existing long term contracts. In that case the ATO took the view that the earn out was reasonably ascertainable based on these existing contracts and therefore did not treat the earn out as “look through”.
Once you have determined whether your business sale is going to be treated as a “look through” earn out arrangement you can determine how the earn out proceeds are treated when received. Below is a layman’s terms summary of the different treatments:
- If you qualify as a “look through” earn out right it means you can defer any tax on the sale of your shares until the amounts are actually received. At that point you go back and amend the tax return for the year that you sold the shares. This amendment needs to be done by the lodgement due date of the tax return that the consideration was actually received in. On amendment of that tax return, even if a few years after, there are no penalties or interest on the tax. You only pay the tax. Additionally, you will have access to the general discount for the capital gain and to the small business concessions (with adjusted timing milestones for the rollover and retirement exemptions) to decrease the CGT on the gain, when you amend the return.
- If you do not qualify as a “look through” earn out right it means that you need to value the rights to the future sale price (a difficult job which takes into account certainty of receiving the amount and bringing the amount back to a present value today) as at the date of initial sale of the business. This valuation would usually need to be done by a valuer experienced in valuations of this type. This situation is not ideal as it would have you paying tax in the year the business is sold even though you may not have received the funds yet (as they could be received years later). Also, when you receive the final amount, if it is more than the amount the right was valued at, you pay tax on the excess as a capital gain in the income tax year received. You would not be able to get the small business concessions on this separate capital gain, which would mean you would pay more tax on the capital gain than if you had been able to add it to the gain in the initial year sold when the concessions would have been available. Additionally, if the amount received is less than the valued amount initially included in the consideration, then there would be a capital loss which you could not utilise until you make a future capital gain.
It is important to be aware of the “look through” earn out provisions, especially in the drafting of the sale agreement for the sale of your business. You need to ensure that the agreement reflects the true nature of the earn out conditions and to ensure that the wording supports it being able to satisfy the conditions listed above. In particular, the need to be receivable only on achieving certain economic performance and not be reasonably ascertainable is imperative.
The ATO website has some good resources that cover the above issues and this link can be found here.
If you are planning to sell your business and the negotiations revolve around a possible earn out component in the proceeds, please contact your client manager at KSW early so we can review the effect on your transaction.
Author: Michael Goodrick
*Correct as of 29 January 2024
*Disclaimer – this article has been produced by Kreston Stanley Williamson as a service to its clients and associates. The information contained in the article is for general comment only and is not intended to be advice on any particular matter. Before acting on any areas contained in this article, it is imperative you seek specific advice relating to your particular circumstances. Liability is limited by a scheme approved under professional standards legislation.