Finally, after more than 22 years (the original ruling was issued in 1993), the saga regarding the CGT consequences of earnout arrangements has come to an end, well mostly to an end. The new CGT and earnout rules in Tax and Superannuation Laws Amendment (2015 Measures No. 6) Bill 2015 have been passed by both houses of parliament and received Royal Assent. The new rules mostly apply to earnout arrangements entered into after 23 April 2015 although taxpayers who applied the look through approach to an arrangement entered into before 24 April 2015, in anticipation of the new rules coming into force, will be protected. A brief summary of the new rules follows.
Under a standard earnout arrangement the buyer agrees to pay the seller additional amounts if certain performance thresholds are met within a particular time. Under a reverse earnout arrangement the seller agrees to repay amounts to the buyer if certain performance thresholds are not met within a particular time.
As anticipated, a look through approach will apply. Under a standard earnout arrangement any additional amounts received by the seller will be treated as part of the consideration received for the disposal of the underlying assets and thus in determining the amount of capital gain or loss made. As well the additional amounts will be included in determining the cost base or reduced cost base of the asset acquired by the buyer. For example, a seller sells its business goodwill to a buyer for $3 million to be paid at settlement plus a further $500,000 to be paid 2 years later if net profit of the business exceeds certain amounts in the those two years. The targets are met and so the buyer pays the seller the additional $500,000 two years after settlement of the original sale. For CGT purposes the goodwill is treated as being sold for $3.5 million.
Under a reverse earnout arrangement any amounts repaid by the seller to the buyer will reduce its cost base and the seller will reduce its capital proceeds (and thus capital gain). The effect of the look through approach is that taxpayers will need to amend their tax returns for the year the CGT event happened to take into account the change in consideration. The new rules allow for these amendments to be undertaken after the normal two or four year amendment periods (and also allow the ATO to make amendments).
One significant advantage of the look through approach is that if the seller can satisfy the conditions to obtain the small business CGT concessions then the concessions will also apply to the earnout amounts received. The view in the ATO ruling was that the concessions did not apply to such amounts.
The new rules apply to a ‘look through earnout right’. In order to be a look through earnout right a right must satisfy all the following conditions:
- The right is a right to future financial benefits that are not reasonably ascertainable at the time the right is created;
- The right is created under an arrangement that involves the disposal of a CGT asset;
- The disposal cause CGT event A1 to happen;
- Just before the CGT event the CGT asset was an ‘active asset’ (as defined in the small business CGT concessions, but an alternative test can apply for shares) of the seller/disposer;
- All the earnout payments must be paid within five years after the end of the income year in which the CGT event happens;
- Those payments are contingent on the economic performance of the CGT asset sold or a business in which the CGT asset will be used;
- The payments reasonably relate to that economic performance; and
- The buyer and seller deal with each other at arm’s length in relation to the earnout arrangement.
As always, the devil is in the detail and the tip is to ensure the detail is understood so that taxpayers are not caught out.