Selling or purchasing a business will be made easier after the Coalition government has agreed to a simple approach to the tax treatment of earnout arrangements.
On 14 December 2013, the Assistant Treasurer announced that the government will proceed with the long-standing proposal to provide “look-through” treatment for qualifying earnout arrangements.
The proposal was originally announced in the 2010-2011 Federal Budget but was shelved during the Gillard government’s frantic efforts to enact the centrepieces of its legislative agenda, including the carbon tax and mining tax bills.
Basic information: 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.
In addition, the lump sum will often assume a base or reasonable profit level and take into account assets that have a relatively certain value (for example, trading stock, plant and equipment, land and buildings, etc). The earnout right typically reflects the uncertainty surrounding future profitability, the value of goodwill and future cash flow projections.
|Example of a standard earnout arrangement: Web Design Co Pty Ltd operates an internet website development company which caters to a niche market. The owner, Paul, owns all the shares in the company. Global IT Ltd is a listed public company and has expressed interest in purchasing all of Paul’s shares in Web Design Co. Paul agrees to sell his shares to Global IT for the following consideration: a lump sum cash payment of $5m and an “earnout” right entitling Paul to further cash payments of 50 percent of the excess (if any) of Web Design’s turnover over $1.5m at the conclusion of the current tax year and the succeeding 2 tax years.|
Sometimes, an earnout right is reversed so that the seller is required to refund amounts to the buyer of the asset if the performance of the business does not meet specified benchmarks.
|Example of a reverse earnout arrangement: Sally runs a bakery as a sole trader and is seeking to sell her business. Sally agrees to sell her business to Amanda for $100,000 payable on the date of settlement. Under the contract, Sally also agrees to pay Amanda 30 percent of the amount (if any) by which the business turnover falls below $25,000 for each of the 3 years following the sale (up to a maximum of $5,000 in each year).|
The proposed changes to be implemented by the Coalition government 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.
Problems with the Current Treatment
The proposed changes are a welcome improvement to the current taxation treatment of earnout arrangements expressed by the Australian Taxation Office (ATO) in its draft ruling issued in October 2007. 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 tax event is triggered because a payment is taken to be received for the cessation of the earnout right. This is where a third problem presents, because any capital gain under this second event will not qualify for the capital gains tax (CGT) concessions for small businesses. A fourth problem will arise if this second 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.
- For reverse earnout arrangements, part of the lump sum amount received from the buyer is proceeds for the sale of the relevant asset, and the other part of the lump sum is taken to be proceeds for the creation of the reverse earnout right. This allocation is, as for standard earnout arrangements, dependent on an imprecise and potentially costly valuation exercise and any capital gain arising from the creation of the reverse earnout arrangement will not qualify for the ordinary CGT discount. Any subsequent reverse earnout payments will trigger yet another tax event for the buyer because they are receiving a payment for the cessation of the reverse earnout right.
The proposed changes will apply to all earnout arrangements entered into after the date enabling legislation is formally enacted by Parliament, with transitional provisions to be made available in certain cases with effect from 17 October 2007.
ATO Transitional Administrative Treatment
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 enabling legislation is enacted.
- In addition, the buyer in a standard earnout arrangement will have the choice to apply the look-through treatment for arrangements entered into on or after 17 October 2007, (the date of release of the draft ATO ruling).
However, the ATO will require any taxpayers who use the transitional arrangements to review their tax positions once the outcome of the proposed changes is known.
Watch for Enabling Legislation
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 (2014).