Australian tax treatment of earnout arrangements
June 2015 | PROFESSIONAL INSIGHT | CORPORATE TAX
Financier Worldwide Magazine
The Australian Treasurer recently released draft legislation to address significant uncertainty around the taxation of earnout arrangements. In Australia, earnout arrangements are used in mergers and acquisition transactions and their use has increased in recent years.
Earnout arrangements can go both ways. For example, the buyer of a business may agree to pay the seller additional amounts if certain performance thresholds are achieved from the business within a particular time. Alternatively, the seller of a business may agree to repay amounts to the buyer if those performance thresholds are not met or exceeded within a particular timeframe.
Commercially, the key driver of the use of earnout arrangements is the difficulty in reaching an agreement as to the appropriate value of an asset or business. This may be due to difficulty in determining the future economic performance of the asset or business. Similarly, regulatory issues may make the valuation of an asset or business difficult if not impossible. An example of such valuation difficulties would be attempting to value a company holding mineral exploration licences or rights to mineral extraction subject to regulatory approval.
Australia imposes a capital gains tax (CGT) on the disposal of assets. A capital gain or loss will arise, depending on the difference between the capital proceeds received and the ‘cost base’ held in the relevant assets. The capital proceeds and cost base of CGT assets generally include monetary consideration and the market value of any property provided or received.
Uncertainty as to the taxation of earnout arrangements arose following the Australian Taxation Office (ATO) issuing a draft ruling in 2007 (TR 2007/D10) containing its interpretation of how the tax law applied to earnouts. The ATO took the view that in the common earnout context, the seller’s proceeds from the disposal of an asset included any cash and the market value of any earnout right received. Subsequent payments made under the earnout right would be treated as relating to the earnout right alone and not in relation to the asset originally disposed of. This was on the basis the earnout right itself constituted a separate CGT asset from the underlying asset originally disposed of.
The ATO’s interpretation of the tax law significantly limited a seller’s access to certain CGT concessions which apply to the disposal of business assets. The relevant CGT concessions would be available for the initial proceeds received for the disposal of assets, but would not be available for amounts received under earnout rights.
An example of the concessions which would have a more limited operation under the ATO’s approach included exemptions to Australian tax on the disposal of assets, or shares in companies holding assets, in an ‘active’ foreign business. Concessions available to small businesses would also be unavailable in respect of amounts received under an earnout right.
From the buyer’s perspective, the ATO took the view that a buyer’s cost base in assets acquired would include cash paid and the market value of any earnout right at the time of disposal. Amounts paid by the buyer under an earnout right would not be included in the cost base of the assets acquired. Conversely, in a reverse earnout arrangement, a separate CGT asset is deemed to be granted by the seller to the buyer, and the sales proceeds had to be apportioned between this asset and the business assets being sold.
The ATO’s approach recreated the problems associated with valuing certain businesses or assets which resulted in an earnout being implemented in the first place. As the rationale for the use of earnout arrangements is the difficulty in estimating the value of the business, the ATO’s approach did not make sense as it required a taxpayer to value earnout rights, with the associated tax consequences based on that valuation. In practice, valuing earnout rights is equally as difficult as valuing the underlying business or assets disposed of.
To illustrate the ATO’s approach, consider a taxpayer who sells shares in a company for AU$100 plus a right to a certain percentage of profits arising from the business owned by the company. The seller will generally be subject to tax on the difference between AU$100 plus the market value of the right acquired and their cost base in the asset disposed of. If the seller subsequently receives an amount that exceeds the market value of the right they recognised at the time of disposal, they will make a separate capital gain.
Conversely, a buyer would generally treat the AU$100 plus the market value of any right as the cost base in the asset acquired and generally not pay tax on the underlying asset acquired until it is disposed of or otherwise dealt with. If the buyer is subsequently required to pay an amount in respect of the right, under the ATO’s approach that payment will not be recognised for CGT purposes as a cost base item in either the original asset acquired or the earnout right disposed of, and it is not clear if it would be otherwise recognised as a deduction under the income tax law.
The approach put forward by the ATO in its 2007 draft ruling and its accompanying difficulties spurred the government to announce in 2010 that legislative changes would be made. The announced changes once enacted would simplify the taxation of earnouts and allow amounts received in relation to an earnout to relate to the original underlying asset. Following the 2010 announcement, the ATO stated that it would allow taxpayers to lodge tax returns based on the treatment proposed by the government. However, if the announced legislation was not enacted the ATO would then require taxpayers to review their positions.
In 2013, the incoming government announced its intention to proceed with the previous government’s legislative changes, including those in relation to earnout rights. Despite various government announcements and the release of a discussion paper by the Australian Treasury, no progress had occurred on this issue until recently.
On 23 April 2015, the Australian Treasury released draft legislation applying a ‘look-through’ approach for certain ‘qualifying earnouts’.
There are number of elements to the look-through approach for qualifying earnouts. On the initial disposal of an asset, a seller will not be required to include the value of any earnout right received in the proceeds of the underlying assets being disposed of. Similarly, buyers will not have to apportion the purchase price between the business assets acquired and a reverse earnout right acquired.
Under the look-through approach, a seller will simply be required to include the amount initially received at the time the assets are disposed of in its tax return for the year in which the disposal occurs. When amounts are subsequently received or paid under the earnout right, the seller will be required to amend its tax return for the year in which the asset disposal actually took place. The draft legislation provides that interest and penalties will not apply where a taxpayer amends a tax return for these purposes.
The draft legislation also provides that for the seller, capital losses arising from the disposal of an underlying asset where an earnout right has been received as proceeds may be deferred until payments on the earnout are received.
The proposed draft legislation in its current form will be restricted to qualifying earnouts, referred to as ‘look-through’ earnouts in the draft legislation. Broadly, a look-through earnout is defined as a right to future financial benefits which are unascertainable at the time the right is created. Further, the right must be created under an arrangement involving the disposal of a CGT asset that is an active asset of the seller, and the financial benefits under the right must be contingent on and reasonably related to the future economic performance of the asset, or a related business. In addition, all of the financial benefits under a particular earnout must be provided within four years of the disposal of the underlying asset.
The simplified definition of a ‘look-through’ earnout attempted above betrays the complexity of the definition contained in the draft legislation. Of particular note is the requirement that the asset being disposed of is an ‘active asset’. Where the relevant assets being disposed of are shares in a company or an interest in a trust, the shares/interest must be an active asset. The shares/interest will be taken to be active assets if at least 80 percent of the value of the assets of the company or the trust is themselves active assets. Certain taxpayers can apply an alternative test under which the shares/interest will be an active asset if the company or trust carries on a business and that for the preceding income year, at least 80 percent of its income was from carrying on the business. In this regard, amounts derived as annuities, interest, rent, royalties, foreign exchange gains and from financial instruments will not be taken into account.
If the draft legislation is enacted in its current form, an issue for taxpayers will be the restrictive nature of the definition of ‘look-through earnout’.
According to the Australian Treasury, the proposed changes are intended to ensure that the tax law does not present a barrier to the sale of a business where disagreement about the value of the business going forward is resolved by at least one of the parties agreeing to provide future financial benefits linked to the performance of the business. Although the proposed legislation should largely address the issues prompted by the ATO’s 2007 draft ruling for qualifying earnouts, taxpayers with earnouts which fall outside the proposed restrictive definition will face continued difficulty and uncertainty from a tax perspective.
According to the draft legislation, the new rules will apply to qualifying earnouts created on or after 23 April 2015. Protection from interest and penalties will be available for taxpayers who applied the look-through treatment announced in 2010. While a grandfathering provision has been proposed where a taxpayer entered into an earnout arrangement in recent years, it would be prudent for taxpayers in this position to now revisit the arrangement.
Betsy-Ann Howe is a partner and Silvino Gomes is a lawyer at K&L Gates. Ms Howe can be contacted on +61 2 95132365 or by email: firstname.lastname@example.org. Mr Gomes can be contacted on +61 2 9513 2488 or by email: email@example.com.
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Betsy-Ann Howe and Silvino Gomes