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Recent Amendments to CGT Treatment of "Earnout Rights"

Recent Amendments to CGT Treatment of "Earnout Rights"

By Robert O'Keefe
March 22, 2016

On 22 February 2016, Federal Parliament passed legislation in relation to the CGT treatment of “earnout rights”. The amending Act was assented to on 25 February 2016.  The changes apply to “earnout rights” created on or after 24 April 2015.

The Act now adopts a “look through” approach when considering the CGT implications relating to so called “earnout rights”.  The meaning of “earnout rights” and the previous and current CGT treatment given to payments made in relation to earnout rights are explained in more detail below.

What are “Earnout rights”

Often a sale of a business (or shares in a company carrying on a business) will involve the Seller continuing to provide services to the new owner for a period of time after the sale occurs. This is common where the value of the business lies in the customers or clients of that business.

In these circumstances it is not uncommon for the sale agreement to include a retention or earnout component where the Seller will be entitled to further payment(s) at a future time subject to certain performance thresholds being met. Earnout rights of this type are commonly referred to as “standard earnout rights”. In some cases the arrangement will involve a so-called “reverse earnout right” where a Seller may be required to repay an amount to the buyer if certain performance thresholds have not been met within a specified period.

The sale agreement will include conditions (usually performance thresholds) which must be satisfied before the retention or earnout amount becomes payable to the Seller. A Seller’s entitlement to be paid under these arrangements is generally called an “earnout right”.

In some cases the payment of an earnout right may involve multiple payments staggered over several years. The amount(s) payable to the Vendor will often depend on the number of “old clients” remaining with the new business owner and the level of fees generated after the sale from those “old clients”.  This is often reflected as a percentage of the pre-completion level of fees from those clients.

The Seller will often provide services to the new owner (and is often employed by the new owner) to assist in the retention of the clients of the business. This is clearly in the Seller’s interest as the amount of the earnout payment will usually depend on the level of clients retained and fees earned.

Problems with the previous CGT treatment of CGT events involving “earnout rights”

Prior to the latest amendments, the CGT consequences for any transactions involving “earnout rights” were often difficult to quantify. Under the previous law, if a person sold a CGT asset under an arrangement which involved an earnout right, the Seller’s capital proceeds included the cash component as well as the market value of the earnout right at the time of the CGT event. The difficulty in this approach was determining with any accuracy the market value of the earnout right when the relevant performance thresholds were to be assessed over an extended period.

Under the previous law, the earnout right was itself considered to be a separate CGT asset and, as a consequence, there were further CGT implications when that earnout right expired or was satisfied (eg by the making of further payment(s) in later years). Depending on the market value of the earnout right at the time of the original CGT event, a further capital gain (or capital loss) could arise when the earnout right was later satisfied or expired.

The amending legislation simplifies the CGT treatment on the sale of a CGT asset which includes an earnout arrangement. The legislation now applies a “look through” approach when considering the CGT implications. Under the new law, the capital proceeds received by a Seller for the sale of a CGT asset which involved a “look through earnout right” is now afforded the following treatment:

  1. The market value of the earnout right at the time of the original CGT event is disregarded (ie, it is not included as part of the capital proceeds for the sale of the CGT asset), and
  2. The value of any financial benefit which is later provided or received under the earnout right is to be included:
  1. In the case of the Seller, as part of the capital proceeds arising from the original disposal of the CGT asset; and
  2. In the case of the buyer, in the cost base (or reduced cost base) of the CGT asset acquired by the buyer. 

ATO’s administrative treatment - Transitional arrangements

The final form of the CGT treatment of earnout rights is described in the Bill which was introduced into Parliament on 3 December 2015.  This CGT treatment differed from the original proposal paper (issued 10 May 2010) and draft legislation (issued for consultation purposes on 23 April 2015).  Many taxpayers will have entered into arrangements involving earnout rights based on the proposals as they existed at the time of that arrangement. The ATO has recognised this and, as a consequence, has announced that certain transitional treatment will be available in these cases.

These transitional arrangements apply to the following earnout rights:

  1. Earnout rights created between 11 May 2010 and 23 April 2015 - Taxpayers can choose to apply the proposed look through treatment described in the original proposal paper;
  2. Earnout rights created on or after 24 April 2015 but before 3 December 2015 - Taxpayers can choose to apply the CGT treatment referred to in the draft legislation (released on 23 April 2015) or the Bill introduced into Parliament on 3 December 2015; and
  3. Earnout rights created on or after 3 December 2015 - Taxpayers can rely on the treatment as described in the Bill introduced into parliament on that date.

Extended amendment period

When a payment for an earnout right is received some time after the original CGT event, the taxpayer is required to seek an amendment to the tax assessment made in respect of that earlier year.  Because the payments in respect of an earnout right may be made some years after the original CGT event, the amendment period for an assessment involving an earnout right has been extended by the Act to a date 4 years after the expiry of the earnout right. Within that period, a taxpayer must request an amendment be made to the assessment for the year in which the original CGT event occurred. 

If necessary, any entitlements to the CGT small business concessions on the happening of that CGT event can also be reviewed when payments under an earnout right are made.

The ATO has advised that if amendments are made to assessments in relation to earnout arrangements within the 4 year period, the ATO will not apply any tax shortfall penalties and will remit any interest accrued up to the date when the amending law is enacted.

The Act describes certain criteria that must be met in order for an earnout right to qualify for the above “look through” treatment. This article does not address all of those criteria.

Further information

If you have entered into transactions involving earnout rights during any of these periods and require further advice, please contact Robert O’Keefe of this office.