Many agreements for the sale of a business include the
payment of an additional amount if the business meets an agreed
benchmark in the future is known as earnouts.
While it may make commercial sense, earnouts can have
significant adverse income tax impacts on both the buyer and
seller of the business/company.
Implications for the seller
A typical earnout agreement is an arrangement where the
buyer pays more for the business or shares in a company based
on its future performance.
For this exercise, we will look at what the impact of an
earnout can have on the sale of shares in company that owns the
business. For example,consider the situation where the seller
who founded a business is selling post capital gains tax shares
in a company that cost $2.00 for $1,000,000, plus $500,000 in
one year's time if the profit exceeds a certain
The proceeds for the sale of the shares are considered to be
$1,000,000 plus the market value of the seller's rights
under the earnout arrangement. Accordingly, the right to
receive the $500,000 has to be valued based on the timeframe
and the probability of receiving the money.
Assuming the right is considered to be worth $200,000, the
seller will pay income tax on the capital gain of $1.2m even
though $200,000 has not been received.
If the business does not achieve the desired profit, the
seller then makes a capital loss of $200,000 when the right
expires (i.e. the seller has paid tax on $200,000 that was
never received) and can only be used against future capital
Alternatively, if the seller receives the full $500,000 he
will pay tax on a $300,000 capital gain. However, if the
earnout lasts for less than one year, the seller will not
receive the 50 per cent capital gains tax (CGT) discount,
effectively doubling the tax payable on the gain. Furthermore,
the seller is not eligible for the small business CGT
concessions on the earnout gain of $300,000. These concessions
reduce the tax by a further 50 per cent and can in some
circumstances eliminate the capital gains tax on the sale of a
In a slightly different example, consider a merger of two
companies where one company issues shares in return for the
shares in a company that is being acquired and the number of
shares issued by the acquiring company is determined by the
performance of the seller's company.
CGT relief by way of scrip for scrip rollover relief is
usually available when shares in a company are disposed of in
return for shares in the new company.
However, because the earnout is treated as a separate asset
the scrip for scrip rollover relief is not available for the
earnout component of the disposal. As a result, tax is payable
on part of the transaction which would ordinarily be tax
Again the subsequent expiry or satisfaction of the earnout
right is a separate CGT event, which will result in either a
capital gain or loss to the seller, so if the earnout
conditions are not met, the seller can be assessed on a capital
gain even though he did not actually receive the additional
shares in the company or receiving any cash for the sale of the
shares that could fund the tax payment.
Implications for the buyer
The same treatment of the earnout applies for the buyer.
That is the cost of the shares in the company is treated as the
amount paid for the shares plus the market value of the
earnout. The buyer can determine their valuation of the earnout
independently from the seller, so the values do not have to
The issue is what happens to the subsequent payment under
the earnout agreement? If the amount paid exceeds the estimated
market value of the earnout, is the difference
included in the cost of the shares; or
deductable over time; or
simply ignored so that a deduction or capital loss is
The Australian Taxation Office has recently issued a recent
draft tax ruling regarding earnouts. While this draft ruling
does clarify some of the issues outlined above, surprisingly it
does not deal with the difference between the buyers'
market value of an earnout and the amount eventually paid.
There is a second type of earnout, where the purchase price
of the business/shares is fixed but the seller pays an amount
to the buyer if the business meets certain benchmarks. The
treatment of reverse earnouts is effectively the opposite of
the treatment of earnouts (i.e. in reverse earnouts the buyer
has the asset earnout right) and can have a capital gain or
loss on that asset.
Earnouts are useful in aligning the interests of sellers and
buyers of a business. However, they attract significant income
tax issues which can create additional tax for both the seller
and buyer. Many of the issues outlined can be successfully
resolved if you consider the income tax implications before any
agreement is concluded.
The content of this article is intended to provide a
general guide to the subject matter. Specialist advice should
be sought about your specific circumstances.
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