Australia: Earnouts – Creating Tax Complexity

Last Updated: 1 September 2008
Article by Howard Badger

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 hurdle.

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 gains.

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 business.

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 free.

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 agree.

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 never obtained?

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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