Earnout Structures: Bridging Valuation Gaps In M&A – Beware The Tax Complexity

With an observable increase in the use of earnout and contingent consideration structures in M&A, it is timely to consider the related tax complexity.

In brief

• Our recent Private M&A Report highlights a rise in the use of earnout and contingent consideration structures in private M&A transactions as parties seek to bridge valuation gaps.
• There are a number of tax pitfalls that can arise for the unwary when using earnout structures. According to the ATO, a seller, for example, may be subject to tax at the time of sale on the market value of the earnout regardless of whether any additional payments are received from the buyer under the arrangement. A buyer, on the other hand, may not receive full tax recognition of the earnout payments it makes in the tax cost of the target shares leaving it with an unenviable task of finding an alternative tax recognition for the payments.
• A concessional 'look-through' earnout regime exists to address these anomalies but only for qualifying arrangements, the requirements of which are not always aligned with the commercial requirements of a transaction. Parties to non-qualifying arrangements may find some relief in the 'taxation of financial arrangement' regime, however, as recent case law demonstrates, the current tax settings make it difficult for some regular earnout arrangements to be subject to these rules. Careful and early planning is essential. In our experience, such planning can generally enable these potential pitfalls to be successfully navigated, or at least factored into deal modelling.

Bridging the value gap

It is common for prospective sellers and buyers to disagree on the underlying value of the assets of the target. Sellers want to secure the best possible price for what they perceive is a high performing asset while prospective buyers – who face a level of information asymmetry about the business, and uncertainty about its future performance – think sellers are overinflating the asset's value. Turbulent markets can also trigger disparities between seller and buyer expectations on price.

One way to bridge this value gap is for the parties to adopt a purchase price mechanism which consists of an 'upfront payment' of cash or shares (or a combination of the two) and an 'earnout payment' consisting of cash or shares or a combination. Unlike the upfront component, the earnout component is generally conditioned on the achievement of financial or other performance targets of the business after the deal closes.

As reported in our recent Private M&A Report, there was a material increase in contingent deferred payments and earnout structures in calendar year 2024. We expect this was a function of buyers and sellers bridging the valuation gap in this period of valuation and performance uncertainty.

With a rise in the use of these structures, related tax complexities must be considered.

ATO's views on earnout arrangements

According to the Australian Taxation Office (ATO), where a seller is entitled to additional purchase price conditional on the performance of an underlying business, for capital gains tax (CGT) purposes, the seller acquires – and the buyer is taken to provide – a separate 'earnout right' that is independent of sale transaction from which it arises.

Based on this approach, the tax treatment for the seller and buyer may be summarised as follows:

The ATO's views produce several anomalous tax and commercial outcomes:

• Arguably no true gain — As a commercial matter, the seller would be subject to tax on the market value of the earnout right without realising any economic gain as the right to payment remains contingent upon events which may be outside the seller's control (the performance of the target under the buyer's ownership).
• Non-availability of CGT concessions or exemptions — The seller may not be able to apply certain CGT concessions or exemptions – for example, the CGT discount will not apply to payments under the earnout right unless those payments are received more than 12 months after the creation of the right, and CGT scrip for scrip rollover relief will not be available to the extent the seller's capital proceeds comprise the market value of the earnout right (rather than shares), even if the seller is entitled to additional shares under the earnout (a converting share may work better in this case).
• Potential double tax for seller — If the receipt of the earnout payments is treated as ordinary income, the seller may be subject to double tax under the arrangement.
• Tax recognition for subsequent earnout payments — The buyer will not be able to include any subsequent payments made under the earnout right in the cost base of the shares so will need to rely on an alternative tax recognition for the expenditure (eg, an immediate tax deduction, or a deduction over five years), which may be challenging.
• Expiry of earnout right — If the earnout right expires without any payment being made, or where the payments are less than the initial market value of the right, the seller will generally not be able to offset any capital loss made as a consequence of the 'earnout right' expiring against any capital gain made on the disposal of the shares, and the buyer will not be required to reduce the cost base of its shares.

Look-Through Earnout Tax Concession

The Government introduced a 'look-through earnout regime' in response to the anomalies produced by the ATO's views above, however, the legislative regime only applies to qualifying 'look-through earnout rights'.

The current legislative regime

Under the look-through earnout regime, the tax treatment for the seller and buyer for qualifying earnout arrangements may be summarised as follows:

Arrangements that do not qualify for 'look-through' treatment

Some earnout arrangements may not qualify for look-through treatment under the existing regime:

• Maximum five-year term — Broadly, earnout payments that can be provided under the right must be provided within five years. Most earnout arrangements are typically structured for between two to five years so this requirement is generally not problematic – however, longer term arrangements, for example, royalty based arrangements typically seen in the sale of mining or petroleum assets, will not qualify for look-through treatment.
• Contingent on economic performance — The earnout payments provided under the right must be contingent on the economic performance of the underlying business. This should generally apply to contingencies based on financial measures such as profit, sales or turnover of a business, and may also extend to contingencies based on non-financial measures (such as number of clients retained or attracted), however, when it comes to other non-financial measures, there is some uncertainty about whether a requisite nexus to economic performance exists based on the ATO's sometimes narrow application of this requirement.
• Widely held entities — A shareholder or unitholder in a widely-held (eg, listed) company or trust will not qualify for 'look-through' treatment, unless their interest in the company or trust is greater than 20%. Although earnout arrangements are less common in a public market context, they are not entirely novel. The scheme of arrangement involving Bingo Industries Limited in 2021, the scheme of arrangement involving Crestone Holdings Limited in 2022 and the proposed scheme of arrangement involving TPC Consolidated Limited announced in 2024, each contained an earnout component to the scheme consideration.
• Foreign law mergers — For a right to qualify as a look-through earnout right, it must be created under an arrangement that involves the 'disposal' of a CGT asset, and that disposal must cause CGT event A1 to occur. CGT event A1 does not always occur in mergers and acquisitions of businesses, particularly when such transactions occur under foreign law.
• CGT assets only — The rules only apply for the purposes of gains taxed under the CGT provisions. Accordingly, a sale of a mining or petroleum tenement covered by the depreciation provisions will not qualify even if all of the above requirements are otherwise satisfied.

Where an arrangement does not qualify for concessional 'look-through' treatment, the ATO has confirmed that the 'separate asset' approach described above will continue to apply.

Taxation of Financial Arrangements

The 'taxation of financial arrangements' (TOFA) rules may offer a potential solution to mitigate some of the adverse tax effects for non-qualifying earnout arrangements and thereby create greater commercial flexibility over the arrangements that can be used.

Where an earnout arrangement qualifies as a TOFA financial arrangement, the tax treatment for the seller and buyer may be summarised as follows:

Challenges with application of TOFA to earnout arrangements

As the recent decision in Merchant v Commissioner of Taxation [2025] FCAFC 56 demonstrates, the current legislative settings for the TOFA rules make it challenging to apply to some earnout arrangements. That is because:

• Qualifying taxpayers — TOFA will generally not apply to individuals and other entities that do not meet certain turnover or asset thresholds, unless they make an irrevocable election to apply the rules to all their financial arrangements.
• Short-term arrangements — TOFA will generally not apply for arrangements of no more than 12 months.
• Proceeds from sale of business — A key reason many earnout arrangements are not subject to the TOFA rules is because of the exclusion relating to certain business sales. As a practical matter, this exclusion can disqualify many standard earnout arrangements from TOFA treatment except those arrangements that are contingent only on receipt or turnover of the entity after the sale or otherwise contingent on some matter that is not a measure of economic performance.

Overall, while we expect parties to continue to use earnout and contingent consideration structures in private M&A transactions to bridge valuation gaps, careful and early planning is required to navigate the high level of tax complexity associated with the use of such structures.

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.