Co-authored by Aishwarya (Law Intern)
During any business transaction, differing expectations of the buyer and the seller on the value of the entity is bound to arise. Earn-out transaction1 is a mechanism which helps to achieve a balance between such differences and protect the interests of both the parties concerning the pricing of the business. Usually inducted into contracts by way of a deferred consideration clause, it acts as an economic risk allocation instrument as it gauges the value of an investment at a future date. This kind of transaction entails withholding a part of purchase consideration for a business in an escrow account which shall be released pursuant to achievement of certain performance milestones which are usually profit and EBITDA ('Earnings Before Interest, Taxes, Depreciation, and Amortization') targets. Revenue metrics are not the only key consideration; retention of key managerial personnel, who the acquirer believes shall be instrumental in achieving a company's monetary goals, also forms a significant part of such deals.
The basic objective behind carving such a deal is to maximize the wealth that shall be accruing to both parties, by looking towards the future – the seller shall receive the maximum cash compensation that one can receive if the business performs in accordance with its forecasted uptick, and the buyer can mitigate potential heavy losses if the said business performs dismally, by not paying a fixed consideration at the instant of the sale.
While such a strategy seems ideal to stakeholders in a corporate transaction, they still have to be wary of the regulations that govern these deals in their given jurisdiction. Pre-liberalization in 2016, FDI involving deferred consideration required RBI approval. However, RBI released a notification2 dated May, 2016 permitting for a deferral of not more than twenty five per cent of the purchase consideration for a period not longer than eighteen months. The said notification also allows the seller to execute an indemnity clause for furnishing at most twenty five per cent of the total consideration within a period of eighteen months "from the date of the payment of the full consideration."
The automatic permission from RBI does not remove all impediments for earn-outs as the taxability of consideration accruing to the seller has not been clarified in India. The problem involves (i) nature/ characteristic of the consideration, and (ii) the time at which consideration shall be taxed.
Category under which consideration shall be taxed
The issue being sought to be addressed is whether the deferred consideration shall align with 'salary' income under Section 17 of Income Tax Act, 1961 ('the Act'); 'profits and gains' under Section 28 of 'the Act'; or 'Capital Gains' under Section 45 of 'the Act', 1961?
The Hon'ble Madras High Court3 opined that were the earn-out component of linked only to the performance of the manager and not directly linked to the performance of the acquired business, then the contingent payment would be 'profits in lieu of or in addition to salary' under Section 17 of 'the Act'.
On the other hand the Delhi AAR4 (Authority for Advance Rulings) surmised that where the deferred payment is part of the total purchase price, the entire purchase price will be subject to taxation of Capital Gains under Section 45 of the Act.
When consideration shall be taxed
Section 45 of the Act which provides for taxation of Capital Gains, where the gains are deemed to be income taxable in the year in which the capital assets are transferred. Taxability of assets upon of postponement of accrual of Capital Gains in respect of contingent consideration is dealt with nowhere in the Act. Section 48 which delineates the computation mechanism, also, does not provide for making any adjustment concerning the balance consideration.
In Ajay Guliya v. Assistant Commission of Income Tax5, the transferor of shares contended that the pre-decided entire consideration cannot be taxed as it had not accrued in the year of sale, due to waiving off right to the whole consideration unless stipulated conditions are fulfilled. However, the Hon'ble Delhi High Court held that share consideration became conclusive when the Share Purchase Agreement was executed. As the title of shares would not revert to the transferor even upon non-payment of balance consideration - which is depended upon the performance of company, not that of the seller – the whole of consideration is taxable in assessment year of execution of agreement, irrespective of time of receipt of such.
In a later case, the Hon'ble Bombay High Court6 gave a contrasting view that computation of Capital Gains will take place when the earn-out payment is made. According to the Hon'ble Court, the amount sought to be taxed failed the test of accrual, i.e., whether the assessee had an unconditional right to the mentioned consideration, and the right was legally enforceable. Since the all-inclusive consideration was the maximum amount payable to the assessee and not an assured consideration, tax could not be levied upon the consideration which the transferor might never be entitled to.
Despite the Hon'ble Bombay High Court serving a respite to the selling party in an earn-out deal, the Ajay Guliya judgement combined with the potential applicability of Section 50D of the Act, can still drive sellers to claim an exorbitant compensation which in turn shall deter investors. Section 50 allows for imputation of the Fair Market Value ('FMV') of the capital asset transferred as the full value of the consideration, in order to impose tax on Capital Gains accruing from the transfer of aforesaid assets, even if actual consideration is indeterminable.
There is an unsavoury possibility that in case the final consideration ultimately received exceeds that which was taxed as FMV, the tax authorities shall reject the FMV stating that it was computed incorrectly. Conversely, there is no refund mechanism under India's tax regime to recover the excess tax paid, were it to emerge that the final consideration ultimately paid was less than the FMV that was taxed; unless the assessee claims capital loss in subsequent assessment years7, the position regarding became ambiguous with the introduction of the 1961 Act.
1 Harminder Chawla, Gaurav Dayal, 'Earn-Outs: an Overview', Legal Era, http://www.legaleraonline.com/articles/earn-outs-an-overview
2 Notification No.FEMA.368/2016-RB
3 In re, Anurag Jain, 308 ITR 302
4 In re Moody's Analytics, Inc., AAR No. 1186 of 2011; AAR No. 1187 of 2011; AAR No. 1188 of 2011; AAR No. 1189 of 2011
5 (2012) 209 TAXMAN 176 (Bom)
6 Commissioner of Income Tax v Hemal Raju Shete, (2016) 239 TAXMAN 176 (Bom)
7 TV Sundaram Iyengar v Commissioner of Income Tax, 1959 37 ITR 26 Mad
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