On 12 May 2010 and as part of the Commonwealth Budget 2010-11, the Assistant Treasurer announced the Government's intention to enact legislation to apply a 'look-through' capital gains tax (CGT) treatment for qualifying earn-out arrangements in the sale of business assets.1 As part of the announcement, Treasury simultaneously released a discussion paper outlining proposals to implement the look-through approach (Discussion Paper) and which sought taxpayer submissions and comments.2
Broadly speaking, the Government intends treating payments under so-called 'standard' earn-out arrangements as related to the original asset and therefore as part of the capital proceeds received by the Seller and part of the cost base for the Buyer. For so-called 'reverse' earn-out arrangements, payments will be treated as a repayment of part of the capital proceeds.
This announcement ends a protracted period of uncertainty in respect of the proposed taxation treatment of earn-out rights which dates back to 17 October 2007 when the Commissioner of Taxation released Draft Taxation Ruling TR 2007/D10 (TR 2007/D10). The current proposals overturn the Commissioner's views in TR 2007/D10 (which adopted a 'separate asset' approach to earn-out rights for both Buyer and Seller).
The purpose of this article is to provide an overview of:
Earn-out arrangements are often entered into where the parties to the sale of an asset are unable to agree on a value for the asset at the time of entering into the sale. The Discussion Paper does not specify in detail the asset sales to which the proposed provisions will apply, although the Assistant Treasurer's foreword refers to 'the sale of a business (or business assets)'. Presumably, the provisions will apply to the sale of a business and to the sale of shares in a company that carries on a business. It is not clear whether they will have broader application, for example, to the sale of individual business assets (such as intellectual property rights).
There are two (2) types of arrangements dealt with in the Discussion Paper, as discussed below.
Under a standard earn-out arrangement, the consideration will often consist of a lump sum payment and an earn-out right consisting of payments which are typically contingent on the underlying performance of the asset. These arrangements are referred to as standard earn-out arrangements. Under these arrangements, the lump sum component may represent an undervalue of the asset and the purpose of the earn-out right is to increase the consideration where it transpires that the asset acquired in fact has a higher value, as evidenced by its performance following completion of the sale.
The other type of arrangement that the Discussion Paper deals with is the so called reverse earn-out arrangement. Under this arrangement, the Seller accepts consideration for an asset and undertakes to pay the Buyer an amount or amounts calculated by reference to the performance of the asset during a specified period after the completion of the sale. Payments will be triggered under a reverse earn-out arrangement if the initial consideration represented an over-valuing of the asset, as evidenced by the asset's post-completion performance.
From 20 May 1993 (when it was issued) to 17 October 2007 (when it was withdrawn), the Commissioner's views as to the taxation of earn-out rights were largely contained in TR 93/15W. This ruling dealt with the CGT consequences for both the Buyer and Seller under a standard earn-out arrangement.
TR 93/15W adopted a partial look-through approach to such earn-out arrangements, that is, a look-through for the Buyer only. Payments made by the Buyer were treated as being part of the Buyer's cost base of the original asset. However, the Seller was treated as receiving a separate asset, namely the earnout right, and the market value of which was treated as part of the consideration received from the sale. Any amounts received by the Seller under the earn-out right were treated as proceeds of disposal of the earn-out right, triggering CGT events (specifically, CGT event C2) unrelated to the disposal of the original asset. The Seller would make a capital gain or gains under such CGT event(s) to the extent that the amount(s) received exceeded the cost base of the right (being its estimated market value at the time of the original sale) and a capital loss to the extent that the amount(s) received were less than that cost base.
While it was not specifically dealt with in the ruling, separate asset treatment for the Seller meant the Seller's access to CGT concessions (such as the 50% CGT Discount, CGT Small Business Relief Measures, etc) (CGT Concessions) needed to be separately determined for the earn-out right.
TR 93/15W will remain relevant if proposed transitional arrangements are adopted (see below).
On 17 October 2007, the Commissioner released TR 2007/D10, which was to replace TR 93/15W, which was withdrawn on the same day. This ruling was to apply to both standard earn-out arrangements and reverse earn-out arrangements. Broadly, it treated the rights under such arrangements as separate assets from the underlying business asset for CGT purposes, for both Buyer and Seller.
In respect of the consequences for the Seller of receiving an earn-out right, the Commissioner's view remained unchanged from TR 93/15W. In addition, the Commissioner confirmed the separate asset treatment of the earn-out right on the basis that while the earn-out right is created by the original sale contract, its ending and any payments under it do not occur under that contract.
The consequences of this were that the CGT treatment of transactions effected under the original sale contract, including the availability of CGT Concessions, was not applicable to the payments made under the earn-out right. Any capital gains arising from receipt of payments under the earn-out right needed to qualify independently for any CGT Concessions under this separate asset treatment. In respect of CGT Small Business Relief measures, the Commissioner's view was that the earn-out right was not an 'active asset' and therefore these concessions would not apply to reduce any capital gains made on the earn-out right. In respect of the CGT discount, the earn-out right would need to be held for at least 12 months at the time of the payment for the capital gain to qualify for the discount. Further, any capital loss arising in respect of the earn-out right (because the payments received were less than the market value at the time of the original sale, including if the right expired without any payments becoming payable) would not be able to be offset against the capital gain on the original sale if the capital loss arose (i.e. payment was received or the right expired) in a later income year.
In respect of the consequences for the Buyer, the Commissioner's views in TR 2007/D10 were a departure from TR 93/15W. Under TR 2007/D10, only the market value of the earn-out right at the time of the sale was to be included in the Buyer's cost base for the asset any payments made under the earn-out right in excess of that market value would not be included in the cost base of the original asset. These payments would therefore need to qualify for recognition under other income tax provisions (such as the 5-year deduction for 'blackhole' expenditure in section 40-880 of the Income Tax Assessment Act (1997 Act)), if at all. Likewise, the cost base would not be reduced if the payments were less than that market value.
For the Seller, the estimated market value of the earn-out obligation was to be excluded from the capital proceeds from the sale. However, where payments exceeded that market value, there would not be any further reduction of the capital proceeds. The excess, unless it qualified for the deduction for blackhole expenditure, would have no tax effect, to the detriment of the Seller.3 Likewise, if the payments under the earn-out obligation were less than the market value, the capital proceeds would not be increased.
For the Buyer, the reverse earn out right was treated as a separate CGT asset acquired by the Buyer, with a cost base equal to so much of the original purchase price as is reasonably attributable to the acquisition of that right (that is, the estimated market value of the right at the time of the sale). The amount allocated to the earn-out right would not form part of the Buyer's cost base of the underlying business asset. Payments received by the Buyer in respect of the reverse earn-out right would trigger CGT event C2, with CGT consequences for the Buyer.4 A capital gain or capital loss would arise if the payments exceeded (in the case of a capital gain) or were less than (in the case of a capital loss) the cost base of the right.
Payments to the Buyer under the reverse earn-out would not be treated as a refund of the original purchase price paid and therefore would not attract the operation of the 'repaid rule' in section 116-50 of the 1997 Act (so as to reduce the Seller's capital proceeds) or the 'recoupment' rule under subsection 110-45(3) of the 1997 Act (so as to reduce the Buyer's cost base).
Broadly speaking, the proposal will treat additional payments under a standard earnout arrangement as:
Under reverse earn out arrangements, the payment will effectively be treated as a repayment of part of the capital proceeds for the sale of the original asset. This approach overturns the position adopted by the Commissioner in TR 2007/D10.
True to their description as a 'look through' approach, these proposals will treat earn-out rights and obligations for CGT purposes as part of the transaction effected by the original sale contract rather than as separate assets.5 In extending the look-through treatment to both Buyer and Seller, the proposals go further than the partial look-through treatment applied by the Commissioner in TR 93/15W.
Some consequences of this look-through approach are:
For standard earn-out arrangements, the 'cost recovery method' is proposed and for reverse earn-out arrangements, the 'repaid method' is proposed. These are discussed below.
The Discussion Paper describes the cost recovery approach as follows:
For the Seller, this approach aligns the timing of the Seller's tax liability with the timing of the receipt of payments. That is, all payments received by the Seller, including the initial capital proceeds and any subsequent payments under the earn-out right, will be applied against the Seller's cost base in the asset and, once the cost base has been reduced to nil, further payments will give rise to capital gains as and when they become payable (which capital gains will be entitled to any applicable CGT Concessions). It also means that the Seller cannot realise a capital loss until the end of the earn-out arrangement. The Discussion Paper says that this avoids the high compliance costs of amended assessments and is consistent with the deferred realisation of capital gains when the Seller makes an overall capital gain.6
For the Buyer, as payments are required to be made, its cost base in the acquired asset will increase.
Treasury has submitted some legislative approaches to implementing the look through approach, which include:
The Discussion Paper also considers some further scenarios arising from the future disposal by the Buyer of the business asset prior to the expiry of the earnout arrangement and asks for submissions in respect of the appropriate tax treatment in these circumstances.
For reverse earn-out arrangements, subsequent payments by the Seller to the Buyer will effectively be treated as a partial refund of the capital proceeds paid to the Seller.
For the Seller, each time a payment is made to the Buyer, the Seller's capital proceeds will be reduced, allowing the Seller to amend its capital gains calculation to reduce their capital gains proceeds from the disposal of the original asset as and whey it becomes obligated to pay an amount to the Buyer under the reverse earn-out arrangement.
For the Buyer, its cost base in the acquired asset will be decreased each time it becomes entitled to receive payments under the arrangement.
As with standard earn out arrangements, the Discussion Paper also considers some further scenarios which include the future disposal by the Buyer of the business asset prior to the expiry of the earn-out arrangement and asks for submissions in respect of the appropriate tax treatment in these circumstances.
These are arrangements which consist of both a standard earn-out arrangement and a reverse earn-out arrangement. The Discussion Paper seeks submissions on these arrangements but envisages that the cost recovery method will apply to the extent that the arrangement is a standard earn-out arrangement and the repaid method will apply to the extent that the arrangement is a reverse earn-out arrangement.
The proposed amendments will apply to all earn-out arrangements entered into after the date on which the relevant legislation is given Royal Assent. However, the following transitional arrangements are proposed:
In each of the above cases, it is not entirely clear what the treatment will be under the current law if the relevant choice is not made or not available, given that TR 93/15W has been withdrawn and TR 2007/D10 has not been finalised.
It is also intended that some specific 'integrity' measures accompany any legislated look through approach. Some specific measures referred to in the Discussion Paper include the following:
The proposed 'look through' approach is welcome and should prevent the anomalous tax consequences that the views in TR 2007/D10 would have produced. Like all tax legislation, the devil will be in the detail and we await the release of draft legislation.
1 Assistant Treasurer's Media Release No.098 of 12 May 2010
2 Capital gains treatment of earn out arrangements, Proposals Paper, May 2010.
3 The Commissioner's view was that CGT event D1 is not considered to happen on the basis that the 'borrowing money or obtaining credit' exception applies.
4 Section 104-70 of the 1997 Act.
5 As stated in the Discussion Paper (on page 3), 'The underlying principle of the lookthrough approach is to ignore the earn-out right and treat all payments as related to the sale (or purchase) of the original business asset'.
6 Discussion Paper, page 5.
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