There is often a higher level of uncertainty associated with the buying and selling of small and medium sized businesses. Owners wonder whether they are getting enough and purchasers if they are paying too much. These concerns are frequently allayed now by structuring the sale transaction around "Earnout Rights".
What are Earnout Rights?
An earnout arrangement is an arrangement whereby as part of the sale of a business or the assets of a business, the buyer and seller agree that subsequent financial benefits may be provided, based on the future performance of the business or the related business in which the assets are used.
In a standard earnout arrangement, the buyer agrees to pay the seller additional amounts if certain performance thresholds are passed within a particular time. In a reverse earnout arrangement, the seller agrees to repay amounts to the buyer if certain performance thresholds are not passed within a particular time. Some earnout arrangements combine the features of both a standard earnout and a reverse earnout as both the buyer and seller may be obligated to provide financial benefits dependent on performance.
Earnout arrangements are commonly used in the sale of businesses where there is difficulty agreeing about the value of the business due to difficulty determining its future economic performance. In this situation, to allow the parties to agree on a price, the earnout arrangement ties additional financial benefits (or, for a reverse earnout, refunds of prior financial benefits) to the future performance of the business.
For example, if two parties are negotiating the sale of the business where a significant part of the value of the business is tied to its customer base (accounted for as goodwill) there is considerable uncertainty about how the sale and other factors may impact upon this goodwill. The parties could agree to a price based on the best available estimate of the businesses’ value, but there would be a significant chance that the estimate will be incorrect in a material way. Alternatively, the parties could agree to an earnout arrangement under which part of the consideration for the sale was linked to the future economic performance of the business. This avoids the need to rely on an estimate by linking financial benefits to the ascertainment of future events.
The CGT Implications of Earnout Rights
Understandably, receiving the proceeds from selling a business triggers a series of CGT event with income tax implications.
Since 2007, where the sale of a business involved an earnout arrangement, the earnout right or rights that were created were treated as separate CGT assets. Where an earnout right was provided by the buyer to the seller in relation to the disposal of a business (a standard earnout arrangement) the earnout right would be property the seller received in relation to the disposal and formed part of the capital proceeds of the disposal. Where a right was provided from the seller to the buyer (a reverse earnout arrangement), the right was an additional asset being provided along with the other business assets and the capital proceeds needed to be apportioned between the creation of the right and the sale of the business other assets.
This distinction was very significant because the CGT concessions that often applied to the sale of business assets would often not apply to the amounts paid for or received as a consequence of that right.
The recent changes
However, recent changes to the law now require a 'look-through' CGT treatment for certain earnout rights created on or after 24 April 2015, which satisfy the criteria of a ‘look-through earnout right’.
Put simply, the look through approach means that the taxation outcome associated with the sale or purchase of a business should be consistent with what would have arisen had the benefits of the earnout right been included in the seller's capital proceeds or buyer's cost base in the first place.
Therefore, under this new law:
The ATO has provided an updated CGT Guide which provides further information on these changes, and in particular, more specific guidance on what transactions come under these new laws.
This can be accessed on the ATO website here.
Bruce Mulvaney is a Fellow Chartered Accountant and Turnaround and Insolvency Practitioner operating from Melbourne's eastern suburbs. He is a past State Chairman and National Board Member of the Institute of Chartered Accountants in Australia.
He is freely available to business groups and industry associations for speaking engagements.
This article is obviously not intended to provide specific business or investment advice and no responsibility is accepted for any loss arising from reliance on this material. Readers should formally obtain specific independent advice before making any business or investment decision.