Despite this delay, merger and acquisition (M&A) transactions still continue and taxpayers encountering various types of earnout arrangements need to be mindful of these changes.
What is an earnout arrangement?
Earnout arrangements are commonly used in the sale of a business where there is uncertainty about the future earnings of that business.
Typically the value of a business is determined by reference to those future earnings. As a result, and depending on the nature of the business, the (cautious) buyer is more likely to bid a lower amount and the (bullish) vendor is likely to have a higher price expectation. The earnout arrangement tries to resolve this impasse. The sale contract is drafted such that there is a payment of a lump-sum amount together with an entitlement to additional payments (or repayments) contingent on the subsequent performance of the business (this latter component being the earnout).
There are typically two types of earnouts:
- Standard earnout arrangement. This is where an income-earning asset is sold for consideration that includes a right to an amount calculated by reference to the earnings generated by the asset for a defined period following the sale. The seller also acquires a right to receive deferred, indeterminate amounts of money.
- Reverse earnout arrangement. This is a variant of the standard earnout arrangement and involves a seller agreeing to repay some of the original purchase price for the asset depending on the earnings it generates in the period following the sale.
We note that an “earnout arrangement” (which is contingent on earnings or profitability) is to be distinguished from a deferred settlement or instalment payment arrangement (which are not contingent). The comments below focus on the standard earnout arrangement.
How does the “old law” apply?
According to TR 2007/D10, which outlined the treatment of earnouts until the changes were announced last year, the capital proceeds for the vendor equal the lump-sum payment received, plus the market value of the earnout right.
For the purchaser under a standard earnout agreement, the cost base equalled the lump-sum payment made plus the market value of the earnout right. The purchaser does not take into account the amount actually paid under the earnout.
The following is an example of a standard earnout arrangement under TR 2007/D10.
Apple wishes to sell its restaurant, iEAT to PC. On 31 May 2009, Apple and PC agree to an initial payment of $500,000, with an earnout right for an additional $150,000 if the business makes a profit of at least $1,000,000 in the next 24 months. The payment of $500,000 is made before 30 June 2009.
The consideration for the sale will be $500,000 plus the market value of the earnout. The business valuer values the right to be worth $50,000 for both the vendor and the purchaser.
In this example, the capital proceeds for the vendor are $550,000 and are taken into account for the year ended 30 June 2009. The vendor will have to pay CGT on $550,000, $50,000 of which he has not yet received and may not receive if the business under-performs. Where Apple does not become entitled to the earnout amount in 24 months, it will realise a capital loss of $50,000.
Hypothetically if the deal is settled within 12 months, there may be no discount on the additional gains. Small business CGT concessions would not apply either as the contingent right would not be an “active asset”.
Interestingly, the purchaser is considered to have a cost base of $550,000, yet may end up paying $650,000. This amount is also recognised in the 2009 income year.
