The proposed look-through treatment for earnouts
On 12 May 2010, the Assistant Treasurer announced a “look-through” treatment for earnouts, which is aimed at simplifying their tax treatment.
A “look-through” treatment looks at the underlying business asset. From a vendor’s perspective this makes it clear that all amounts received (whether at the time of completion or at a later time) are capital proceeds that are taken into account when calculating the taxable capital gain. Where it is a reverse earn-out, a vendor’s proceeds are the amount received at completion less any payments made under the reverse earnout.
Therefore under a standard earnout arrangement, the seller reduces the cost base of the asset being sold as and when the earnout amounts they are due to receive become certain (that is, the taxpayer is entitled to receive the amount). After the cost base is reduced to zero, the seller realises a capital gain on all further amounts. This ensures that the seller’s capital proceeds for the sale of the business asset reflect the total amount received.
Any capital gain is treated as realised on the business asset and is eligible for any CGT concessions that were available for that asset. This is a significant improvement to the old law.
For the buyer, payments are included in the asset’s cost base as and when the buyer pays them. This ensures that the cost base reflects the actual amount paid for the asset.
Returning to the earlier example of a standard earnout arrangement, under the proposed new law the following would apply:
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 business does make the required $1,000,000 and XYZ pays $150,000 to Apple on 31 May 2011. This means that the overall capital proceeds for the vendor, Apple will be $650,000. $500,000 of this amount will be recognised in the year in which it is received (that is, the year ended 30 June 2009) and the balance of the payment, that is $150,000 will be recognised in the following year (the year ended 30 June 2011).
The cost base for the purchaser will be $650,000 recognised as and when the amount is paid.
Sealing off loopholes
We should also add that the proposed amendments are only intended to apply to what are described as “genuine” earnouts. Therefore, integrity rules have been proposed to minimise the exploitation of the “look through” treatment. These integrity rules provide:
- a maximum time limit for the earnout arrangement
- payments must be genuinely contingent and related to the performance of the asset
- the earnout right must exist due to uncertainty about the value of one or more of the assets
- the transaction must be at arm’s length
- the asset(s) is not a revenue asset or trading stock.
When can you apply the proposed law?
The amending legislation has still not received Royal Assent, so the old laws are still in place.
According to the announcement made by the Tax Office as recently as 4 May 2011, they will give taxpayers the transitional choice to apply the new look-though treatment for earnout arrangements entered into between 12 May 2010 and the date of Royal Assent of amending legislation. Furthermore, buyers in a standard earnout arrangement will have an option to apply the proposed treatment for transactions entered into on or after 17 October 2007 (ie allowing them to increase the cost base of their assets where the payments exceed the value of the earnout right previously brought to account).
The Tax Office will accept returns as lodged until the amending law is enacted and will not review assessments until the outcome of the proposed amendment is known. Any taxpayers that use the transitional arrangements are asked to review their tax positions once the outcome of the proposed amendment is known, as the Tax Office will be waiving certain penalties if taxpayers actively seek to amend their assessments within a reasonable timeframe.
Disclaimer
The views in this article are those of the authors and do not represent the views of Deloitte Private or Deloitte Touche Tohmatsu or any of its related practice entities. This article is provided as general information only and does not consider anyone’s specific objectives, situation or needs. You should not rely on the information in this document.
