It was announced in the recent Australian Federal Budget (11 May 2010) that there would be a change to the way in which capital gains tax applies to earnout arrangements.
What’s an earnout arrangement? This is usually encountered in sale of business situations where the parties to the contract either cannot agree on a value or are uncertain about the value of the business. Typically, a lump sum amount is paid with a further amount to be paid if the business performs to certain pre-agreed levels. For example, a business may be sold for $500,000 plus 5% of the sales for the next 12 months. There are many variations of these arrangements.
What’s the problem?
On 17 October 2007, the Australian Taxation Office (“ATO”) released a Draft Taxation Ruling TR 2007/D10 on this topic. The ATO considered that the contingent, earnout component of the consideration for the sale of the business was a separate asset from the underlying business. The earnout component was seen by the ATO as the vendor disposing of a right to an uncertain amount of money. In addition, the vendor was also selling the actual assets of the business (for example the goodwill) for any amount that was certain in the consideration.
This interpretation created problems. First, the value of the earnout had to be determined in order to determine the capital gain that related to that earnout. In most situations this is quite difficult to do as, of necessity, one must predict the future. Second, the earnout component was not something to which the small business capital gains tax concessions could apply. This was because the earnout right was not an “active asset”.
The law is to be changed to what is referred to as a “look through” approach. This means that the law will look through to the underlying transaction – the sale of the business assets – and deal only with those assets and not treat the earnout arrangement as a separate asset.
The new law will apply from the date that it receives Royal Assent. This is after the law passes both houses of parliament and the Governor-General signs it into law.
However, Senator Nick Sherry, the Assistant Treasurer, has released a proposals paper on the topic. The purpose of this paper is to consult with the business community about the changes. The closing date for submissions is 11 June 2010. In this paper some transitional provisions are announced. Taxpayers will have the choice to apply the look-through treatment entered into between the date of announcement and Royal Asset (inclusive). Also the buyer in a standard earnout arrangement will have the choice to apply the new treatment for arrangements entered into on or after 17 October 2007.