Issue 9 : CGT consequences of earnout arrangements
A draft ruling was issued by the Commissioner on 17 October 2007 that deals with the CGT consequences of standard and reverse earnout arrangements (TR 2007/D10).
What are earnout arrangements?
A standard earnout arrangement is any transaction in which an income-earning asset (often a business or the underlying business-owning assets, such as shares in a company which is carrying on a business) is sold for consideration that includes the creation of an “earnout right” in the seller of the asset. This is a right to an amount calculated by reference to the earnings generated by the asset for a defined period following the sale (generally a period of between one and five years).
A reverse earnout arrangement is a contract for the sale of an asset in which the seller accepts a nominated sum by way of consideration, but undertakes to pay an amount or amounts (post-sale payments) to the buyer, calculated by reference to the earnings generated by the asset during a specified period after completion of the sale.
In a reverse earnout, the earnout right is the buyer’s right to a post-sale payment, whereas, in a standard earnout, the earnout right is the seller’s right to the possibility of a post-sale payment.
Standard earnout arrangement consequences
The seller
From the seller’s perspective under a standard earnout arrangement, the earnout right is not an entitlement to money for the purposes of calculating the seller’s capital proceeds from the happening of CGT event A1 (the sale of the asset). It is “other property ... received” by the seller in respect of the disposal of the asset sold (sec 116-20(1) ITAA 1997). This means that the seller’s capital proceeds from the event include the market value of the right (worked out at the time of the CGT event). It is not possible for the seller to “look through” the earnout right and to treat any payments made in relation to it as capital proceeds in respect of the disposal of the asset sold.
The earnout right is property (and, therefore, a CGT asset) in the hands of the seller. It commences to be owned and is acquired (for CGT purposes) at the time when the contract for the sale of the original asset is made. The first element of the cost base of the earnout right is that part (which may be all) of the market value of the asset sold which is given by the seller in exchange for the earnout right as is reasonably attributable to its acquisition (sec 112-30(1) ITAA 1997).
Generally, the seller’s ownership of an earnout right will come to an end when satisfied by the payment of an amount or amounts by the buyer, or by expiring without any amounts becoming payable. In each of these situations, CGT event C2 (cancellation, surrender and similar endings) happens. The contract for the sale of the original asset for an earnout right is not a “contract that results in the asset ending”, which means that the time of CGT event C2 is when the right ends and not before.
Where an earnout is discharged progressively in instalments, the CGT treatment will differ depending on the circumstances of the payments. In some circumstances, it will be appropriate to regard each right to an instalment as a separate CGT asset. In others, it may be more appropriately characterised as part of a single CGT asset (comprising the totality of the rights under the contract) that covers both the sale of the original asset and the earnout arrangement. The totality of rights under a contract is generally regarded as a single asset for CGT purposes. However, this is ultimately a question of fact to be determined on a case by case basis.
Where the rights to progressive payments are part of a single CGT asset (comprising the totality of the rights under a single contract), CGT event C2 happens to part of it at the time specified for each payment (other than the final payment). The seller’s cost base for the part of the right to which the event happens is apportioned (according to the formula in sec 112-30(3) ITAA 1997). The remainder of the cost base after each payment date is attributed to the part of the asset that remains (sec 112-30(4) ITAA 1997).
Where each right to a progressive payment under the earnout arrangement is a separate CGT asset, the seller is required to determine the cost base of each separate right when it is acquired. The first element of the cost base of each right is ascertained in accordance with sec 112-30(1) ITAA 1997.
Availability of small business concessions
An earnout right is not an “active asset” and a capital gain arising from the happening of a CGT event in relation to it is ineligible for the small business CGT reliefs. The capital gain may qualify for the CGT discount capital gain concession if the seller is an individual or a trust.
The buyer
From the buyer’s perspective, the creation of an earnout right in the seller under a contract of sale is the giving of property by the buyer for the purposes of the CGT cost base rules. Accordingly, when a buyer acquires a CGT asset in exchange for the granting of an earnout right, the first element of the buyer’s cost base of the asset includes the market value of the right (worked out at the time of acquisition) (sec 110-25(2) ITAA 1997).
A buyer who has created an earnout right is not required to pay “money” for the purposes of the cost base rules. Further, any money which is paid (pursuant to the earnout arrangement) is not paid to acquire the original asset, but is paid to discharge the buyer’s obligation under the earnout arrangement.
CGT event D1 does not happen
When creating the earnout right, the buyer is considered to be “borrowing money or obtaining credit” from the seller. This means that CGT event D1 (creating contractual or other rights) does not happen as a result of the creation of an earnout right in the seller (sec 104-35(5)(a) ITAA 1997).
Reverse earnout arrangement consequences
The seller
From the seller’s perspective, a right created by the seller in the buyer to a post-sale payment or payments (a reverse earnout right) is granted “by way of borrowing money or obtaining credit” (sec 104-35(5)(a) ITAA 1997). Accordingly, CGT event D1 does not happen, although a reverse earnout right is nevertheless created by the seller in the buyer.
It follows that the initial payment received by the seller under a reverse earnout arrangement is received in connection with a transaction that relates to a CGT event (the disposal of the original asset) and “something else” (the creation of the reverse earnout right in the buyer).
The seller’s capital proceeds from the CGT event exclude so much of the payment as is reasonably attributable to the granting of the right (sec 116-40(4) ITAA 1997).
The buyer
Under a reverse earnout arrangement, the buyer acquires a CGT asset in the form of the reverse earnout right. The buyer’s cost base for this CGT asset is so much of the original purchase price that is reasonably attributable to the acquisition of the right (sec 112-30(1) ITAA 1997).
When an amount becomes payable in respect of the right or part of the right (or when the right or part of the right expires with no amount being payable), CGT event C2 (cancellation, surrender and similar endings) happens to the right or relevant part. The buyer’s capital proceeds from the CGT event will generally be the amount payable by the seller under the reverse earnout arrangement.
It is not possible for the buyer to “look through” the reverse earnout right in order to treat the amounts paid to satisfy the right as being relevant solely to the calculation of the first element of the cost base of the original asset.
Application of the “repaid rule” and recoupment provision to reverse earnout arrangements
A payment made by the seller to the buyer pursuant to a reverse earnout arrangement is not a refund of part of the purchase price. It is properly characterised as an amount paid to discharge an independent obligation created by the seller’s promise to pay an amount to the buyer calculated by reference to the earnings of the asset. Accordingly, a payment made by a seller pursuant to a reverse earnout arrangement:
- does not attract the operation of the “repaid rule” in sec 116-50 ITAA 1997 and, therefore, does not bring about a reduction in the seller’s capital proceeds from the original sale;
- does not give rise to a capital loss for the seller (no CGT event happens to any CGT asset of the seller); and
- is not a “recoupment” of the buyer’s expenditure under sec 110-45(3) ITAA 1997.
