A welcome change to the treatment of earnout arrangements

The release by Treasury of its Proposals Paper on the Capital Gains Tax (CGT) treatment of earnout arrangements is most welcome.  The changes outlined in the paper will result in a less complicated and fairer approach to the tax treatment of earnouts for taxpayers and will reduce the unnecessary compliance costs borne under the previous tax rules.

The look-through approach proposed by the paper is good news for both sellers and buyers.  As the look-through approach ignores the earnout right and treats all payments as related to the sale of the original asset, there would be no need to value the earnout in order to calculate the overall consideration on disposal of the original asset, thus reducing the complexity and compliance costs.

Impact on the seller

From a seller’s viewpoint, the capital gain or loss under a look-through approach would incorporate all earnout related payments in subsequent years, effectively ensuring that total capital proceeds (initial plus earnout) are compared to the asset cost base in determining whether a capital gain or loss is made on the sale of the asset. 

This is a much more sensible and equitable outcome compared to the current rules where any capital gain or loss from the earnout is calculated separately and a capital loss arising from an earnout in a later year could not be carried back and offset against a capital gain from the sale of the original asset.  In some instances, this has resulted in the seller being taxed on the full amount of the original capital gain but being unable to utilise any later capital loss on the earnout.

Another positive aspect for the seller from the look-through approach is that, where the capital gain on the sale is eligible for CGT small business concessions, these concession will now apply to the entire capital gain (original plus earnout), as opposed to the approach in the draft tax ruling which only allows the component of the capital gain related to the original sale to qualify for those concessions.  This is a common sense and practical outcome.

Impact on the buyer

From the buyer’s point of view, under the look-through approach the cost base of the asset purchased will include all payments made in respect of both the original purchase and any subsequent earnout payments.  Previously, the buyer’s cost base was limited to the initial proceeds on the sale plus the estimated market value of the earnout. 

Where there was any disparity between the earnout’s original market value and what was subsequently paid under the earnout arrangement, these amounts were not reflected in the cost base.  This meant that where subsequent amounts in excess of the earnout value were paid, these amounts did not qualify for any form of tax relief, and where lesser amounts were paid, the cost base was not adjusted to reflect the reduction.

There’s still work to be done

The potentially adverse impacts on both buyers and sellers discussed above have been largely rectified under the proposed look-through approach to earnouts and thus are a step in the right direction for taxpayers.

However, several important issues remain unresolved in the proposals paper.

For instance, there is still uncertainty about how the finalisation of Tax Ruling TR 2007/D10 will impact the changes outlined in the Proposals Paper.  As the documents have differing requirements, taxpayers are left in a position of uncertainty until both have been finalised. 

Furthermore, the proposals paper does not define “qualifying earnouts”.  It is important that further clarification is provided as to which earnouts fall within these rules to ensure that all appropriate arrangements are covered.

It is unclear whether sellers who have previously applied the rules in TR 2007/D10 to their earnouts will be able to go back and amend prior years tax returns to reflect the changes in the Proposals Paper. 

As they currently stand, the transitional provisions in the Proposals Paper allow buyers to apply the look-through approach to earnouts in the period between the release of TR 2007/D10 and the Proposals Paper but remain silent on whether sellers have the same opportunity.  It would seem that for equity and consistency the same treatment must be offered to all taxpayers.

So, while the proposed changes are a definite step in the right direction, we await further detail.

For more information on these changes and how they may effect you, contact your usual Grant Thornton advisor or the author of this article.

Author, Clive Bird, October 2010

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