Typically, an earnout is an extended payment to the vendor post the deal closing, based on actual future earnings of the asset acquired, rather than the predicted. Earnout arrangements are a well-known way of pricing the sale of business where there is uncertainty about value.
The good news is that in many instances, tax law allows taxpayers to treat payments received under a qualifying look through earnout right as related to the original asset and therefore as part of the capital proceeds received by the seller and the cost base for the buyer. Importantly, this allows sellers to defer the taxing point of earnout arrangements until such time as the cash payment subject to the earnout right is actually received. Also, importantly, it allows sellers to ensure that any amounts received from the earnout rights are able to qualify for the same CGT concessions that were applicable to the original business sale.
However, please note that not every earn out arrangement qualifies as an eligible look through earn out right. Specifically, to qualify for deferral as discussed above, the right to future payments must be contingent on – and reasonably related to – the future economic performance of the asset, and cannot extend beyond a period of five years. In this regard, there may be situations where future payments are made contingent on, for example, key-person retention which may not qualify for tax deferral under the look through approach.
Therefore, taking a proactive approach to earnout clauses when negotiations are underway is crucial, and care must be taken to ensure that any earnouts not only achieve the commercial objectives of vendors and buyers, but also maximize their after tax outcomes. As tax advisors, the earlier that we can be involved in reviewing draft term sheets and/or sale documentation allows us to ensure that the parties to the transaction are not left with nasty and unintended tax consequences subsequent to the transaction.