On 23 April 2015, the Government released eagerly anticipated Exposure Draft legislation which proposes to amend the capital gains tax (CGT) treatment of payments made under earnout arrangements.
Since the release of Draft Taxation Ruling TR 2007/D10, which stated that earnout rights should be valued as separate CGT assets and included in the capital proceeds/cost base of assets, the treatment of earnouts has remained uncertain. The approach taken in TR 2007/D10 has proven to be problematic and results in increased tax payable by a seller on amounts that ultimately may never be received.
The ‘look-through’ approach proposed by the Exposure Draft recognises that an earnout is a contingent payment reflecting the value of a business that may only be quantified at a later date. Accordingly, under the proposed amendments, each time an amount becomes payable under a ‘qualifying earnout,’ it will be added to the cost base/capital proceeds of the purchaser/vendor. Tax will therefore only be payable once the deferred consideration is payable. In a tax consolidated context, this would mean that the purchaser’s allocable cost amount calculation will need to be reviewed each time an element of an earnout is paid.
Under the proposed legislation, the sale of depreciating assets and non-active assets will be excluded, as will earnouts that extend past 4 years and earnouts that are contingent on turnover/non-profit based metrics.
The amendments will apply to earnout arrangements entered into after 23 April 2015. Taxpayers who have reasonably and in good faith taken positions in anticipation of the amendments based on the 2010 Federal Budget announcement which proposed the changes will not be amended by the Commissioner.
KPMG is currently examining the draft legislation and is participating in the consultation process with Treasury. In particular, the definition of a ‘qualifying earnout’ under the ED is complex, especially in the context of a share (rather than asset) disposal. The tax treatment of earnouts that are not ‘qualifying’ also needs to be confirmed (i.e. would the taxpayer be required to apply TR 2007/D10?).
The closing date for submissions on the draft legislation is 21 May 2015.