Private ruling: CGT - earnout arrangements
Date of advice: 26 November 2015
Published: February 2016
Ruling period: Year ended 30 June 2014
Date scheme commenced: 1 July 2013

Ruling: Q1: Will the payment of the 'earn out amount' to the Trust result in a capital gain or loss from a separate CGT event to the original disposal of the business? | A1: Yes | Q2: Will any capital gain that arises from the payment of the 'earn out amount' to the Trust be a gain from an active asset that is eligible for the small business concessions? | A2: No | Q3: Will the 'acquisition bonus' payments be ordinary income? | A3: No | Q4: Will the 'acquisition bonus' payments result in a capital gain or loss? | A4: Yes

Relevant facts and circumstances: The Trust the Agreement. The Trust agreed to sell the assets of the business (including goodwill) to the purchaser under the Agreement. The vendors also entered into a Facilities and Services Agreement with the purchasers. The 'acquisition bonus' clause in the Agreement requires the purchasers to pay a proportion of any increases in the cash flow derived by the purchasers each anniversary year until just time that the Facilities and Services Agreement is terminated or expires. Any 'acquisition bonus' payment is adjusted in years that an 'earn out amount' is paid. The Agreement provides how the 'acquisition bonus' and earn out amount' payments are to be calculated. The Trust received $X as an 'earn out amount' under the Agreement.

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 104-25 | Income Tax Assessment Act 1997 Paragraph 116-20(1)(a) | Income Tax Assessment Act 1997 Division 152

Reasons for decision: Summary: Draft Taxation Ruling TR 2007/D10 addresses the consequences of earnout arrangements. A standard earnout arrangement is any transaction in which an income-earning asset (often a business asset) is sold for consideration that includes the creation of an 'earnout right' in the seller of the asset. An earnout right is a right to an amount calculated by reference to the earnings generated by the asset for a defined period following the sale. It is to be distinguished from a right to a sum in respect of that sale which is certain as to amount and as to receipt, in terms of paragraph 116-20(1)(a) of the Income Tax Assessment Act 1997 (ITAA 1997). TR 2007/D10 provides that the earnout right is not an entitlement to money for the purpose of calculating the seller's capital proceeds from capital gains tax (CGT) event A1. An earnout right is 'other property' received by the seller in respect of the disposal of the original asset. Accordingly, the seller's capital proceeds from that event include the market value of that right (worked out at the time of the CGT event). The 'look-through' approach is also discounted under TR 2007/D10 which provides that any payment made in relation to the earnout right cannot be treated as being in respect of the original asset. 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. In each of these situations CGT event C2 under section 104-25 of the ITAA 1997 will happen. Where the original assets provided by the seller under an earnout arrangement satisfy the conditions for the small business concessions in Division 152 of the ITAA 1997, capital gains made by the seller in relation to the CGT A1 event may be reduced by one or more of the concessions contained in that Division. However, relief under Division 152 of the ITAA 1997 is only available for gains made in respect of 'active assets' as defined in section 152-40 of the ITAA 1997. An earnout right can not satisfy the definition of 'active asset' under section 152-40 of the ITAA 1997. This is because: • an earnout right is not used, or held ready for use, by the seller in the course of a carrying on a business by the seller or by a small business affiliate thereof (paragraph 152-40(1)(a) of the ITAA 1997) • an earnout right is not an intangible asset inherently connected with a business carried on by the seller or a small business affiliate thereof (paragraph 152-40(1)(b) of the ITAA 1997); and • an earnout right is in the nature of a 'financial instrument' and is excluded from the definition of 'active asset' by the exception in (paragraph 152-40(4)(d) of the ITAA 1997). | Detailed Reasoning - Earn out amount: In this case, the Trust disposed of the business assets. Although not listed in the purchase price, the Agreement provided the vendors with rights to receive future payments under the earn out clause. The nature of the arrangement is such that the taxation of the additional payment received by the Trust on 1 November 2013 may be calculated in accordance with the standard earnout arrangement as described in TR 2007/D10. The right to receive the 'earn out amount' was acquired by the Trust at the time the contract for the Agreement was signed. At this time the cost base will be calculated on a reasonable basis. The payment will not be subject to a 'look through' approach in relation to the original disposal of the business assets. Instead, these proceeds will be in respect of the newly created earnout rights and will be assessed in the year of receipt; CGT event C2 being the relevant event. As the right to receive the 'earn out amount' is not an active asset, the Trust cannot apply the small business concessions in relation to the C2 event. | Detailed Reasoning - Acquisition bonus payments: Similarly, under the Agreement, the vendors have received rights to payments under the 'acquisition bonus' clause. This right was also acquired by the Trust at the time the Agreement was signed. We consider that these payments are also considered payments under a standard earnout arrangement described in TR 2007/D10. Accordingly, 'acquisition bonus' payments received by the Trust will not be considered ordinary income, rather they will be capital proceeds from CGT event C2, the disposal of the rights acquired under the Agreement. Subsequently the CGT events resulting from the 'acquisition bonus' payments will not be eligible for the small business concessions.