New CGT treatment for qualifying earnout rights finally becomes law – how will the ATO administer these new rules?
Earnout rights, in the context of a sale of a business, generally involve the payment of additional consideration that is contingent on the future performance of the business.
On 25 February 2016, the Tax and Superannuation Laws Amendment (2015 Measures No. 6) Bill 2016, which was introduced into Parliament on 3 December 2015, received Royal Assent. This instrument changes the capital gains tax (CGT) treatment of earnout rights by introducing new look-through provisions. These provisions operate as follows:
- capital gains and losses made on the earnout rights are disregarded;
- for the purchaser, the value of an earnout benefit provided increases, retrospectively, the cost base or reduced cost base of the underlying asset acquired; and
- for the seller, the value of an earnout benefit received increases, retrospectively, the capital proceeds of the underlying asset disposed of.
Please refer to our previous publication for further details regarding earnout rights and the application of the new legislation.
It should be noted that the new rules only apply to capital gains. As such, they will not provide relief to taxpayers who hold their assets on revenue account – which could include some venture capitalists looking to turn-around and flip an investment for a profit. Nor will they apply to taxpayers who are subject to rules that deem their sale proceeds to be a dividend - for instance, off-market share buy-backs.
Given the long incubation process for these rules, and the various changes to their scope and application over the years, it is unsurprising that the ATO has provided taxpayers with guidance as to how it will administer the changes to the earnout rules.
Administrative treatment of the new earnout legislation by the ATO
Treatment of earnout rights created prior to 24 April 2015
The new legislation does not apply to earnout rights created prior to 24 April 2015.
However, for earnout rights which were created between 11 May 2010 and 23 April 2015, taxpayers are given the option of applying the proposed CGT treatment outlined in the original proposal paper issued by the Government in May 2010. The ATO will provide transitional protection to those taxpayers that acted in good faith in the anticipation of the proposed changes becoming law. This transitional protection operates by imposing a statutory bar on the ATO, preventing it from amending an income tax assessment to the extent that the assessment is consistent with the taxpayer’s reasonable anticipation of the changes to the law. However, if the taxpayer makes a statement for a later year of income that is inconsistent with this reasonable anticipation, this statutory protection will be lost.
Treatment of earnout rights created on or after 24 April 2015
The CGT treatment as provided by the Tax and Superannuation Laws Amendment (2015 Measures No. 6) Act 2016 applies to all qualifying earnout rights created on or after 24 April 2015, with the following allowances made to taxpayers to account for the differences between the draft legislation released on 23 April 2015, the Bill introduced into Parliament on 3 December 2015, and the Act commencing on 26 February 2016:
- for earnout rights created between 24 April 2015 and 3 December 2015, taxpayers may choose to apply the CGT treatment as outlined in the draft legislation, the Bill or the Act; and
- for earnout rights created between 3 December 2015 and the 26 February 2016, taxpayers may choose to apply the treatment as outlined in the Bill or the Act.
The differences between the draft legislation, Bill and finalised Act - while apparently minor - could result in significantly tax outcomes for vendors.
Treatment of earnout rights which do not satisfy the criteria under the new legislation
The new look-through CGT treatment will only apply to earnout rights which meet the qualifying criteria outlined in the Act (please refer to our previous publication for details of these criteria). For earnout rights which do not qualify under these criteria, taxpayers will instead be subject to the CGT treatment as outlined in the ATO Draft Tax Ruling TR 2007/D10.
Under this ruling, the market value of the earnout right must be brought to account at the time of the original sale. The earnout right is a separate CGT asset, and any amounts subsequently received from the earnout right give rise to separate CGT events at that later time.
Get in touch with us
If you’d like to discuss how the new earnout legislation may affect you or your clients, please feel free to give us a call.
This article was written with the assistance of Tim Hutton, Paralegal.
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