Edited version of private advice

Authorisation Number: 1051593712467

Date of advice: 15 October 2019

Ruling

Subject: Look-through earnout right qualification

Question 1

Will the look-through earnout provisions in Subdivision 118-I of the Income Tax Assessment Act 1997 (ITAA 1997) apply to the earnout payments payable under the Purchase Agreement (PA) entered into by the Trust?

Answer

No

Question 2

If the look-through earnout provisions in Subdivision 118-I of the ITAA 1997 do not apply to the earnout payments payable under the PA entered into by the Trust, will the value of those earnout payments at the time of entry into the PA form part of the capital proceeds received (or entitled to be received) by the Trust pursuant to section 116-20 of the ITAA 1997 in relation to the disposal of the assets?

Answer

Yes

Question 3

If the look-through earnout provisions in Subdivision 118-I of the ITAA 1997 do not apply to the earnout payments payable under the PA entered into by the Trust, will the subsequent provision of those earnout payments result in a CGT event C2 under section 104-25 of the ITAA 1997 for the Trust?

Answer

Yes

This ruling applies for the following periods:

Year ended 30 June 20XX

Year ended 30 June 20XX

Year ending 30 June 20XX

Year ending 30 June 20XX

Year ending 30 June 20XX

Year ending 30 June 20XX

Relevant facts and circumstances

In the year ended 30 June 20XX, the Trust entered into a Purchase Agreement (PA) under which it disposed of the assets relating to its business to X Pty Ltd (X). The assets were active assets just before their disposal.

The buyer (X) and the seller (the Trust) are unrelated and the transaction under the PA was at arm's length.

Under the PA, initial sale proceeds of approximately $y were paid to the Trust.

Following the sale, the Principals commenced employment with X.

Under the PA, earnout mechanisms are in place whereby certain conditions must be satisfied before the Principals qualify for the earnout payments.

Clauses in the PA defer earnout payments to a period ending more than 5 years after the income year in which the assets were disposed of if the Principals resign, have their employment terminated, or cease their employment with X for any other reason.

Relevant legislative provisions

Income Tax Assessment Act 1997, paragraph 35-55(1)(a)

Income Tax Assessment Act 1997, section 104-10

Income Tax Assessment Act 1997, section 104-25

Income Tax Assessment Act 1997, paragraph 104-25(2)(a)

Income Tax Assessment Act 1997, paragraph 104-25(2)(b)

Income Tax Assessment Act 1997, subsection 112-30(1)

Income Tax Assessment Act 1997, subsection 112-30(3)

Income Tax Assessment Act 1997, subsection 112-30(4)

Income Tax Assessment Act 1997, section 116-20

Income Tax Assessment Act 1997, Subdivision 118-I

Income Tax Assessment Act 1997, subsection 118-565(1)

Income Tax Assessment Act 1997, paragraph 118-565(1)(a)

Income Tax Assessment Act 1997, paragraph 118-565(1)(b)

Income Tax Assessment Act 1997, paragraph 118-565(1)(c)

Income Tax Assessment Act 1997, paragraph 118-565(1)(d)

Income Tax Assessment Act 1997, paragraph 118-565(1)(e)

Income Tax Assessment Act 1997, paragraph 118-565(1)(f)

Income Tax Assessment Act 1997, paragraph 118-565(1)(g)

Income Tax Assessment Act 1997, paragraph 118-565(1)(h)

Income Tax Assessment Act 1997, subsection 118-565(3)

Income Tax Assessment Act 1997, paragraph 118-565(3)(a)

Income Tax Assessment Act 1997, section 152-40

Income Tax Assessment Act 1997, paragraph 152-40(1)(a)

Income Tax Assessment Act 1997, paragraph 152-40(1)(b)

Income Tax Assessment Act 1997, section 974-160

Reasons for decision

All legislative references are to the ITAA 1997.

Question 1

Summary

The look-through earnout provisions in Subdivision 118-I do not apply to the earnout payments payable under the PA entered into by the Trust.

Detailed reasoning

Subsection 118-565(1) states that a look-through earnout right is a right for which the following conditions are met:

(a)  the right is a right to future financial benefits that are not reasonably ascertainable at the time the right is created;

(b)  the right is created under an arrangement that involves the disposal of a CGT asset;

(c)  the disposal causes CGT event A1 to happen;

(d)  just before the CGT event, the CGT asset was an active asset of the entity who disposed of the asset;

(e)  all of the financial benefits that can be provided under the right are to be provided over a period ending no later than 5 years after the end of the income year in which the CGT event happens;

(f)   those financial benefits are contingent on the economic performance of:

(i)    the CGT asset; or

(ii)   a business for which it is reasonably expected that the CGT asset will be an active asset for the period to which those financial benefits relate;

(g)  the value of those financial benefits reasonably relates to that economic performance;

(h)  the parties to the arrangement deal with each other at arm's length in making the arrangement.

Future financial benefits that are not reasonably ascertainable: paragraph 118-565(1)(a)

Section 974-160 provides that 'financial benefit' means anything of economic value, and includes property and services. Under the PA the earnout payments are a 'financial benefit'.

The Explanatory Memorandum to the Tax and Superannuation Laws Amendment (2015 Measures No. 6) Bill 2015 (the EM), which was enacted as Tax and Superannuation Laws Amendment (2015 Measures No. 6) Act 2016, and inserted Subdivision 118-I into the ITAA 1997, states that 'in most cases, the fact that financial benefits are contingent will mean that they are also reasonably unascertainable'. Where there is little or no doubt that the contingent or future events will transpire and the quantum of the payment is fixed or can be reasonably determined, the benefit can be reasonably ascertained.

Under the PA, the Trust will be entitled to the earnout payments if certain conditions are met.

The earnout payments are financial benefits that are not reasonably determinable and are contingent on future events which are not certain to transpire. It is therefore accepted that the earnout payments are not reasonably ascertainable and that the condition under paragraph 118-565(1)(a) is satisfied.

Created under an arrangement that involves the disposal of a CGT asset: paragraph 118-565(1)(b)

The earnout right was created pursuant to the terms of the PA which resulted in the disposal of CGT assets.

It is accepted that the earnout right was created under an arrangement to dispose of a CGT asset and that the condition under paragraph 118-565(1)(b) is satisfied.

CGT event A1 happens: paragraph 118-565(1)(c)

CGT event A1 under section 104-10 happened in respect of the CGT assets sold in accordance with the PA and the condition under paragraph 118-565(1)(c) is satisfied.

The CGT asset was an active asset of the entity who disposed of the asset : paragraph 118-565(1)(d)

Paragraph 152-40(1)(a) provides that a CGT asset is an active asset at a time, if at that time you own the asset (whether the asset is tangible or intangible) and it is used in the course of carrying on a business carried on by you (or an affiliate or a connected entity). Paragraph 152-40(1)(b) provides that an intangible asset will also be an active asset if you own it and it is inherently connected with a business that is carried on by you (or an affiliate or a connected entity). Note 3 to section 152-40 states that goodwill is an asset that is inherently connected with a business.

The assets disposed of under the PA were active assets of the Trust and the condition under paragraph 118-565(1)(d) is satisfied.

All financial benefits that can be provided under the right are to be provided over a period of 5 years: paragraph 118-565(1)(e)

The CGT event happened in the 2018 income year (the income year ended 30 June 2018). The five year period in which the financial benefits can be provided will end on 30 June 2023.

Clauses in the PA defer earnout payments by 5 years or more if the Principals resign, have their employment terminated, or cease their employment with X for any other reason.

Subsection 118-565(3) states that for the purposes of paragraph (1)(e), in working out the period over which financial benefits under a right can be provided, disregard any part of an arrangement that allows for an entity to defer providing such a financial benefit if:

(a)  the deferral is contingent on an event happening that is beyond the control of the parties to the arrangement; and

(b)  the deferral cannot change the amount of any financial benefit provided, or to be provided, under the right; and

(c)  when the arrangement is entered into, the contingent event is not reasonably expected to happen.

The PA provides that the earnout payments are deferred for more than 5 years or more. Such a deferral would mean that the earnout payments impacted will be provided after 30 June 2023.

The word "control" is defined in the Macquarie dictionary as "to exercise restraint or direction over; dominate; command".

The non-commercial losses provisions of the ITAA 1997 contain the phrase "outside the control of the operators". Paragraph 35-55(1)(a) provides that the business activity was or will be affected in the excluded years by special circumstances outside the control of the operators of the business activity, including drought, flood, bushfire or some other natural disaster. These events are akin to what are usually included in a force majeure clause.

Resigning or being terminated from their employment are not considered to be events that are "beyond the control" of the parties to the PA. The ending of a Principal's employment due to any reason other than those events may well include reasons which are not "beyond the control" of the parties to the PA. The condition in paragraph 118-565(3)(a) is therefore not satisfied.

As a result, it is not accepted that all of the financial benefits that can be provided under the PA are to be provided over a period of no more than 5 yearsafter the end of the income year in which the CGT event happened, and the condition under paragraph 118-565(1)(e) is not satisfied.

The financial benefits are contingent on the economic performance of the CGT asset or a business for which the CGT asset will be an active asset: paragraph 118-565(1)(f)

The EM states that for financial benefits to be contingent on the economic performance of a particular business or asset, the benefit must be linked to a reasonable measure of the performance of the business or asset. Appropriate measures include financial measures such as profit, sales or turnover of the business.

Entitlement to the financial benefits under the PA are contingent on certain conditions following the sale. These certain conditions are considered to be an appropriate measure of the economic performance of the business.

It is accepted the financial benefits are contingent on the economic performance of a business for which the CGT asset will be an active asset and the condition under paragraph 118-565(1)(f) is satisfied.

The value of those financial benefits reasonably relates to that economic performance: paragraph 118-565(1)(g)

The EM states that the financial benefit must be a reasonable estimate of economic performance. The value of the financial benefits must not be out of all proportion to the benefits that could have been reasonably expected to result from the performance. The value of the financial benefits must also be related to the contingency to which the financial benefit is linked.

The Trust will only be entitled to the earnout payments if certain conditions are met, and the amount of the earnout payments are scaled based on what conditions are achieved.

It is accepted that the value of the financial benefits are reasonably related to the economic performance and the condition under paragraph 118-565(1)(g) is satisfied.

The parties to the arrangement deal with each other at arm's length: paragraph 118-565(1)(h)

The Trust and X have no connection with each other, other than as seller and buyer under the PA. It is accepted that the parties to the PA were dealing with each other at arm's length in making the earnout arrangement and the condition under paragraph 118-565(1)(h) is satisfied.

Conclusion

The look-through earnout provisions in Subdivision 118-I do not apply to the earnout rights under the PA entered into by the Trust as the PA enables financial benefits to be provided over a period greater than 5 years after the end of the income year in which the CGT event happened.

Question 2

Summary

As the look-through earnout provisions in Subdivision 118-I do not apply to the earnout payments payable under the PA entered into by the Trust, the value of those earnout payments at the time of entry into the PA form part of the capital proceeds received (or entitled to be received) by the Trust pursuant to section 116-20 in relation to the disposal of the assets.

Detailed reasoning

As Subdivision 118-I does not apply to the earnout arrangement, Draft Taxation Ruling TR 2007/D10 Income Tax: capital gains: capital gains consequences of earnout arrangements (TR 2007/D10) applies to the earnout arrangement.

TR 2007/D10 provides that under section 116-20, an earnout right is not an entitlement to money for the purposes of calculating the seller's capital proceeds from CGT event A1, but 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 includes the market value of that earnout right (worked out at the time of the CGT event).

An earnout arrangement is not merely a mechanism by which the parties agree to set an appropriate amount of compensation for the assets delivered in the contract. The deferred payments are not, as a matter of substance, made in respect of the acquisition of those assets.

They are paid in respect of a separate obligation under which the seller stands to make a financial gain depending on the economic performance of an asset which the seller has ceased to own. In these circumstances, the CGT provisions recognise that what the buyer has given in respect of the acquisition of the original asset is property in the form of a promise to pay an indeterminate amount of money. Similarly, the CGT provisions recognise that the seller has received property in the form of a right to receive an indeterminate amount of money.

Under the PA there are earnout payments These earnout payments together form part of the purchase price of the assets. It is considered that these are part of a single CGT asset comprising the totality of the rights under a single contract.

The Trust will need to determine the market value of the earnout payments at the time the PA was executed. This market value will form part of the capital proceeds received (or entitled to be received) by the Trust in relation to the disposal of the assets.

Question 3

Summary

As the look-through earnout provisions in Subdivision 118-I do not apply to the earnout payments payable under the PA entered into by the Trust, the subsequent provision of those earnout payments will result in a CGT event C2 under section 104-25 for the Trust.

Detailed reasoning

Generally, 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, or by expiring without any amounts becoming payable. In each of these situations, CGT event C2 under section 104-25 (about cancellation, surrender and similar endings) happens.

The contract for the sale of the original asset for an earnout right is not a 'contract that results in the asset ending' under paragraph 104-25(2)(a). Accordingly, under paragraph 104-25(2)(b), the time of the CGT event is when the right ends and not before.

Where an earnout is discharged progressively in instalments, the CGT treatment will differ depending on the circumstances of the payments. In some circumstances, it will be appropriate to regard each right to an instalment as a separate CGT asset. In others, it may be more appropriately characterised as part of a single CGT asset comprising the totality of rights under a contract covering both the sale of the original asset and of the earnout arrangement.

The totality of rights under a contract is generally regarded as a single asset for CGT purposes. However, this is ultimately a question of fact to be determined on a case by case basis.

Where the rights to progressive payments are part of a single CGT asset comprising the totality of the rights under a single contract, CGT event C2 happens to part of it at the time specified for each payment (other than the final payment). The seller's cost base for the part of the right to which the event happens is apportioned according to the formula in subsection 112-30(3). Under subsection 112-30(4), the remainder of the cost base after each payment is made is attributed to the part of the asset that remains.

Where each right to a progressive payment under the earnout arrangement is a separate CGT asset, the seller is required to determine the cost base of each separate right when it is acquired. Under subsection 112-30(1), the first element of the cost base of each right is that part of the expenditure that relates to its acquisition.

Under the PA there are earnout payments. These earnout payments together form part of the purchase price of the assets.

It is considered that the earnout payments are part of a single CGT asset comprising the totality of the rights under a single contract. As each earnout payment is paid, CGT event C2 happens to part of the single CGT asset at the time specified for each earnout payment. The cost base for the part of the right to which the event happens is apportioned according to the formula in subsection 112-30(3). Under subsection 112-30(4), the remainder of the cost base after each payment is made is attributed to the part of the asset that remains.

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