Tax confusion down under

Changes to taxation of earn-outs in Australia is still causing uncertainty for private fund professionals, writes tax lawyer Toby Eggleston.

Private equity funds will sometimes use an earn-out to bridge the gap between buyer’s and seller's views on value of the target. However, since the Australian Tax Office issued a draft tax ruling in 2007, the taxation implications of earn-outs in Australia has been unclear from both a buyer's and seller's perspective.

From the seller's perspective, under the draft ruling the seller's capital gain was calculated by the reference to the cash proceeds on completion plus the market value of the earn-out, based on the likelihood of the earn-out being paid out. The earn-out right is considered a separate asset for the purposes of the CGT rules. When the earn-out is paid out, the seller then has a separate CGT event.

From the buyer's perspective, the buyer's cost base similarly comprises the cash proceeds on completion plus the market value of the earn-out. The tax treatment for the buyer of the actual payout of the earn-out is unclear.

The effect of the draft ruling was that the seller will attribute a low value to the earn-out right so that they only pays tax on the earn out when the cash is received. Conversely, the buyer wants to attribute a high value to the earn-out right so the maximum amount is included in the buyer's cost base. This doesn’t make any sense –  the parties use an earn-out because the seller thinks the target is worth more than the buyer.

This tax uncertainty has hindered the use of earn-outs as the tax position of the buyer and seller is open to review by the ATO.

The proposed new rules will apply a “look through” perspective for “qualifying earn-outs.” This means that the seller will treat any earn-out payment as referable to the capital gain or loss from the sale of the target and the buyer will include the actual amount paid under the earn-out in the cost base. These new rules will apply to earn-outs created on or after April 23 2015 even though the rules have not yet been finalized.

These changes should remove tax as an impediment for the use of earn-outs that meet the qualification criteria. However, the definition of a qualifying earn-out is not straightforward and will probably require private equity funds to obtain advice on whether these new rules will apply. For example, an earn-out will only qualify if it is in respect of an Australian company and the target must satisfy an “active asset” test.

In the end, if the earn-out doesn't meet the qualifying criteria, the parties are back into the uncertainty caused by the draft ruling.

Toby Eggleston is a Melbourne-based director at law firm Greenwoods & Herbert Smith Freehills.