Reverse Earnouts

The current ATO view is set out in draft Taxation Ruling TR 2007/D10, which of course provides protection from interest and penalties only, and not from primary tax (assuming that ruling protection is available: refer Bellinz –v- FCT (1998) FCR 154.

The draft ruling has been the subject of extensive criticism from the tax profession. The result of that is that the Public Rulings Program of the ATO is considering issuing another version of the draft ruling on the topic before proceeding to finalise it. So the shelf life of these comments may only be a few months.

The old ATO view which is set out in TR 93/15 is, from a vendor’s perspective, not very different to the new position set out in the draft. From the vendor’s point of view, what is new is the treatment of “reverse earnout” arrangements.

TR 2007/D10 introduced the concept of a “reverse earnout”. That is explained as being:

4. A reverse earnout arrangement is a contract for the sale of an asset in which the seller of an asset accepts a nominated sum by way of consideration, but undertakes to pay an amount or amounts (post-sale payments) to the buyer calculated by reference to earnings generated by the asset during a specified period after completion of the sale.

5. In a reverse earnout, the earnout right is the buyer’s right to a post-sale payment whereas, in a standard earnout, the earnout right is the seller’s right to the possibility of a post-sale payment.

An example of a reverse earnout is given:

9. The following is a simplified example of a typical reverse earnout arrangement:

• A seller wishes to dispose of all the shares in a company which owns and operates a business;
• The seller considers that the market value of the shares is $600,000. This valuation is based on projections that the business will generate sales of $450,000 per annum;
• A potential buyer considers that the shares are worth an amount somewhere in the range of $400,000 to $600,000. The buyer agrees to pay $600,000, but wants an undertaking from the seller to pay him or her subsequent amounts on terms that will take into account the performance of the business in the succeeding two years;
• The parties enter into a contract in which:

1. The buyer agrees to pay $600,000 consideration for the shares; and
2. The seller agrees to pay the buyer 50% of the amount (if any) by which the business turnover falls below $450,000 in each of the two years following the sale, and
3. In the next two years, the gross annual business sales of the business are $425,000 and $435,000 respectively. Accordingly, the seller is required to pay to the buyer $12,500 at the conclusion of the first year and $7,500 at the conclusion of the second year.

Prior to TR 2007/D10, while the term “reverse earnout” was not in wide use, the common view was that any amounts repaid to the purchaser fell under the repaid rule in s116-50, and accordingly were excluded from being “capital proceeds”. That has now changed.

The creation of a reverse earnout by the vendor is exempt from CGT event D1 applying.

The vendor’s capital proceeds received on the sale of the underlying assets excludes the reasonable amount allocated to the granting of the reverse earnout right.

Any payments actually made under a reverse earnout do not reduce the consideration paid for the assets, as the payment is made in respect of the separate reverse earnout asset. No CGT event happens to the Vendor whether or not a payment is made and whether or not the reverse earnout right simply expires without having effect. This may lead to anomalous results, depending on the quantum of any reverse earnout paid and the market value of the obligation assumed.

Example

Ms Z sells the shares in her company, Z Pty Ltd to Mr Y for a purchase price of $500,000. Mr Y is unsure that the company is able to meet the financial forecasts and requires a reverse earnout arrangement as part of the sale transaction.

Under that reverse earnout, Ms Z will repay 50% of the amount by which Z Pty Ltd fails to meet earnings forecasts over the next two years.

Assume that the reverse earnout right has a market value of $100,000 at the time it is given.

Accordingly, Ms Z only makes a capital gain of $400,000 ($500,000 capital proceeds less $100,000 market value of reverse earnout).

In fact Z Pty Ltd exceeds its earnings targets, due to a newly resurgent economy. In this case Ms Z has made an economic gain of $500,000 but has only been subject to tax on $400,000.

However, if payments of $150,000 had been required to be made, the opposite economic effect would occur: Ms Z would be subject to tax on $400,000 but only have made an economic gain of $350,000.

Issues for the Buyer – reverse earnouts

In the case of a reverse earnout, it is now the buyer who may make a capital gain or loss under CGT event C2 depending on the quantum of payment and the market value of the right acquired.   This capital loss may be carried forward indefinitely.

Avoiding Earnouts and Reverse Earnout issues

It is possible draft around the earnout issues by simply providing that the purchase price is $X, payable in instalments, with one instalment at completion and others post-completion. The purchase price is then adjusted by reference to a formula, with this formula essentially mimicking an earnout arrangement.

Any decreases to the purchase price are applied against the subsequent payments (which as a result may never occur). It may be that the purchase price cannot be less than the completion instalment of the price.

This leaves a taxpayer perhaps little worse at the beginning (as the tax is payable on the highest possible figure) but it is subject to adjustment in later years. Any pre-CGT status of assets is retained, as is access to the small business CGT concessions.

It also enables access to the Division 115 discount where an earnout period is within 12 months of the date of execution of the sale contract.