Tax things to know when selling a business.
This is a very confusing and stressful time for both buyers and sellers of a business. No two buts about it. Add tax complications and you’ll think you are in a Zombie movie, with sleepless buyers and sellers wandering the streets – probably looking for donuts and almond croissants if you are in Melbourne! Don’t think so? Here’s one for the ages. Wrap your head around this one.
Capital Gains Tax (CGT)
CGT makes the worst friend on its best days. Here, even more so. Let’s talk about earnout arrangements. Typically involving the sale of a business for a predetermined sum along with a percentage of future profits over a defined period. The tax treatment of these future income rights has undergone several modifications over time. The most recent alteration was introduced by the Tax and Superannuation Laws Amendment (2015 Measures No 6) Act 2015 (referred to as the legislation), which incorporated new provisions into the Income Tax Assessment Act 1997 (ITAA 97) effective from April 24, 2015.
Under the current rules, capital gains and losses arising from look-through earnout rights are no longer taken into account. Instead, payments received or made within the earnout arrangements impact the capital proceeds and cost base of the underlying asset or assets associated with the earnout arrangement.
This taxation treatment of earnout rights results in a potential adjustment to the capital gain or loss recorded during the initial sale of business assets due to the financial benefits received or provided in subsequent income years.
Here’s a rephrased version of the example from the explanatory memo of the legislation:
Anna completed the sale of all the shares in her company, ABC Co, to Purple Ltd in March 2016. The sale agreement entailed Anna receiving an initial payment of $1 million at the time of the sale and the right to receive two future payments of up to $100,000 each in March 2017 and March 2018, provided that ABC Co’s turnover exceeded specific thresholds in 2016 and 2017, respectively. This entitlement to future income is categorized as a look-through earnout right.
For the purposes of calculating the capital proceeds from the share sale, Anna’s capital proceeds are determined as $1 million, which corresponds to the total of the upfront payment she received. Even though Anna also received the right to future payments, which would typically be included in the capital proceeds, the value of this right is disregarded due to it being a look-through earnout right.
Given that Anna’s cost base for the ABC Co shares is $600,000, the capital gain she realizes from the sale is $400,000 (capital proceeds of $1 million minus the cost base of $600,000) as of the time of the sale.
In 2016, ABC Co’s turnover exceeded the agreed-upon threshold, leading Purple Ltd to make an additional payment of $100,000 to Anna. Consequently, the capital proceeds from the original share sale are adjusted to $1.1 million, comprising the initial $1 million payment and the $100,000 payment Anna received in March 2017. This results in a capital gain of $500,000 (capital proceeds of $1.1 million minus the cost base of $600,000) due to the sale.
Subsequently, in July 2017, Purple Ltd opted to terminate the arrangement prematurely. They proposed to pay Anna $50,000 in exchange for her agreement to waive her right to further payments under the look-through earnout right, and Anna accepted this offer.
The financial benefit provided to terminate the look-through earnout right is treated in the same manner as a financial benefit provided under the right itself. Consequently, Anna’s total capital proceeds from the sale amount to $1.15 million, comprising the initial $1 million payment, the subsequent $100,000 payment under the earnout right, and the $50,000 payment for terminating the earnout right.
Anna’s final capital gain resulting from the sale totals $550,000 (capital proceeds of $1.15 million minus the cost base of $600,000). It’s important to note that this gain is considered to have arisen in March 2016, at the time of the original Capital Gains Tax event, necessitating an amendment to her return for that year.
In accordance with Section 118-565 of the Income Tax Assessment Act 1997 (ITAA 97), a look-through earnout right must meet the following criteria:
- It must be established as part of an arrangement related to the sale of a business or its assets, resulting in the occurrence of Capital Gains Tax (CGT) event A1.
- The right should entail future financial benefits that cannot be reasonably determined at the time of its creation.
- The financial benefits associated with the right should be contingent upon and reasonably linked to the future economic performance of the asset or a related business, with the value of these benefits being reasonably tied to this performance.
- It should be formed as part of agreements entered into on a fair and equitable basis.
- All financial benefits that can be provided under the right must be delivered within a period not exceeding five years from the conclusion of the income year in which the relevant CGT event is triggered due to the disposal of the pertinent active asset. The five-year requirement will be violated if the agreement includes provisions for extending the duration of financial benefit provision or for entering into a new agreement that continues to provide substantially similar financial benefits.
Choices and choices – what tax treatment to pick?
As previously mentioned, the tax treatment of earnout rights can lead to changes in the calculation of capital gains or losses due to financial benefits received or provided in subsequent income years. Consequently, specific provisions have been incorporated into the Income Tax Assessment Act 1997 (ITAA 97) to ensure that taxpayers are not unfairly disadvantaged and to minimize unnecessary compliance and administrative burdens.
Since these financial benefits may extend up to five years after the conclusion of the income year in which the Capital Gains Tax (CGT) event occurred, it’s possible that the review period for the relevant income year has lapsed before the taxpayer has either received or provided the financial benefits, necessitating an amendment. Consequently, the review period is extended for all tax-related liabilities that could be impacted by the nature of the look-through earnout right. This extension persists until the later of:
- The standard review period that would typically apply, and
- Four years after the conclusion of the final income year in which financial benefits can be provided.
This extension also encompasses taxpayers’ rights to file objections if they are dissatisfied with an assessment.
GENERAL INTEREST CHARGE (GIC) AND SHORTFALL INTEREST CHARGE (SIC)
Taxpayers will not incur a General Interest Charge (GIC) for any shortfall arising from financial benefits received or provided under a look-through earnout right, provided they request an amendment to their income tax assessment within the deadline for lodging their income return for the relevant income year when the financial benefit occurred. Likewise, the Commissioner will not owe any interest on tax overpayments stemming from such financial benefits.
In cases where taxpayers have accessed concessions for which they are ultimately ineligible due to these financial benefits, they will be subject to a Shortfall Interest Charge (SIC).
TEMPORARY DISREGARD OF LOSSES
In instances where entities dispose of assets and receive a look-through earnout right, initially resulting in a capital loss position, these capital losses will be considered as “temporarily disregarded” until they become certain.
However, once these losses become certain, they will be accessible from the year in which the loss initially occurred, rather than when the amount became certain. Here’s a rephrased version of the example from the explanatory memorandum of the legislation:
In June 2016, Lucas sold the shares of his business, Software Enterprises Ltd, which was classified as a small business entity with primarily active assets, to Buyer Co.
Lucas received a fixed upfront payment of $750,000 and acquired multiple entitlements to future payments through various look-through earnout rights, contingent on the achievement of various profit and performance targets by Software Enterprises.
Considering that Lucas had an initial cost base of $800,000 for the shares, at this point, he incurred a capital loss of $50,000. However, since Lucas had the potential to receive further payments exceeding $50,000 under the look-through earnout rights, he must disregard this loss.
During the 2016-17 fiscal year, Lucas received additional payments totaling $250,000 under these look-through earnout rights. These payments were included in the calculation of the capital proceeds from the sale of Software Enterprises shares, resulting in Lucas receiving a total of $1 million and realizing a capital gain of $200,000. This gain increased his income tax liability for that fiscal year.
Simultaneously, when Lucas filed his tax return for the 2016-17 year, he also requested an amendment to his assessment for the 2015-16 income year to incorporate the additional capital gain resulting from the payments under the rights. As a result, he is exempt from incurring a shortfall interest charge on any additional tax owed for the 2015-16 year due to this amendment. Essentially, he is in a similar position as if the payment had been subject to taxation in the year it was received.
In June 2020, Lucas received a final payment of $100,000 under the look-through earnout rights. Like previous payments, this amount was included in the capital proceeds from the sale. Lucas then requested an amendment to his income tax assessment for the 2015-16 year to reflect the increased capital gain of $300,000.
Typically, an individual like Lucas, who did not meet the conditions for an extended amendment period, would only be able to amend their assessment for the 2015-16 year within two years from the date of the original assessment. By June 2020, this time frame would have passed.
However, in this particular case, the Commissioner may still amend Lucas’s assessment in relation to the payment, as it constitutes a financial benefit under a look-through earnout right that impacts the amount of Lucas’s income tax liabilities for the year in which the sale occurred. The amendment request was made within four years of the end of the income year in which the final potential financial benefit under the right was supposed to be provided.
ACCESS TO CGT CONCESSIONS
The tax treatment of look-through earnout rights has implications for a taxpayer’s eligibility for Capital Gains Tax (CGT) concessions. This can occur because the value of the underlying disposal now encompasses all the amounts provided for and under the earnout right.
As a result, taxpayers should reconsider their choices and entitlements to concessions in light of subsequent receipts and payments. This ensures that any resulting gain, loss, or cost base accurately reflects the available concessions.
In some scenarios, a taxpayer may not initially be able to elect that a concession applies to a CGT event. Alternatively, a taxpayer may be concerned that anticipated future financial benefits related to a look-through earnout right could disqualify them from a concession after they have taken irreversible actions based on that concession, such as making superannuation contributions. In such cases, taxpayers can choose to wait until it becomes clear whether they will ultimately qualify for the concession before making any decisions.
It’s important to note that while the receipt of financial benefits under a look-through earnout right may allow taxpayers to revisit their choices, it does not grant them the ability to undo actions taken during that period. For example, if taxpayers have made superannuation contributions to access a concession, they cannot withdraw these contributions once they are no longer eligible.
Furthermore, certain CGT small business concessions may have specific timeframes for compliance (e.g., the CGT small business retirement exemption often requires taxpayers to contribute a specified amount to their superannuation upon receiving proceeds or when making a choice for an individual, or within seven days after these times for a trust or company). In such cases, the timeframe for accessing these concessions is appropriately extended.
If you have read any of my content, you know the following. That this article provides general information only and does not offer recommendations or advice tailored to individual circumstances. To make informed decisions, it is advisable to consult with a registered tax professional i.e. reach out to me? Maybe we can help? Save you a few hundred thousand dollars? Who knows? For a $300 consult, you could do worse.
Taxes are out to get you. Time to take precautions.