The purpose of this article is to set out the capital gains tax ("CGT") implications of a standard earnout arrangement as stipulated in the new Draft Taxation Ruling TR 2007/D10 ("the Draft Ruling").

1. Background
The Australian Taxation Office ("ATO") has recently released the Draft Ruling to express its views on how to treat an earnout arrangement for tax purposes when the capital proceeds contains a deferred component that is payable contingent on a certain level of earnings being met. An earnout right is not considered to be an entitlement to money by the ATO since the amount to be paid is not ascertainable at the time of sale of the business. The ATO considers the earnout right to be the provision of property to the seller.

On that basis, we comment on the CGT implications of a standard earnout agreement in the table overleaf. 
 

	Seller	Buyer
Sale of asset	Capital proceeds = cash received + market value of earnout right.	Cost base = Cash paid + market value of earnout right.
Earnout right	Cost base = market value of earnout right.	No creation of contractual right and therefore no CGT event.
Payment(s)	Separate CGT event. Capital gain/loss will arise depending on whether payment(s) is/are higher than the relevant cost base.	No subsequent implication for the original asset.
Valuation of earnout right	Market value of business acquired less cash paid/payable on disposal; or Amount equivalent to market value of the right. Tip: A low valuation will minimise capital gain at the time of disposal (i.e. defer tax).	Market value of business acquired less cash paid/payable on disposal; or Amount equivalent to market value of the right. A high valuation will give the buyer a higher cost base.
Consolidation	N/A	The buyer is entitled to push down the whole cost base of the shares acquired irrespective of whether the deferred amount is actually paid.

2 Planning Opportunity

Once finalised, the Ruling will apply to arrangements carried out both before and after the date of issue of the Ruling. However, if the outcome under this Ruling is less favourable for any existing arrangement as at the date of the issue, the taxpayer may still apply the preceding Ruling.

2.1 Implication for the buyer
It is our view that the new Draft Ruling would provide a favourable outcome to the buyer where the market value of the earnout right is greater than the actual earnout payments made. This means that the buyer will have a higher cost base compared to the amount that was actually expended.
The above potential benefit may also come in handy for a tax consolidated group, where the market value of the earnout right could be pushed down to the underlying assets of the Target companies and the earnout amount is not paid or the amount paid is less than the market value to the right.

We have set out below comparative scenarios to demonstrate how this works in relation to a tax consolidated group.
 

	Prior Draft Ruling position	Post Draft Ruling position
Cash payment	$20m	$20m
Deferred consideration	$15m	$15m
Tax cost setting	$20m is allocated at first instance	$34m is allocated*
Payment	Tax cost setting amount to be re-adjusted for deferred consideration paid .	No re-adjustment irrespective of whether the profit target has been made or not..
Net position (assuming profit target not met)	$20m allocated to asset cost base.	$34m allocated to asset cost base.

* Assuming that the market value of the right is $14m.

However, the Draft Ruling is currently silent on the situation where the amount eventually paid exceeds the market value of the right. It would be arguable in this case that the difference could be deducted as a black-hole expense over 5 years if the relevant conditions are satisfied.
Please contact Tim Olynyk or Daren Yeoh if you want to discuss the Draft Ruling or any tax structuring issues on (03) 9614 4444.