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Figuring it out

Feature Articles

Cite as: (2008) 82(4) LIJ, p. 44

Buyer and seller beware: the tax laws relating to earnout arrangements and issuing shares for assets are complex.

By Reynah Tang and James Farrell

In two recent draft taxation rulings,[1] the Commissioner of Taxation (Commissioner) has outlined his views in relation to the tax treatment of earnout arrangements and the consequences of issuing shares for assets. As the tax consequences can depend on the manner in which asset or share sale and purchase arrangements are documented, it is important for commercial lawyers to be aware of the issues in order to advise their clients appropriately.

What are earnout arrangements?

Standard “earnout arrangements” involve a purchase of a business or shares (i.e. dealing with income-producing assets) where the consideration for the purchase is a payment plus a future payment or payments usually conditional on, and calculated by reference to, the future earnings of the business. Conceptually, the future payment or payments are seen as a “right” in themselves, i.e. a right to payments if certain hurdles are met.

Both standard earnout arrangements and “reverse earnout arrangements” are discussed in TR 2007/D10. A reverse earnout arrangement involves an upfront payment to the vendor where the purchaser obtains a right to refunds from the vendor if the earnings of the assets do not meet specified thresholds.

Often the valuation of the goodwill of a business is difficult to quantify, with vendors tending to “overvalue” goodwill and purchasers having more sanguine views. Earnout and reverse earnout arrangements can bridge the gap by protecting the vendor, who is rewarded if the business is as successful as suggested during pre-contractual negotiations, and also protecting the purchaser who pays an appropriate price if the business is unable to maintain its performance post-sale.

CGT consequences of earnout arrangements

The Commissioner’s view is that earnout arrangements involve two separate assets for capital gains tax (CGT) purposes, one being the actual asset sold (original asset) and the other being the earnout right, which is a proprietary legal right to future payments.

CGT consequences of sale and purchase of the original asset under a standard earnout arrangement

In determining the capital gain (or loss) derived by the vendor on the sale of the original asset, the capital proceeds must be calculated by reference to the ordinary capital proceeds rules,[2] and will be the sum of any upfront cash payment and the market value of the earnout right. Determining the market value of an earnout right may be complex, with the value likely to depend on the quantum of the payments and their timing, the preconditions to payment and the likelihood the preconditions will be satisfied.

The purchaser’s cost base arising on acquisition of the original asset is determined under the ordinary cost base rules,[3] and will be calculated on a similar basis to that adopted by the vendor in establishing the capital proceeds. This is a significant departure from the Commissioner’s previous position, where it was accepted that all of the consideration provided by the purchaser was monetary and so could be reflected in the purchaser’s cost base for the original asset based on what was actually paid.[4]

CGT consequences of payments under standard earnout arrangements

If the preconditions are satisfied and the vendor receives an earnout payment, it will give rise to CGT event C2,[5] being the termination of a legal right (or part thereof).[6] The capital proceeds will generally include the amount of the earnout payment received by the taxpayer, and the cost base of the earnout right will have been determined by the valuation of the earnout right (at the time of sale of the original asset), together with any costs associated with creating that right.

For a vendor, an earnout arrangement could potentially defer CGT to the extent that the earnout payment(s) exceed the value of the earnout rights at the time they were granted.

However, the Commissioner considers that unlike the original asset, no small business concession will be available to shelter any capital gain on disposal of the earnout right. Further, if the right to the earnout is acquired and disposed of (i.e. by satisfaction) within 12 months, no CGT discount[7] is available.

When acting for a purchaser, lawyers need to be cognisant of the fact that the Commissioner considers that the buyer will not obtain any cost base for the original asset to the extent the earnout payments exceed the value of the earnout rights when granted. It remains unclear whether a purchaser will be entitled to a deduction for this difference under capital allowance rules or if it is simply “black-hole” expenditure. Of course, it is possible that the market value of the earnout right at the time it is granted exceeds the earnout payments subsequently made. In such a case, it would seem that no reduction is made to the cost base of the original asset in the hands of the purchaser.

CGT consequences of reverse earnout arrangements

The use of reverse earnout arrangements is less common, but may provide an alternative method to effect the client’s desired commercial outcome. These are addressed in the ruling and give rise to a range of different, but equally complex, CGT issues, which must be considered.

Issuing shares for assets

For various commercial reasons, companies will often wish to issue new shares as consideration when purchasing assets. In TR 2008/D1, the Commissioner considers the tax consequences for a company of issuing shares for assets in a range of circumstances, with the result depending on the nature of the asset acquired.

Revenue assets

In the Commissioner’s view, the issue of shares as consideration for the purchase of revenue assets (such as trading stock disposed of in the ordinary course of business) does not give rise to a loss or outgoing, and thus there is no deduction available to the company. This is because, while the shares will provide value to the vendor, they do not involve any expenditure or loss of value to the company.[8]

Importantly, however, the Commissioner will accept that there is a loss or outgoing where there is a clear monetary obligation which is set-off against an independent and countervailing obligation of the vendor to subscribe for shares in the vendor company. The ruling provides guidance as to when the Commissioner will accept this as being the case.

Trading stock

Where a vendor sells a business to a purchaser, the disposal of any associated trading stock will usually be outside the ordinary course of the vendor’s business. In this scenario, the vendor will be treated as disposing of, and the purchaser will be treated as having bought, the trading stock for its market value.[9]

This will solve any difficulties for the purchaser that has issued shares for the trading stock, but may potentially lead to other issues if there is a discrepancy between the market value of the shares issued by the purchaser and the market value of the trading stock sold by the vendor.

Depreciable assets

When a company issues shares for depreciable assets (e.g. motor vehicles, plant and equipment), the market value of the shares will be considered to form part of the cost of the assets to the company for the purposes of the tax depreciation regime.[10]

It is important to note that the value at which the shares are recorded in the accounts of the company will not necessarily be the same as the market value of the shares, and cannot be treated as evidence of that value. Therefore, a valuation may be required.

CGT assets

Similarly, the Commissioner now accepts[11] that the provision of shares as consideration for assets is recognised for the purposes of the cost base rules in the CGT legislation.[12] Therefore, the market value of the shares will be a component (generally the first component) of the cost base of the assets, unless the parties are not dealing at arm’s length, in which case the market value of the assets may be substituted.[13]


The use of earnout arrangements and the issue of shares as consideration for the purchase of assets are quite common in commercial sale and purchase transactions. As the commentary above reveals, the tax implications can be complex and require careful consideration in light of the views expressed by the Commissioner in the draft rulings. Relevantly, the fact that a client may be receiving advice from an accountant in relation to the transaction will not necessarily absolve the legal practitioner from responsibility to address the tax issues in preparing the relevant sale or purchase documentation.[14]

As these are only draft rulings, the LIV Taxation and Revenue Committee will be making submissions to ameliorate some of the adverse effects of these rulings. Practitioners should monitor Friday Facts and the LIV Commercial Law Section Updates for developments in this regard.

REYNAH TANG is a partner in the taxation group at Corrs Chambers Westgarth and an LIV Councillor. He regularly publishes articles and presents seminars on tax issues. JAMES FARRELL is a lawyer in the taxation group at Corrs Chambers Westgarth.

[1] Draft Taxation Ruling TR 2007/D10: Income tax: capital gains: capital gains tax consequences of earnout arrangements) and Draft Taxation Ruling TR 2008/D1: Income tax: tax consequences for a company of issuing shares for assets.

[2] Refer to Division 116 of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997).

[3] Refer to Division 110 of the ITAA 1997.

[4] Taxation Ruling TR 93/15.

[5] Section 104-25 of the ITAA 1997.

[6] Where earnout rights involve several instalment payments following settlement of the sale transaction, these may be characterised as a single asset or multiple assets for CGT purposes, depending on the contractual arrangements. The practical consequences of treating the earnout instalments as one asset (with instalments being a disposal of “part” of that asset) is that it becomes necessary to “apportion” the cost base to the separate instalments.

[7] 50 per cent in the case of an individual or trust, or 33¹/³ per cent in the case of a superannuation fund. No CGT discount is available for companies.

[8] Although it seems clear that there is a loss of value to the company’s shareholders.

[9] Refer to s70-95 of the ITAA 1997.

[10] Refer to s40-185 of the ITAA 1997.

[11] Compare the former view expressed at para 27 of TR 93/15, which is withdrawn by the Commissioner in TR 2008/D1.

[12] Note 2 above.

[13] Section 116-30 of the ITAA 1997.

[14] Hurlingham Estates Ltd v Wilde & Partners (1996) 37 ATR 261; Bayer v Balkin 95 ATC 4609; EVBJ Pty Ltd v Greenwood 88 ATC 4977.


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