By Isobel Feben, Lawyer

The value of a business is inherently uncertain, and depends on the future financial performance of the business. Purchasers, particularly in the private business space, often insist on structuring a business acquisition so that part of the purchase price is contingent upon the future financial performance of the business (i.e. an Earnout).

Earnouts – ATO and Government Uncertainty

Earnouts are popular. However, the Capital Gains Tax (CGT) treatment has been volatile for almost 10 years, due to various ATO and Government pronouncements. This has caused numerous problems for vendors, purchasers and their respective professional advisers.

Earnouts – New Rules Now Apply

On 22 February 2016, new Earnout Rules came into effect. The Rules apply to Earnouts entered into from 24 April 2015. Under the new Earnout Rules, there are two vastly different methods of treating Earnouts for CGT purposes:

“The Opaque Method”

• Earnout treated separately from business (with separate CGT consequences)
• Earnout must be valued upfront (note: often problematic in practice)
• Further CGT consequences when the Earnout is paid (or not paid)

“The Transparent Method”

• Earnout not treated separately (i.e. CGT dealt with as part of the business sale)
• No CGT consequences until the time that the Earnout must be paid

Which method produces a better tax outcome?

Both the “transparent” method and the “opaque” method are complex. Generally, the transparent method produces a better tax outcome (e.g. access to small business concessions and pre-CGT exemptions). However in some circumstances the “opaque” method may produce a better tax outcome.

Do I have a choice on which method to use?

For Earnouts entered into before 24 April 2015, taxpayers had a degree of flexibility on which method applied. Under the new Earnout Rules, the specific terms of the Earnout dictate which method applies. To qualify for the “transparent” method under the new Earnout Rules, the Earnout must satisfy a number of complex requirements. When considering an Earnout, professional advice should be sought to ensure that the desired tax treatment applies. Naturally we can advise on all tax and commercial issues that are associated with Earnouts.