New CGT rules when selling or buying a business
Recent changes were made to the CGT treatment on the sale and purchase of businesses involving ‘look-through earnout’ rights.
On 25 February 2016, a new law was enacted to deal with the tax treatment of earnouts for vendors and purchasers.
An earnout is an arrangement, usually entered into on the sale of an asset or business, where rights to future financial benefits are linked to the performance of an asset or assets on sale. It is commonly used where the parties cannot agree on the value of an asset or business.
Not all earnout arrangements will qualify for the CGT look-through treatment under the new law.
The ATO considers a right as a 'look-through earnout right' if:
- it is created on or after 24 April 2015
- the right is to future financial benefits, which cannot be reasonably ascertained at the time the right was created
- the right was created under an arrangement involving the disposal (CGT event A1) of a CGT active asset of the seller
- all financial benefits under the right are provided within five years, from the end of the income year in which the CGT event occurred
- the financial benefits are contingent and relate to the future economic performance of the CGT asset or a business for which it is expected that the CGT asset be an active asset
Under the new law, the changes to CGT treatment of ‘look-through earnout rights’ include:
- capital gains and losses arising in respect of look-through earnout rights are disregarded;
- for the purchaser, any financial benefit provided (or received) under a look-through earnout right increases (or decreases) part of the cost base or reduced cost base of the underlying asset; and
- for the vendor, any financial benefit received (or provided) under the lookthrough earnout right increases (or decreases) the capital proceeds for the underlying asset.
- he arrangement must be dealt with on an arm’s length basis.
It is important to note that this new law does not apply to earnout arrangements entered into prior to 24 April 2015. However, transitional protection is provided to taxpayers that have reasonably and in good faith anticipated the changes to the tax law in this area as a result of the announcement by the former government.
The new law also has implications for entitlements to the small business CGT concessions as they can now be revisited as and when payments under the earnout are received.