On Monday 3.12.18, the ATO issued a Discussion Paper for comment on Issues concerning earnout arrangements (excluding arrangements that create look-through earnout rights).

‘Earn-out’ arrangements usually involve the grant of a right (or multiple rights) to one or more future payments which are contingent on future events in connection with the business. The quantum of the payments may also be unascertainable at the time the right is granted.

Introduction (from the Discussion Paper)

1. The Board of Taxation is currently conducting a post-implementation review of the tax treatment of contingent consideration (including earnouts). In light of the Board’s review, the ATO is seeking your feedback on the need and priority for additional public advice and guidance on the income tax treatment of arrangements (commonly referred to as ‘earnouts’) outside the ‘look through’ approach that applies under subdivision 118-I of the ITAA97.

2. On 26 February 2016, Legislation amended the ITAA97, to insert subdivision 118-I, to allow this ‘look-through’ CGT treatment for qualifying earn-out arrangements (as defined) in the sale of business assets. This allowed was designed to avoid stifling business, by allowing taxpayers to ignore (or ‘look through’) the earn-out rights created (or those created on or after 24 April 2015). An overview of this approach is provided by s118-560, which is set out below.

Object of Subdiv 118-I

118-560(1)  –  This Subdivision and its related provisions set out special rules for *look-through earnout rights. The object of these rules is to avoid unnecessary compliance costs and disadvantageous tax outcomes when entities involved in the sale of a business:

(a)  cannot agree on the current value of some or all of the business ‘ assets due to uncertainty about the future economic performance of the business; and

(b)  resolve this uncertainty by agreeing to potentially provide future additional consideration linked to this performance.

118-560(2)  –  These rules achieve this object by:

(a)   disregarding any *capital gain or *capital loss relating to the creation of a *look-through earnout right; and

(b)  for the acquirer of the business – treating any *financial benefits provided (or received) under the right as forming part of (or reducing) the cost base or reduced cost base of the business assets; and

(c)  for the seller of the business – treating any financial benefits received (or provided) under the right as increasing (or reducing) the capital proceeds for the business assets.

3. While it is expected that most standard and reverse earn-out arrangements created on or after 24 April 2015 would qualify for look-through treatment under Subdivision 118-I, there are arrangements that do not satisfy the requirements of a look-through earn-out right. This discussion paper focuses on such arrangements which do not qualify as look-through earnout rights under Subdivision 118-I.

4. In addition to seeking feedback, this discussion paper also seeks to highlight some of the issues which may need to be considered when you enter into such an arrangement and this may also assist you in determining whether these issues may be better understood through the provision of additional ATO public advice and guidance.


5. Draft Taxation Ruling TR 2007/D10 Income tax: capital gains: capital gains tax consequences of earnout arrangements was concerned with the CGT consequences of standard and reverse earnout arrangements. It did not deal with tax consequences outside of Parts 3-1 and 3-3.

6. TR 2007/D10 defined a standard earnout arrangement as any transaction in which an income-earning asset (often a business asset) is sold for consideration that includes the creation of an ‘earnout right’ in the seller of the asset. TR 2007/D10 also dealt with reverse earnout arrangements. This paper does not deal with reverse earnout arrangements specifically, but they may be considered for public advice and guidance in the future.

7. TR 2007/D10 was withdrawn with effect from 7 December 2016 because it was expected that most standard and reverse earnout arrangements created on or after 24 April 2015 would qualify for look-through treatment under Subdivision 118-I. Taxpayers can still rely on TR 2007/D10 for earnout arrangements created on or before the date of withdrawal. However, there has been no change to the ATO’s view on the CGT consequences for earnout arrangements that do not satisfy the requirements for look-through treatment under Subdivision 118-I.

8. For the purposes of TR 2007/D10, an ‘earnout right’ is a right to an amount calculated by reference to the earnings generated by the asset for a defined period following the sale (generally a period of between one and five years). It is to be distinguished from a right to sum in respect of that sale which is certain as to amount and as to receipt (such as an instalment sale).

9. TR 2007/D10 did not address a number of issues, including:

  • the possibility that a receipt from an earnout right with a term of one to five years may be assessable, in full or in part, as ordinary income (as it was considered that would only be the case in extreme circumstances)
  • the possibility that payments made to satisfy an obligation under an earnout right may be allowable as an ordinary deduction,
  • the income tax consequences of selling a depreciating asset in consideration for an earn-out arrangement under Division 40.

10. This discussion paper considers a number of tax issues in relation to earnout arrangements, including the sale of a Division 40 depreciating asset where the consideration includes an earnout arrangement. However, it does not apply to look-through earnout rights as defined in Subdivision 118-I or arrangements under which such rights are created.

11. The Commissioner recognises that there may also be a need for further ATO guidance on issues in relation to Subdivision 118-I look-through earnout rights. These issues are outside the scope of this discussion paper and may be considered at a future time.

Scope:  The ATO is also considering the scope of non-qualifying earnout arrangements that would be covered by any guidance, including:

  • whether it should be limited to arrangements that are contingent on the economic performance of an asset or business;
  • arrangements connected with the sale of a Div 40 depreciating asset;
  • earnout arrangements which are long term or of indefinite duration (such as arrangements linked to the life of a business such as a mine); and
  • royalty-like earnout arrangements linked to the production of commodities.

Issues discussion in the Paper include:

  • Separate asset approach.
  • Deductibility of earnout payments under s 8-1.
  • Deductibility of earnout payments under s 40-880.
  • Ending of the earnout right.
  • Creating the earnout right.
  • Granting a right to income from mining.
  • Earnout arrangements in respect of Division 40 depreciating assets.

COMMENTS are due by 1 February 2019.

FJM 2.1.19

[ATO website: Earn-outs Discussion Paper; LTN 233, 3/12/18; Tax Month December 2018]


CPD questions (answers available – below)

  1. What is the Board of Taxation inquiring into (which is complementary to the ATO’s discussion paper)?
  2. What provisions in the ITAA97 deal with ‘earn-outs’?
  3. Is the approach that it implements, to ignore (or ‘look through’) the right to a contingent sum as as part of the vendor’s ‘capital proceeds’ from the sale, and, instead, look at the money paid, under this right, as capital the relevant ‘capital proceeds’ for the sale?
  4. Had the Commissioner developed a different approach, which he put forward in TR 2007/D10 (a long time ago, and never finalised)?
  5. Was this approach to treat the vendor as having treated receiving the ‘sum certain’ and the rights to the variable/contingent consideration, which had to be valued and was later disposed of, when the conditions were met (or not met)?
  6. What was wrong with this approach (that might ‘stifle’ business)?
  7. What does this discussion paper focus on?
  8. Is one of the issues it considers, deductibility of payments (for the purchaser – under the earn-out payment obligations, created), under the general deduction provision in s8-1 of the ITAA97?
  9. Is another the issues discussed, the possibility that similar payments might be deductible, over five years, under the ‘black hole’ provisions in s40-880?


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