Understanding CGT and Earnouts When Selling a Business

When selling a business in Australia, it’s not uncommon for part of the sale price to be based on future performance. This is known as an earnout arrangement, and while it can help bridge valuation gaps between buyer and seller, it also brings important Capital Gains Tax (CGT) implications that sellers need to be aware of.

What Is an Earnout?

An earnout is an arrangement that is typically built into a sale agreement where a portion of the sale price is contingent on the business achieving certain financial targets after the sale. These targets may relate to revenue, profit, customer retention, or other agreed milestones.

Earnouts are commonly used when the buyer and seller cannot agree on a definitive value upfront. So, by tying part of the consideration to future performance, both parties share some of the risk and reward.

For example, a business may be sold for an initial $2 million, with an additional $500,000 payable if certain revenue targets are met within 12–24 months post-sale.

How Are Earnouts Treated for CGT Purposes?

In Australia, the CGT treatment of earnouts can be complex and depends on how the arrangement is structured. Historically, there was uncertainty and inconsistency in how earnouts were taxed. However, the look-through earnout right rules, introduced in 2010 and refined in 2016, provide clearer guidance in certain situations.

Under the look-through earnout right (LTEOR) rules:

• The earnout right is not treated as a separate CGT asset.
• Instead, any future earnout payments are considered part of the capital proceeds from the original sale.
• This allows the capital gain to be adjusted in future years as additional amounts are received.
• The initial CGT event occurs at the time of sale but is amended as actual earnout payments are realised.

Key requirements for look-through earnout rules

To qualify for the more favourable look-through treatment, the earnout must meet several conditions, including:

• The earnout right must be financial in nature.
• It must be linked to the performance of the business/assets sold.
• It must be genuinely contingent and not fixed or capped in a way that undermines the performance link.
• The arrangement must be made in writing at the time of the sale.

If the earnout does not qualify under these rules, it may be treated as a separate CGT event, potentially leading to less favourable tax outcomes and more complexity in reporting.

Practical Considerations for Business Owners

While earnouts can be an effective tool in bridging valuation gaps and aligning buyer-seller interests, they require careful structuring to manage risk and tax implications. Understanding how CGT applies to earnouts and ensuring you qualify for the most beneficial treatment, can make a significant difference to the final outcome of your business sale.

• Professional Advice: It’s essential to work closely with tax and legal advisers when negotiating an earnout to ensure it qualifies for favourable CGT treatment.
• Documentation: Clearly define earnout terms in writing, including performance metrics, timing, and calculation methods.
• Forecasting: Consider the commercial risk—there’s no guarantee that the earnout will be paid if targets are not met.
• Small Business CGT Concessions: If eligible, these can reduce the tax payable on the gain, including on future earnout payments.

Engage and Moore Advisor