What is an earn-out?
As discussed in last week’s article an earn-out is basically a way for a buyer and a seller to determine the price to be paid for a business. Put simply the seller will receive a larger price for the business provided certain performance targets are achieved by post-sale.
How is an earn out taxed?
So how is an earnout taxed? Well that depends on whether the consideration payable under the earn-out is “ascertainable” or “unascertainable”.
If the amount payable under the earn-out is fixed or can be determined by reference to events that have already happened at the date of disposal, the consideration will be deemed to be “ascertainable”. This means that the earn-out is taxed upfront as part of the initial consideration. If the seller qualifies for entrepreneurs’ relief (ER) on the sale of their shares, the ascertainable consideration will be included.
The resulting CGT liability will only be revised if the seller can satisfy HM Revenue & Customs (HMRC) that part of the consideration has proved irrecoverable.
If the earnout cannot be calculated at the date of disposal and is determined by reference to the future performance of the business, then the consideration will be deemed to be “unascertainable”. In this case the seller would initially be required to estimate the present value of the right to receive future earn-out payments, described as a “chose in action”. The value placed on the “chose in action” would be taxed upfront as part of the initial sale proceeds. The “chose in action” is treated as a separate asset for CGT purposes.
So far so good! If everything goes well and various targets are met, then the seller will be entitled to further payments under the earn-out. These payments will result in further CGT disposals in relation to the earn out right itself. The tax treatment will depend on what form these additional payments take (i.e. cash, shares, loan notes or a mixture of the three).
The earn-out is treated as a separate asset for CGT purposes. The value placed on it at the outset (which has been charged to CGT) forms the base cost of this new asset. On receipt of further cash payments, the seller is liable to CGT on the difference between the additional payment he receives, and the value placed on the earn-out as at the date the company was sold.
- Shares or loan notes
If the earn-out is satisfied by way of shares or loan notes in the purchasing company, the seller will avoid the “up front” tax charge on the value of the earn-out right. This is because the seller is treated as exchanging some of the shares they held in the selling company for the shares/loan notes in the purchasing company. This is known as a “paper for paper exchange” and special rules apply in the CGT code which prevents a tax charge arising in these circumstances. This means that a tax charge on the shares/loan notes received under the earn-out will not take effect until they are sold/redeemed.
As ER may not be available on the subsequent sale/redemption of the shares/loan notes received via the earn-out it is possible to make an election to HMRC to dis-apply the “paper for paper” treatment mentioned above. The result of making this election would be that the shares/loan notes received in the purchasing company would be taxed “upfront” as part of the initial consideration received. In this year’s budget the Chancellor announced that ER is available on qualifying gains of up to £1m. The limit was previously £10m.
Maximising your tax position in these circumstances requires careful thought and a pinch of optimism. If you operate a trading company, you need to consider your position very carefully. If you receive an initial cash sum of £1m plus for your business, then it makes sense for any earn-out to be taxed in a later year since you will already have maximised your entitlement to ER in the year of sale . However, if the initial consideration you receive is less than £1m then taxing the earn-out upfront makes more sense to ensure you pay CGT at 10% rather than 20%.
A Final Thought
There is a risk that HMRC may try and argue that the earn-out should be taxed as employment income rather than as a capital receipt due to the seller’s continuing involvement in the business. This could result in the seller paying additional tax of up to 37% if the earn-out was taxed as income. In addition, the company would be subject to employer’s secondary National Insurance contributions.
HMRC say that an earn-out needs to be taxed as employment income, unless it can be demonstrated that the funds are owed to the seller based on the structure of the original share purchase agreement, HMRC have published guidance listing a set of indicators which they will consider in determining whether the consideration from an earn-out should benefit from the favourable CGT treatment.
In view of HMRC’s stance it is important that the share purchase agreement has been correctly drafted.
These notes have been prepared for the purpose of an article only. They should not be regarded as a substitute for taking legal advice.