1 Will section 118-565 of the Income Tax Assessment Act 1997 (ITAA 1997) apply to the deferred payments payable under the proposed agreement for the sale of shares in the Company?
Yes. This ruling applies for the following period : Income year ending 30 June 20YY The scheme commenced on: 1 July 20YY
E1 and E2 own 50% of the shares in the Company. The Company owns all of the shares Company B. Company B runs a business. The business activities of Company B are entirely dependent upon skilled employees. E3 has put forward an offer to purchase the shares in the Company (the Offer). It is likely that the Offer will progress to a purchase agreement. The purchase agreement is being negotiated in an open market, and is being made at arm's length. More than 80% of the assets of Company B are active assets, and more than 80% of the assets of the Company are active assets. Under the Offer, the proceeds from the sale of the Company's shares will be paid under an earnout arrangement. The consideration receivable is made up of an initial payment and deferred payments. The payment of the deferred payments is subject to the sellers meeting conditions. The sellers will be entitled to the deferred payments if the conditions are met. The sellers entitlement to the deferred payments will end 4 years after the sale of shares.
Income Tax Assessment Act 1997 section 118-565 Income Tax Assessment Act 1997 section 152-40 Income Tax Assessment Act 1997 section 974-160
Earnout arrangements are used in the sale of businesses or business assets where there is difficulty between the buyer and seller agreeing about the value of the business or business assets. Instead of agreeing a fixed payment, the buyer and seller agree that subsequent financial benefits may be provided, based on future economic performance of the business. A look-through earnout right is a right to future financial benefits which are not reasonably ascertainable at the time the right is created. Subsection 118-565(1) of the ITAA 1997 sets out the requirements of a look-through earnout right: A look-through earnout right is a right for which the following conditions are met: (a) the right is right to future financial benefits that are not reasonably ascertainable at the time the right is created; (b) the right is created under an arrangement that involves the disposal of a CGT asset; (c) the disposal causes CGT event A1 to happen; (d) just before the CGT event, the CGT asset was an active asset of the entity who disposed of the asset;
(e) all of the financial benefits that can be provided under the right are to be provided over a period ending no later than 5 years after the end of the income year in which the CGT event happens; (f) those financial benefits are contingent on the economic performance of: (i) the CGT asset; or (ii) a business for which it is reasonably expected that the CGT asset will be an active asset for the period to which those financial benefits relate; (g) the value of those financial benefits reasonably relates to that economic performance; (h) the parties to the arrangement deal with each other at arm's length in making the arrangement. (a) Future financial benefits that are not reasonably ascertainable Section 974-160 of the ITAA 1997 provides that financial benefit means anything of economic value, and includes property and services. The consideration payable under the proposed agreement is a financial benefit. The Explanatory Memorandum (EM) to Tax and Superannuation Laws Amendment (2015 Measures No. 6) Act 2016
which inserted section118-565 into the ITAA 1997, states that 'in most cases, the fact that financial benefits are contingent will mean that they are also reasonably unascertainable. However, in some cases a benefit may be contingent on future events where there is little or no doubt that these events will transpire and the quantum of the payment is fixed or can be reasonably determined given what is known. In this case, the benefit can reasonably be ascertained and the right cannot be a look-through earnout right'. (paragraph 1.63) The proposed agreement will progress from the Offer. Under the Offer (proposed agreement), the sellers will receive an initial payment, and may be eligible to deferred payments. The sellers' entitlement to the deferred payments is subject to the sellers satisfying conditions.. The deferred payments are financial benefits that are contingent on future events. When the proposed agreement is entered into, the sellers right to the deferred amounts will not be reasonably ascertainable. The requirements of paragraph 118-565(1)(a) of the ITAA 1997 will be satisfied. (b) Createdunder an arrangement that involves the disposal of a CGT asset
The right to the deferred payments will arise as part of the agreement for the sale of the shares in the Company, which are CGT assets (see note 1 to subsection 108-5(2) of the ITAA 1997). The right to the deferred payments will be created under an arrangement that involves the disposal of CGT assets. The requirements of paragraph 118-565(1)(b) of the ITAA 1997 will be satisfied. (c) CGT event A1 happens Under the prosed agreement, the seller will dispose of the shares in the Company (ownership of the shares will change from the seller to the buyer) and CGT event A1 will happen in respect of the shares. The requirements of paragraph 118-565(1)(c) of the ITAA 1997 will be satisfied. (d) The CGT asset was an active asset of the entity who disposed of the asset Subsection 152-40(3) of the ITAA 1997 provides that 'a CGT asset is also an active asset at a given time if, at that time, you own it and: (a) it is either a share in a company that is an Australian resident at that time or an interest in a trust that is a resident trust for CGT purposes for the income year in which that time occurs; and (b) the total of:
(i) the market values of the active assets of the company or trust; and (ii) the market value of any financial instruments of the company or trust that are inherently connected with a business that the company or trust carries on; and (iii) any cash of the company or trust is inherently connected with such a business; is 80% or more of the market value of all of the assets of the company or trust. The EM states that 'a membership interest in an Australian resident company or trust will also be an active asset if at least 80 per cent of the assets of the company or trust (by value) are active assets (rather than passive investments). It is important to note that applying the special rules around membership interests may involve a number of steps - for example, if the sole asset of Company A is a share in Company B, which itself only holds a share in Company C, the character of interests of both A and B will depend on the character of the assets of C'. (paragraphs 1.35 and 1.36)
Under the proposed arrangement, the shareholders of the Company will sell the shares in the Company to the buyer. The Company holds all of the shares in Company B which carries on a business. You advise that more than 80% of the assets of Company B are active assets, and more than 80% of the assets of the Company are active assets. The requirements of paragraph 118-565(1)(d) of the ITAA 1997 will be satisfied. (e) Financial benefits that can be providedunder\ the right are to be provided over a period of 5 years Under the proposed agreement, the sellers' entitlement to the deferred payments will end 4 years after the sale of shares (the CGT event). The requirements of paragraph 118-565(1)(e) of the ITAA 1997 will be satisfied. (f) The financial benefits are contingent on the economic performance of the CGT asset or a business for which the CGT asset will be an active asset
The EM states that 'economic performance is a flexible and wide concept, broadly encompassing the success of the relevant economic activity'. Given the breadth of the concept and the variety of context in which it can apply, there is no one means of measuring economic performance. Instead, measuring this performance generally involves identifying various features that represent or are associated with performance in the particular context. For financial benefit to be contingent on the economic performance of a particular business or asset, the benefits must be linked to a reasonable measure of this performance in the context of the business or asset.
Whether a particular measure appropriately identifies economic performance will depend on the context of the business or asset in question. Measures that may be appropriate include both financial measures such as the profit, sales or turnover of the business (or the business in which the asset is used) and non-financial measures such as the number of clients retained or attracted. In some cases, indirect measures of performance may be appropriate - for example, in the case of a CGT asset that is an interest in a holding company, the sole asset of which is a controlling interest in a third entity, an accurate measure of the economic performance of the third entity is also likely to be an accurate measure of the economic performance of the holding company'. (paragraphs 1.51-1.53)
Under the proposed agreement, the sellers will be entitled to the deferred payments if the conditions are met. Company B carries on a business and the conditions are an appropriate measure of the economic performance of the business of Company B. As the Company is a holding company that owns the shares in Company B, the measure of economic performance relevant to Company B will be equally relevant to the Company. The deferred payments (financial benefits) are contingent on the economic performance of the shares of the Company (the CGT assets). The requirements of paragraph 118-565(1)(f) of the ITAA 1997 will be satisfied. (g) The value of those financial benefits reasonably relates to that economic performance The EM states that 'this means that, for example, a right to future financial benefits provided as part of the sale of a business where the financial benefits are contingent on the benefits meeting certain profit targets would generally not qualify as a look-through earnout right if the value of the financial benefits to be provided clearly exceeded the amounts of the profits themselves'.
This requirement does not entail a precise or mathematical link between performance and payment - a lump sum payment may well be appropriate as a percentage of profits if it appears in the circumstances a reasonable estimate of economic performance. Further, in the context of commercial arrangements it is generally for the parties, not the Commissioner to determine what value they place on a particular benefit. However, the value of the contingent financial benefits provided under the right must neither be out of all proportion to the benefits that could have been reasonably expected to result from performance nor otherwise wholly unrelated to the contingency to which they are linked. To the extent financial benefits under a right may not reasonably relate to economic performance, they are for some other purpose than resolving this uncertainty and are outside the scope of this concession'. (paragraphs 1.59 - 1.61)
Under the proposed agreement, entitlement to the deferred payments is subject to the sellers meeting the conditions, and the conditions are an appropriate measure of the economic performance of the business of Company B (the measure of economic performance relevant to Company B will be equally relevant to the Company). The proposed sale will be at arm's length and will be a commercial arrangement. The value of the deferred payments will reasonably relate to the economic performance of the shares of the Company. The requirements of paragraph 118-565(1)(g) of the ITAA 1997 will be satisfied. (h) The parties to the arrangement deal with each other at arm's length The sellers and buyer are unrelated, and the proposed agreement has been negotiated in an open market. The parties to the arrangement have dealt with each other at arm's length. The requirements of paragraph 118-565(1)(h) of the ITAA 1997 will be satisfied. Conclusion Section 118-565 of the ITAA 1997 will apply to any deferred payment that becomes payable under the proposed agreement.