The recent federal budget has some good news in store for those selling a business.

1. 48 National Accountant October/November 2010
technical update
If any of your clients are propos-
ing to sell their businesses in the
immediate future you may want
to rethink the timing and how
you structure the sale to take
advantage of the Government’s
intention to introduce new legis-
lation which is more favourable
to both seller and buyer.
When it comes time to sell
a business there is always the
inevitable negotiation process
where the seller wants to obtain
as much as possible for the sale
and the purchaser the exact
opposite. A common solution
to this problem to maximise the
potential sale proceeds for the
seller in a way acceptable to the
buyer is to include what is com-
monly referred to as an earn-out
arrangement as part of the terms
of sale.
How earn-outs work
An earn-out arrangement is the
right to further payments that
are usually contingent on the
performance of the business
subsequent to its sale. This is in
addition to a sum paid up front.
The current tax treatment
covering this type of arrangement
is complex and administratively
burdensome. The global
financial crisis has created a
lot of uncertainty surrounding
underlying earnings, and earn-
out arrangements can be quite
useful circuit breakers particularly
in volatile times to reach
agreement between parties.
The seller will only get additional
extra payments if the business
achieves a certain level of profit
or meets revenue targets.
The seller is taking on some
risk by holding back some of
the proceeds and therefore
effectively keeping some ‘skin’
in the business. Buyers, on the
other hand, do not have to
make further payments unless
expectations are met.
The tax treatment
The ATO draft ruling on the
tax treatment of earn-outs was
released back in 2007 and has
remained in draft format ever
since. In this ruling the ATO
treats the earn-out component
as a separate asset from the
underlying business asset for CGT
purposes for both the seller and
the purchaser. This creates an
unnecessary compliance cost and
could deprive sellers of valuable
CGT concessions.
Under this ruling, sellers
were taxed on both the cash
The recent federal budget has some good news
in store for those selling a business.
Show me the money
1The Government is
amending tax legislation
covering the treatment
of earn-outs included in a
business sale.
2Look-through CGT
treatment will apply
to qualifying earn-out
arrangements.
3Reduced compliance
costs and a better tax
outcome for buyers will
result from the change.
Reality checklist
component and the market
value of the earn-out even if
this amount was not actually
received. Sellers could be in a
position of having a tax liability
and not having all the cash to
pay for it. They were also faced
with the possibility of paying too
much CGT if the business missed
its targets and did not perform as
well as expected.
In this approach, sellers
would be required to value the
earn-out right and include this
as part of the capital proceeds.
If the expected value of the
earn-out right was more than
the amount eventually received
the capital gain paid by the seller
at the time of the sale would be
more than the value of the right,
meaning the seller could claim a
capital loss.
The problem here is that
any loss on the earn-out right
could not be carried back to a
different year to reduce a gain
taxed originally leaving sellers
potentially out of pocket if they
paid any tax on the sale after
taking advantage of any small
business CGT concessions.
Tony Greco
NIA1010_048-050-Greco.indd 48 17/9/10 2:30:07 PM

2. A change of heart
The Government has now come
to the realisation that earn-out
arrangements are a common
and efficient way of structuring
the sale of a business or business
assets and the tax rules should
facilitate the process of dealing
with uncertainties with respect
to values.
In May this year, the Assistant
Treasurer announced that the
Government will provide “look-
through” treatment for qualify-
ing earn-out arrangements. The
proposed measure will treat
additional payments made under
a standard earn-out arrange-
ment as capital proceeds for the
original asset for the seller and
add these to the asset’s cost base
for the buyer.
The underlying principle of
the look-through approach is to
ignore the earn-out right and
treat all payments as related
to the sale (or purchase) of the
original business asset. This
removes the task of having to
value the earn-out right. The
proposed way to achieve look-
through treatment for standard
earn-out arrangements is the
cost recovery method. Consistent
with the normal capital proceeds
rules, amounts will be recognised
when they become certain (that
is, money or property a taxpayer
is entitled to receive).
Cost recovery method
Under this method, the seller
reduces the cost base of the
asset as and when amounts
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Table 1
Proposed tax treatment of seller
Cost base
Capital
proceeds
Adjusted
cost base
Capital gain /
loss (annual)
Year 0 $1 million $800,000 $200,000 $0
Year 1 $200,000 $100,000 $100,000 $0
Year 2 $100,000 $150,000 $0 $50,000
Year 3 $0 $100,000 $0 $100,000
Total $1 million $1.15 million $150,000
Table 2
Proposed tax treatment of buyer
Amount paid Cost base
Year 0 $800,000 $800,000
Year 1 $100,000 $900,000
Year 2 $150,000 $1.05 million
Year 3 $100,000 $1.15 million
NIA1010_048-050-Greco.indd 49 17/9/10 2:30:17 PM

3. technical update
due become certain (including
the initial capital proceeds and
subsequent payments). After the
cost base is reduced to zero, the
seller realises a capital gain on
all further amounts. This ensures
that the seller’s capital proceeds
for the sale of the business
asset reflect the total amount
actually received. Any capital
gain is treated as realised on the
business asset and is eligible for
any CGT concessions that were
available for that asset.
For the buyer, payments are
included in the asset’s cost base
as and when the buyer pays
them. This ensures that the cost
base reflects the actual amount
paid for the asset.
The cost recovery method is
very similar to the approach used
for CGT event E4, which reduces
the cost base of interests in a
unit trust when tax preferred
distributions are made. The
Government has two options on
how to legislate the change in
approach. Option 1 is to create
a new CGT event that applies to
earn-out arrangements. Option
2 is to modify existing rules (such
as CGT event A1). Either way will
achieve the desired result.
The following example
illustrates how where there is an
eventual capital gain, the seller
can attribute this to the original
asset. In addition, the buyer’s
cost base accurately reflects what
they paid to acquire the asset.
The seller’s proposed tax treat-
ment is shown in Table 1 and the
buyer’s proposed tax treatment
in Table 2 (on previous page).
Cost recovery example
A seller and buyer agree that
a business is worth at least
$800,000 but more if the
majority of clients stay with
the business. The buyer is
only prepared to pay more if
expectations are met so agrees to
an earn-out arrangement on the
following terms:
■ the buyer pays an initial lump
sum of $800,000
■ the buyer agrees to pay the
seller an earn-out right which
is 50 per cent of the revenue
above $500,000 for the next
three financial years capped at
$200,000 per year.
Revenues for the business
in the following three years
are $700,000, $800,000 and
$700,000 and the seller receives
payments of $100,000, $150,000
and $100,000. Assume the
seller’s cost base for the business
is $1 million.
Continued on page 67
Earn-out
arrangements can
be quite useful
circuit breakers
particularly in
volatile times to
reach agreement
between parties.
NIA1010_048-050-Greco.indd 50 17/9/10 2:30:27 PM

4. October/November 2010 National Accountant 67
to keep records for longer than
the general five-year period, not
simply limited to the above two
situations. Another example is
when you are recouping prior
year losses, which may date back
several years. Taxation Determi-
nation TD 2007/2 provides that
where a taxpayer has incurred
a tax loss or made a net capital
loss, the taxpayer should retain
records relevant to the ascertain-
ment of that loss until at least the
later of the following times:
■ the end of the statutory record
retention period (which is five
years in the case of section
262A of the ITAA 1936), or
■ the end of the statutory period
for reviewing assessments for
the income year in which the
loss is fully deducted.
Beware shared interest
in assets
Particular attention should be
paid in circumstances where
other parties have shared
interests with you in certain
assets. For example, you may
own property jointly with a
spouse or business partner. In the
event of a separation or fallout,
ensure you can access these tax
records or obtain copies for your
own records.
Security is an issue
Taxes can potentially cost you
or save you thousands or even
millions of dollars, therefore it is
essential that you keep important
records in a safe place to protect
against damage or loss through
theft, fire or similar.
Consider making additional
copies and storing them in
separate locations, one of them
being a safe storage place such
as a safe-deposit box.
The key takeaway is that you
should always think of future
consequences before you destroy
any records. Once destroyed,
they will become very difficult
to replace and may land you in a
problematic situation.
Disclaimer
The views in this article are those of the
authors and do not represent the views of
Deloitte Private or Deloitte Touche Tohmatsu
or any of its related practice entities. This
article is provided as general information only
and does not consider anyone’s specific objec-
tives, situation or needs. You should not rely
on the information in this document.
Spyros Kotsopoulos is a partner at
Deloitte Private, Sydney. Manisha
Singh is a tax consultant at Deloitte
Private, Sydney.
If records are not
kept or retained
as required, the
taxpayer may
be subject to
administrative
penalties.
Because the look-through
approach ignores the earn-out
right there is no need to estimate
the market value of the earn-out.
Proposed tax treatment
Overall the seller’s capital
proceeds were $1.15 million,
resulting in an overall capital
gain of $150,000 realised as two
separate gains of $50,000 and
$100,000 (the capital gains in
Year 2 and Year 3 are brought
to account in the respective
income year for Year 2 and Year
3 and not when the contract was
signed). The seller will have ac-
cess to any CGT concessions for
the subsequent capital gains that
they could access for the original
capital gain (50 per cent CGT
discount and small business
CGT concessions).
Applying the cost recovery
method, the buyer’s cost base for
the business is $1.15 million.
One implication of the cost
recovery method is that the seller
cannot realise a capital loss until
the end of the arrangement. This
avoids the high compliance costs
of amended assessments, while
still achieving look-through treat-
ment. It also is consistent with
the deferred realisation of capital
gains when the seller makes an
overall capital gain.
Application date
The proposed amendments
will apply for all earn-out
arrangements entered into after
the date of Royal Assent of
the Bill containing the relevant
legislative provisions. At the
time of writing, Treasury had
only issued a proposal paper
for consultation. Contained
within this proposal paper
Tony Greco is the NIA senior tax
adviser. He can be contacted at
tony.greco@nia.org.au or on
(03) 8665 3134.
Continued from page 50
Show me
the money
are the following transitional
arrangements:
■ taxpayers will have the choice
of applying the proposed
look-through treatment for
earn-out arrangements
entered into between the
dates of announcement and
Royal Assent (inclusive)
■ the buyer in a standard
earn-out arrangement will
have the choice of applying
look-through treatment for
arrangements entered into on
or after 17 October 2007, the
date of release of the draft rul-
ing. For arrangements entered
into before this date they have
the choice to rely on Tax Ruling
93/15 (which effectively pro-
vides look-through treatment
by allowing payments made
under an earn-out arrange-
ment to be included in the
buyer’s cost base).
A good result
The policy change is a welcome
announcement which will lessen
the compliance cost as well as
facilitate better tax outcomes for
both buyer and seller. The Gov-
ernment should be applauded for
making the necessary changes.
Structuring the sale of a
business using an earn-out
arrangement to deal with the
uncertainty about its value will
no longer be as complex as it has
been in the past. With so many
owners trying to offload their
businesses to fund their retire-
ment, this change in policy may
assist the sale.
NIA1010_066-067-Kotsopoulos.indd 67 17/9/10 2:34:53 PM