JOINT SUBMISSION BY The Institute of Chartered Accountants Australia, CPA Australia, National Institute of Accountants, The Taxation Institute of Australia and Taxpayers Australia Draft Taxation Ruling TR 2007/D10 Income tax: capital gains: capital gains tax consequences of earnout arrangements Date: 14 December 2007 The Professional Bodies welcome the opportunity provided by the Australian Taxation Office (ATO) to comment on Draft Taxation Ruling TR 2007/D10 (the Draft Ruling ). All statutory references are to the Income Tax Assessment Act 1997 unless otherwise stated. GENERAL COMMENTS 1. The Professional Bodies acknowledge the significant effort and comprehensive analysis of the issues relating to the treatment of earnout arrangements in the Draft Ruling. However, we have some significant concerns about the practical application of the approach taken in the Draft Ruling and we seek a reconsideration of the approach taken in light of those practical concerns, given the ample power for the ATO to take a different approach. 2. The Professional Bodies are particularly concerned that, in the Draft Ruling, the ATO has persisted with the separate asset ( deconstructionist ) approach in respect of standard earnout arrangements in respect of the treatment of the seller (as was the case in Taxation Ruling TR 93/15), contrary to submissions for this approach to be abandoned. That is, when amounts come finally to be paid in relation to earnout obligations, the divergence between the ultimate payments and the market value at the time of the sale transaction is proposed to be treated as a separate CGT event rather than being treated as an adjustment of the consideration in respect of the sale (the look through approach); the separate asset approach is proposed to be extended to reverse earnout arrangements and to the treatment of a buyer under a standard earnout arrangement, rather than using a look through approach. 3. The commercial reality of earnout arrangements in relation to sales of businesses is that they are typically used as mechanisms to quantify the goodwill of a business in order to settle on the total amount of the sale proceeds. Earnouts and reverse earnouts have come into use as a more effective mechanism to allow the setting of the sale price of a business or company than the alternative, a fixed amount supplemented by representations and warranties to deal with any failure to achieve anticipated outcomes after the sale. The reality of the matter (the key analytical approach, as discussed in the Draft Ruling) is that an earnout and reverse earnout represent the sale proceeds of a business/share sale in the same manner as a fixed price sale contract, and this is in the view of the Professional Bodies the preferred interpretive approach to be taken. 1
4. As the Draft Ruling notes in various places, there is ultimately a judgment to be made in the interpretive approach used. Where there is no clear approach emerging from the legislation, the ATO has made such interpretive judgments in the past on characterising rights associated with underlying transactions (such as compensation and damages awards) and the ATO has the capacity to make such judgments in respect of earnouts. 5. The Professional Bodies submit that the ATO and the Rulings Panel must consider the consequences of the approach taken for the remainder of the income tax legislation, rather than focusing on an analysis for CGT purposes to the exclusion of the other provisions. The application of the separate asset approach to both the buyer and seller in standard and reverse earnout arrangements will result in inappropriate economic outcomes for taxpayers and for the revenue in a number of circumstances, and would lead to major practical compliance issues. The Professional Bodies identify a number of these issues in the Specific Comments section of this submission. 6. The Professional Bodies submit, with respect, that the Commissioner could not countenance an interpretative approach being taken in relation to earnouts, as is proposed in the Draft Ruling, that would cause such widespread damage to conventional positions taken in numerous areas of income tax. 7. The Draft Ruling does not accept the alternative deferred consideration approach (referred to as the look-through approach in the Draft Ruling). We submit that the reasons put forward in the Draft Ruling for not adopting the look-through approach are unfounded on both a technical and policy basis. 8. The Professional Bodies submit that the look-through approach is the preferred solution for the matrix of potential outcomes that can arise under a standard or reverse earnout arrangement. 9. The Professional Bodies request, given the breadth of issues raised in this submission, this Draft Ruling should be subject to internal whole-of-ato consultative processes, with the involvement of the Rulings Panel, to identify the interactions and the potential damage that could result from this approach. 10. If the ATO was to persist with the separate asset approach (the separate asset approach is not supported by the Professional Bodies) one way of resolving the resulting revenue and compliance challenges would be for the ATO to provide taxpayers with an optional administrative concession to adopt a market value for earnout rights equal to the face value of future payments/receipts once relevant contingencies have been satisfied. This would be essentially a look-back approach to determining the market value of earnout rights. This concession would apply for the purpose of determining capital proceeds and cost base in respect of the disposal/acquisition of the underlying asset and also in respect of the separate earnout rights. The Commissioner has the power under s.170(9) of the 1936 Act to reopen prior year assessments for a 4 year period. 11. If the ATO considers it is impossible to provide an integrated business oriented interpretative approach (under the look through approach) to the tax treatment of earnouts then the Professional Bodies request that the ATO should: A. champion an initiative to approach government, together with the Professional Bodies, to ensure that a comprehensive look through treatment is applicable to earnouts and reverse earn-outs, together with such other administrative changes are as necessary to ensure that the technique produces consistent and clear outcomes; 2
B. ensure that consultation on a legislative solution involves not only the Treasury advisory team dealing with CGT issues but also the groups responsible for core business tax development namely tax consolidation, capital allowances and the blackhole rules, in order to ensure that this strategic area of business capital expenditure does not have a suboptimal tax treatment designed to fit it into approaches used for CGT purposes, which are not properly responsive to Australia s need for clear, unambiguous tax treatment of business expenditures and business receipts; and C. withdraw the Draft Ruling pending a formal parliamentary policy approach being determined. SPECIFIC COMMENTS Ordinary income 12. The Professional Bodies note and agree with the approach that the Draft Ruling does not deal with the possibility that an earnout receipt may be assessable, in full or in part, as ordinary income and this submission does not deal with such situations. ATO has the capacity to determine whether a look through approach can be used 13. As the Draft Ruling notes in various places, there is ultimately a judgment to be made about the interpretive approach to be adopted. There is no clear interpretative approach emerging from the legislation and the ATO has the capacity to make such judgments. The Draft Ruling itself notes the flexibility allowable: 86. In Taxation Ruling TR 95/35 the Commissioner stated that one of the principles underlying the interpretation of CGT law is the most relevant asset approach. This approach is described as a process of analysing all the possible assets of a taxpayer to determine the asset to which the capital proceeds received (or entitled to be received) by that taxpayer most directly relates. 87. A further application of the general principle set out in TR 95/35 is the continuum of events approach adopted by the Commissioner in Taxation Ruling TR 1999/19. In effect, this approach provides that it is only possible to relate capital proceeds to a CGT event happening to an underlying asset when they are received in the course of the same continuum of events as that CGT event. Taxation Ruling TR 1999/19 explains the CGT implications of this approach to certain land transactions in which the vendor retains a forfeited deposit. 88. In the case of earnout arrangements, the reality of the matter (to use the language of Zim Properties) is that the parties have entered into a financial arrangement that is independent of the sale transaction from which it arises. The mere fact that the earnout arrangement has its origins in the sale of the original asset is not sufficient justification for treating the earnout arrangement as a merely subordinate part of a larger transaction. (emphases added) 14. This passage confirms, in our view, the ability of the ATO and the Rulings Panel to determine that a look through approach is capable of being used. 3
15. In the Professional Bodies view, neither the cases cited nor a policy analysis can support deconstructing the sale price of a business or shares in a company into different rights for CGT and tax purposes, where the goodwill component of the sale price has: an earnout component causing a price escalation, or a reverse earnout component with a result similar to an adjustment in respect of nonachievement of representations or warranties. Meaning of earnout right 16. Paragraph 3 of the Draft Ruling states that an earnout right is a right to an amount calculated by reference to the earnings generated by the (income earning) asset for a defined period following the sale. 17. An earnout arrangement in respect of an interest in a trust should also be covered by the final ruling. 18. Typically, earnout rights would be incorporated into the contract of sale of the underlying asset. The ATO should confirm that the outcomes in the final ruling will also apply to earnout rights that are contained in a separate agreement, provided that the earnout agreement is entered into contemporaneously with the contract of sale of the underlying asset and is conditional upon the sale of the underlying asset. 19. The Professional Bodies understand that the reference to the (underlying) asset that is subject to the sale would include business assets and shares in a company (taking into account the examples provided in the Draft Ruling). In respect of an earnout arrangement in regard to the sale of shares, it would appear that earnout rights are not to be strictly confined only to those contingencies referable to the earnings generated by the (income earning) asset for a defined period following the sale. Where the underlying asset is a share in a company, contingencies referable to the activities of the company, rather than earnings arising from the shares, should be within the scope of an earnout arrangement. 20. The ruling should clarify that a right to a specified/fixed amount that is payable only on the happening of specified event(s) will also be treated as an earnout right, irrespective of the degree of risk or uncertainty associated with the contingency. That is, the degree of risk in respect of an earnout amount should not impact the recognition of the earnout, however, it may impact the market value of the earnout. Indemnities, warranties and rental guarantees 21. The Draft Ruling takes the view that the creation of an earnout right is the giving of property. This raises issues in the context of a sale agreement where indemnities, warranties or rental guarantees are given by either or both the buyer and seller. 22. Adopting the approach taken by the Draft Ruling to earnout rights, we query whether the giving of an indemnity or a warranty by, say, the seller is, therefore, an additional right that has been created in the buyer. For example, if the seller disposes of an asset to the buyer in consideration for $1 million together with various warranties and indemnities, should any part of the $1 million be attributed to the warranties and indemnities? If so, will future payments in respect of those warranties and indemnities constitute a reduction in the disposal consideration under section 116-50 or will they be treated as discharging 4
the seller s obligations under those warranties and indemnities? From the buyer s perspective, similar issues arise. 23. Many contracts provide that payments under indemnities, warranties or rental guarantees constitute an adjustment to the purchase price. If the approach taken in the Draft Ruling is extended to indemnities, warranties and rental guarantees, the ruling would be, inconsistent with commercial practice. 24. We request the ATO to provide guidance on whether the approach taken in the Draft Ruling will be confined to earnout rights, or whether they envisage its extension to other rights and obligations under contracts for the sale of assets. 25. In the view of the Professional Bodies, the need for a harmonised approach to the typical earnout scenario as compared with the treatment of indemnities and warranties provides a powerful reason to review the approach proposed in the Draft Ruling. Summary of inappropriate outcomes under the separate asset approach 26. As is shown below, this deconstructionist approach, of finding multiple rights and assets within what is in reality one integrated arrangement, results in a series of issues which the Draft Ruling ignores. 27. The ATO s exclusive application of the separate asset approach to both the buyer and seller in standard and reverse earnout arrangements can, in certain circumstances, result in inappropriate economic outcomes for taxpayers and for the revenue (in contrast to outcomes that may arise under the look-through approach). 28. The Professional Bodies identify some of the key problems in the tables below. Problems arising in respect of standard earnouts Earnout received/paid Earnout lapses Position of seller / grantee Underlying asset concessions do not apply to any gain that may arise if the earnout amounts received exceed the cost base of the earnout rights, namely 1. pre CGT status, 2. Div. 152 small business concessions, 3. CGT discount, 4. Div. 768 participation exemption etc Underlying asset concessions do not apply to limit or restrict any loss that may arise if the earnout rights lapse (risk to revenue) Seller is taxed upfront on the market value of the earnout right which creates a tax funding issue No carry back of capital loss to offset any capital gain on the disposal of the underlying asset. 5
No interest on overpayment of tax by the seller Position of buyer / grantor The cost base of the underlying asset only includes the market value of the earnout right at the time the contract is made for the sale of the original asset not the actual earnout amounts paid. This is particularly problematic for consolidated groups acquiring subsidiary members under earnout arrangements Risk of CGT event D1 capital gain on grant of earnout right The cost base of the underlying asset is not reduced (risk to revenue). Blackhole deduction for actual earnout payments made under s.40-880 (risk to revenue) or else is not available (risk to purchaser) 29. The Professional Bodies submit that the interpretative (separate asset) approach being taken in relation to earnouts, as is proposed in the Draft Ruling, would cause such widespread disruption and damage to conventional positions taken in numerous areas of income tax. Problems arising in respect of reverse earnouts Earnout received/paid Earnout lapses Position of seller / grantor If the earnout amounts paid exceed the market value of the earnout rights granted there is no reduction to the capital proceeds in respect of the disposal of the underlying asset Market value of earnout rights granted are not included in the capital proceeds of the underlying asset. No CGT event for the grantor (risk to revenue) Blackhole deduction for actual earnout payments made under s.40-880 (risk to revenue) Risk that the grantor may be assessed in respect of the earnout rights under s.6-5 6
Risk of CGT event D1 capital gain on grant of earnout right Position of buyer / grantee If the earnout amounts received exceed the market value of the earnout rights acquired there is a CGT event C2 capital gain to the buyer rather than a reduction to the cost base of the underlying asset A capital loss arises if the earnout right lapses rather than an increase to the cost base of the underlying asset (risk to revenue). The cost base of the underlying asset excludes the market value of the earnout right acquired. This may be problematic for consolidated groups acquiring subsidiary members under earnout arrangements. 30. Again, the Professional Bodies submit that the interpretative (separate asset) approach being taken in relation to earnouts (including reverse earnouts), as is proposed in the Draft Ruling, would cause such widespread disruption and damage to conventional positions taken in numerous areas of income tax. Trust/escrow arrangements 31. The Draft Ruling does not deal with arrangements where a set amount is contributed to a trust or held on escrow in respect of standard or reverse earnout arrangements. 32. The following is an example of a potential scenario (in the nature of a reverse earnout): Aco enters into a contract to sell a commercial building to Bco. The sale price of the building is $11m which has been based on 100% continued occupancy for a 5 year period. Under an agreement separate to the sale contract, both parties direct that at completion of the sale contract, $1m of the sale price is to be paid into a trust account established for the benefit of the purchaser and vendor under the specified terms. The terms of the trust are that if there is less than 100% occupancy over the next 5 years, then the purchaser will be entitled to a payment of an amount up to $1m (depending on the level of occupancy).. 33. Under the ATO s separate asset approach to a reverse earnout arrangement (where there is no express trust arrangement), the seller would be treated as creating an earnout right in the buyer, with a potential capital gain or loss arising to the buyer on satisfaction or expiry of the earnout right. In the above example, however, at completion, the seller does not have an absolute beneficial entitlement to the $1m of the sale price into the trust and the seller returns an equitable interest in that sum. 7
34. In respect of the scenario outlined above, the following issues would appear to arise: Seller Does the amount of the capital proceeds in respect of the building include, in addition to the $10m cash component of the sale price, the market value of the seller s interest in the trust? Has the seller acquired a CGT asset (potential entitlement from the trust)? What is the cost base of the asset? Buyer Does the cost base of the building exclude the market value of the buyer s interest retained in the trust? Does the buyer subsequently obtain additional cost base for any part of the market value of the buyer s interest retained in the trust that is actually paid to the seller? 35. The Professional Bodies observe that a look through approach is more conducive to achieving appropriate tax outcomes in relation to such trust and escrow cases than the approach in the Draft Ruling. 36. The ATO should address issues that can arise under trust/escrow arrangements, preferably in the final ruling. Economic and accounting characterisation of earnout arrangements 37. From an economic and commercial perspective, earnout payments are inextricably linked to the sale/purchase of the underlying asset. The full amount of any earnout paid/received should be recognised as consideration paid/received in respect of the underlying asset. 38. For financial reporting purposes, earnout payments are dealt with in AASB 3 Business Combinations. (We understand that a revised form of AASB 3 is currently being considered by the International Accounting Standards Board for potential application at some future time). 39. AASB 3 requires contingent consideration to be included in the cost of acquisition if the future adjustment to the price is probable and can be reliably measured. Any changes in the amount of the estimated payment are treated as changes in the cost of acquisition. The Standard provides at paras. 32-34 that: Adjustments to the cost of a business combination contingent on future events 32 When a business combination agreement provides for an adjustment to the cost of the combination contingent on future events, the acquirer shall include the amount of that adjustment in the cost of the combination at the acquisition date if the adjustment is probable and can be measured reliably. 33. A business combination agreement may allow for adjustments to the cost of the combination that are contingent on one or more future events. The adjustment might, for 8
example, be contingent on a specified level of profit being maintained or achieved in future periods, or on the market price of the instruments issued being maintained. It is usually possible to estimate the amount of any such adjustment at the time of initially accounting for the combination without impairing the reliability of the information, even though some uncertainty exists. If the future events do not occur or the estimate needs to be revised, the cost of the business combination shall be adjusted accordingly. 34. However, when a business combination agreement provides for such an adjustment, that adjustment is not included in the cost of the combination at the time of initially accounting for the combination if it either is not probable or cannot be measured reliably. If that adjustment subsequently becomes probable and can be measured reliably, the additional consideration shall be treated as an adjustment to the cost of the combination. 40. The ATO s approach in the Draft Ruling adds yet another tax compliance difficulty and the Professional Bodies would urge the ATO to consider this issue. 41. In respect of reverse earnout arrangements, the ATO s separate asset approach from the perspective of the buyer is perplexing. Under a reverse earnout arrangement a buyer will generally never receive amounts in excess of the consideration originally provided in respect of the underlying asset. There is no prospect for an economic gain to arise to the buyer. Consequently, to treat a reverse earnout arrangement as a separate CGT asset, rather than a refund of the consideration paid by the buyer, appears to be fundamentally misconceived. Technical justification for separate asset approach is questionable 42. The Draft Ruling explains at some length the technical basis for the recognition of earnout rights as a form of property, based on cases such as FCT v Orica (1998) 194 CLR 500. Under such a strict legal analysis, it is argued in the Draft Ruling, that the earnout rights are property and the market value of earnout rights can be taken into account as capital proceeds (for a seller) on the basis that property has been received and can be taken into account as the first element of cost base (for a buyer) on the basis of property given. 43. However, as is detailed below, the Draft Ruling approach is inconsistent with the approach which has underpinned the ATO administrative and interpretive practice following the Orica decision. 44. The Professional Bodies question the applicability of the UK Zim Properties case to determine reality of the matter in relation to an earnout. As the Draft Ruling itself notes, the case related to the tax treatment of a damages award for solicitors negligence. So Zim Properties related, not to characterisation of the sale proceeds of a sale of land, but whether damages under a negligence claim could be assimilated to the proceeds of the sale of property. We consider that this case does not provide authority for the interpretive approach adopted by the Draft Ruling. 45. The Draft Ruling, at paragraph 90, cites the UK Court of Appeal s decision of Marren (Inspector of Taxes) v Ingles [1980] 3 All ER 95, as the primary support for the separate asset recognition of earnout rights in the context of the sale of shares. We note that in that case the parties agreed to adopt a separate asset approach for the purpose of determining the capital gains tax on the disposal of the share what was at issue was the capital gains tax treatment on the subsequent satisfaction of the earnout. On the foundation that a separate asset approach was applied in respect of the underlying asset, it is understandable how the Court of Appeal and the House of Lords came to their decisions to maintain a separate asset approach in respect of the satisfaction of the earnout. 9
46. The facts of the Marren (Inspector of Taxes) v Ingles case are clearly distinguishable and do not provide useful guidance in our view, That case concerned a company which was sold, where the price payable comprised an immediate cash amount plus, if the shares were listed on the stock exchange under an IPO, a percentage of the IPO proceeds ( the listing participation ). So the sale price was set in part by the proceeds of an eventual or potential stock exchange listing. We accept that the contingency and the lack of relationship between the sale and the potential listing cause the reality of the situation to be that the listing participation was a separate right and agreed to by the parties as such. The consideration arising from the listing participation was driven by variables including the state of the stock market and the appetite for stock in the relevant company. However in a conventional earnout the drivers affecting the consideration payable under the earnout or the reverse earnout are the performance of the relevant business or company in other words, the very factors which go to confirm the value of the goodwill sold with the business or underpinning the value of the company. 47. It is clear to the Professional Bodies that the decision in Marren v Ingles is not authority for the proposition that a separate asset approach must be adopted for the purpose of determining capital proceeds and cost base in respect of the sale/acquisition of the underlying asset and the nature of earnout and reverse earnout clauses in sale contracts. Rejection of look-through approach is not justified 48. At paragraph 14, the Draft Ruling states that it is not possible for the seller to lookthrough the earnout right and to treat any actual payments received as the capital proceeds in respect of the disposal of the original asset. A corresponding approach is adopted at paragraph 25 in respect of the cost base of the buyer of the underlying asset. 49. However, on a plain reading of the relevant legislative provisions, it appears that the lookthrough approach is properly available. 50. Under s.116-25(1)(a) the capital proceeds from a CGT event (in respect of the underlying asset) are the total of the money you have received, or are entitled to receive, in respect of the event happening. In respect of earnout entitlements under a standard earnout, once the relevant contingencies are satisfied, an entitlement to receive money will arise. There is no express or implied requirement in the legislation that the entitlement to receive money must exist at the time of the CGT event (eg time of making a contract in respect of CGT event A1). The entitlement to receive money under the earnout right should have a sufficient nexus with the underlying asset to meet the requirement that it is in respect of the event happening. 51. Under s.110-25(2)(a) the first element of the cost base (of the underlying asset acquired) includes the money you paid, or are required to pay, in respect of acquiring it. In respect of earnout obligations under a standard earnout, once the relevant contingencies are satisfied, a requirement to pay money will arise. There is no express or implied requirement in the legislation that the entitlement to pay money must exist at the time of acquisition of the underlying asset. The requirement to pay money under the earnout should have a sufficient nexus with the underlying asset to meet the requirement that it is in respect of acquiring the underlying CGT asset. This was the approach that was properly adopted in TR93/15. 52. This then raises the issue of potential duplication of capital proceeds and cost base, through the recognition of both money receivable/payable and (under the approach 10
proposed in the Draft Ruling) the market value of the earnout property received/granted which might be recognised under s.110-25(2)(b). It is submitted that the market value of the earnout property should be disregarded, on the basis that the provisions that recognise the entitlement to receive/pay money are more appropriate, as they best reflect the economic substance of the arrangement. For this reason the Professional Bodies have not considered any further arguments in relation to the construction of s.110-25(2)(b). Separate asset approach in Draft Ruling is inconsistent with other ATO approaches 53. The Professional Bodies query whether a strict legal rights approach is justified in the context of earnout arrangements as this approach has not been universally applied by the ATO for CGT purposes. 54. In the situation where an asset is sold under an interest free instalment payment arrangement (not subject to any express contingency), the ATO has not sought to treat the right to receive the future instalments as a separate form of property, whereby only the market value of the future instalments is taken into account by the buyer and seller in respect of the acquisition and disposal of the underlying asset. Instead the face value of the money payable or money receivable is recognised, in determining the CGT treatment of the underlying asset. The treatment of contingent earnout rights should be treated in a corresponding manner. 55. The approach in the Draft Ruling is also inconsistent with the ATO s guidance on the application of the principles arising from FCT v Orica (1998) 194 CLR 500. The implications from this decision were that virtually all executory (unperformed) contracts are potentially within the ambit of the CGT provisions as separate CGT assets. 56. In an ATO response paper to the Orica decision that was circulated to members of the CGT subcommittee of the National Taxation Liaison Group dated 10 June 1998, the ATO recognised that the decision expanded the application of the CGT net where executory contracts are involved creating considerable uncertainty for taxpayers. In view of this, the ATO prescribed two general principles for dealing with this issue: The Orica decision applies to debt defeasance transactions that are the same as the Orica circumstances. If the creation of contractual rights is the means by which the ownership of some other asset is transferred, then the CGT provisions will apply only to the acquisition of the underlying asset. That is, the transfer of the asset in satisfaction of other rights under the executory contract will not be treated as a disposal of those contractual rights. 57. The ATO's response paper noted that its approach is consistent with the principles established in the UK case of Zim Properties Ltd v Proctor (H.M. Inspector of Taxes) (1984) 58 TC 371. That is, the ATO acknowledged the distinction between the executory contract that was created in that case (which was clearly not connected with the actual transfer of the underlying property) and other executory contracts that form part of the sale proceeds. 58. The separate asset approach adopted in the Draft Ruling is also inconsistent with the approach in Taxation Ruling TR 95/35 (which has not been withdrawn). 11
59. In TR 95/35, the ATO has adopted the view that if compensation is received in respect of a disposal of an underlying asset, the compensation receipts are taken to have been received as part of the capital proceeds for the disposal of the underlying asset and not for any other asset such as a right to compensation. 60. The ATO has stated at paragraph 70 that: In determining which the most relevant asset is, it is often appropriate to adopt a "lookthrough" approach to the transaction or arrangement which generates the compensation receipt. The Professional Bodies regard this concept as the most appropriate basis on which to determine whether any capital gain arises on the disposal of any asset of the taxpayer. 61. The ATO has further adopted the approach of looking through to the most relevant asset giving rise to the receipt in Taxation Determinations TD 31 (Receipt by a taxpayer of insurance proceeds) and TD 57 (Compensation for uninsured items) supporting the view in both instances that it is the loss or destruction of the asset which generates the right to seek compensation and therefore is the most relevant transaction or event for CGT purposes. 62. The practical approach applied by the ATO in response to the Orica decision and its other taxation rulings, which are supported, are inconsistent with the Commissioner's position in the Draft Ruling as to the application of the CGT rules to both sellers and buyers of assets under earnout arrangements. Draft ruling approach is inconsistent with ATO corporate governance messages 63. At a time when the Commissioner, in considering risk management practices which companies should undertake, highlights the points that boards and companies should ask themselves whether the tax outcomes are at odds with the commercial outcomes of a transaction, The Professional Bodies are bemused that this Draft Ruling appears to result in outcomes whereby the tax outcomes of commercially driven transactions (being the purchase and sale of shares in companies and unit in unit trusts) lead to tax outcomes which are not consistent with the commercial underpinning that the core transaction, the underlying transaction, is the sale of shares or the sale of units. Issues with interaction with income tax consolidation - treatment of a buyer of a subsidiary member and ACA Step 1 64. The view expressed in the draft ruling (para 25 and footnote 4) may be problematic for a buyer of shares/membership interests in an entity that becomes a subsidiary member of a consolidated group, for the purpose of calculating the ACA Step 1 amount for that entity (cost base of membership interests). 65. The separate asset approach adopted in the draft ruling appears to conflict with, and frustrate the clear intention of parliament, in respect of the specific amendments contained in s.705-65(5b) whereby the actual amounts payable under contingent deferred payment arrangements should be taken into account for the purposes of calculating the allocable cost amount of a joining subsidiary member. 12
66. The Professional Bodies submit that the final ruling should confirm that s.705-65(5b) operates to statutorily override the separate asset approach and allows the look-though approach to apply for the purpose of calculating the allocable cost amount of a joining subsidiary member. 67. However, if the ATO persists with the interpretation adopted in the Draft Ruling, contrary to the preferred interpretation above, then this change must only operate on a prospective basis. The ATO interpretation would only apply to subsidiary members that join a consolidated group after the date that the final ruling is released. 68. If this matter can not be satisfactorily resolved in the final ruling, the Professional Bodies will approach the Government to seek yet another amendment to consolidation to preserve the policy outcome that was clearly intended. What is the practical application of the repaid rule? 69. Given the ATO s view in the Draft Ruling on the non-application of the repaid rule to the repayment of consideration in a reverse earnout, it is hard to envisage circumstances where the repaid rule (s.116-50) would apply. This issue requires attention. Consequential impacts on other provisions in the income tax law from the separate asset approach must be reconciled before the approach proposed could be adopted 70. The Draft Ruling is limited to the CGT implications of earnout arrangements, and does not consider the implications under other provisions of the Income Tax Assessment Act, such as s.6-5 (ordinary income) or s. 8-1 (general deductions). 71. However, the separate asset approach is problematic in a number of respects. 72. For example, there is the issue of whether the grant of earnout rights results in a capital gain to the grantor under CGT event D1. The proposed solution adopted in the Draft Ruling (paragraph 26 and 28) is that the creation of the earnout right is considered to be borrowing money or obtaining credit in order to fall within the exclusion provision in s.104-35(5)(a). This interpretation is necessary in order to avoid the clearly inappropriate application of CGT event D1. The Professional Bodies query why the flexible purposive approach taken in those parts of the Draft Ruling were not able to be applied in respect of the look-through approach. 73. Issues are also raised as to the potential impacts and interactions under other provisions, including the following: Section 8-1 deduction for financing cost? As noted above, the Draft Ruling takes the view that CGT event D1 does not happen upon the granting of an earnout right by the buyer because the buyer is considered to be borrowing money or obtaining credit from the seller. If the payments made by a buyer under an earnout arrangement exceed the market value of the earnout right at the time it was granted, we query whether the excess is therefore a financing cost that should be deductible to the buyer under section 8-1. We see no indicia of debt in relation to such payments, which are typically highly contingent. The funds borrowed have been used by the buyer to acquire income-producing assets and, hence, the requisite nexus with the production of assessable income should be satisfied. We 13
request the ATO provide its views on this potential treatment of payments under an earnout arrangement. If the ATO is suggesting that it has seen earnout arrangements being deliberately structured as financing or tax-deferral arrangements, which is not the case in relation to earnout arrangements in typical sale contracts, then this proposition should be clearly articulated and distinguished from the analysis in respect of ordinary earnouts. Debt/equity rules: Is the grant of earnout rights a financing arrangement (as defined in s.974-130) for the purpose of the debt/equity rules in Division 974 (as a consequence of the interpretation that there is considered to be borrowing money or obtaining credit )? If yes, then there is the potential for earnout rights to constitute an equity interest under s.974-75(1) [table item 2], in respect of a standard earnout in respect of the acquisition of shares in a subsidiary member. This is surely not intended and a law change would be required similar to the proposed exclusion contained in s.230-410(13) [proceeds from certain business sales] of Tax Laws Amendment (Taxation of Financial Arrangements) Bill 2007. Section 40-880: In the absence of a deduction under s.8-1, are actual payments made under earnout arrangements deductible under the blackhole deduction provisions in s.40-880 or does the exclusion in s.40-880(9)(b) [return on an equity interest] apply? The potential interaction with section 40-880 is more fully considered in Appendix A. Commercial debt forgiveness provisions: In circumstances where the earnout obligation is discharged for an amount less than the market value of the earnout right when granted (for example, assume the market value of the earnout rights were $500,000 when granted but only $200,000 was ultimately required to be paid under a standard earnout), The ATO is requested to provide guidance on the potential application of the commercial debt forgiveness rules in Schedule 2C of the Income Tax Assessment Act 1936. 74. The Professional Bodies submit that it would not be responsible or good tax administration for such a wide array of issues, as well as the issues mentioned earlier, to be left open and unresolved to be dealt with under separate rulings or guidance. We submit that the ATO should not finalise the Draft Ruling until it has properly considered the implications and interaction outcomes of the separate asset approach. 75. In the light of the numerous recent legislative provisions based on the look-through approach to earnout rights (most clearly the consolidation rules) the ATO must, if it were to persist with the approach in the Draft Ruling, specifically address why that approach was taken given some principles of statutory interpretation, namely: Where there are two competing alternative interpretations or constructions of a provision of an Act, section 15AA of the Acts Interpretation Act 1901 requires the interpretation that promotes the purpose of object of the provision to be adopted in preference to the alternative (more literal) interpretation that does not promote that object. The rule that provisions of general application give way to specific provisions, when in conflict 14
The rule of last resort in statutory interpretation is that, where two provisions cannot be reconciled, the later provision prevails over the earlier inconsistent provision (the doctrine of implied repeal). 1 Reverse earnout arrangements risk to revenue 76. As stated above, the separate asset approach is fundamentally inappropriate for reverse earnout arrangements as no economic gain can arise for the grantee of reverse earnout rights. 77. The Professional Bodies are surprised that the Draft Ruling accepts the outcome that the market value of the reverse earnout granted by the seller is not subject to a CGT event. We acknowledge that this is the necessary outcome of the strict legal rights approach adopted in the Draft Ruling, taking into account the position adopted in respect of CGT event D1 for standard earnout arrangements. 78. There is an unresolved issue as to whether the grantor of a reverse earnout right would be assessed under s.6-5. It would be an extraordinary outcome if the seller of an asset held on capital account was to be assessed on revenue account in respect of reverse earnout rights granted. Conclusion: Look-through approach is preferred 79. The Professional Bodies submit that the look-through approach is the preferred solution for the matrix of potential outcomes [position of buyer/seller, earnout paid/received/expiry] that can arise under a standard or reverse earnout arrangement. Potential market value administrative concession 80. Most of the anomalies that arise under the separate asset approach result from a variation between the market value of the earnout right and actual amount received or paid. That is, the market value of the earnout might be less than or more than the nominal value of funds eventually received. 81. The Draft Ruling includes a somewhat simplified method to value earnout rights as a residual amount after deducting actual amounts payable/receivable in respect of the underlying asset from the market value of the underlying asset. However, this method seems to ignore the threshold problem that earnout arrangements are used because of the lack of a mutual agreement as to the market value of the underlying asset, being the goodwill inherent in the sale of the relevant business or shares. 1 In Goodwin v Phillips (1908) 7 CLR 1 at 7, Griffith CJ said: ' where the provisions of a particular Act dealing with a particular subject matter are wholly inconsistent with the provisions of an earlier Act dealing with the same subject matter, then the earlier Act is repealed by implication. It is immaterial whether both Acts are penal Acts or both refer to civil rights. The former must be taken to be repealed by implication. Another branch of the same proposition is this, that if the provisions are not wholly inconsistent, but may become inconsistent in their application to particular cases, then to that extent the provisions of the former Act are excepted or their operation is excluded with respect to cases falling within the provisions of the later Act.' 15
82. If the ATO persists with the separate asset approach (which is not supported by the Professional Bodies) one way of resolving the resulting revenue and compliance challenges would be for the ATO to provide taxpayers with an optional administrative concession to adopt a market value for earnout rights equal to the face value of future payments/receipts once relevant contingencies have been satisfied. This is essentially a look-back approach to determining the market value of earnout rights. 83. This concession would apply for the purpose of determining capital proceeds and cost base in respect of the disposal/acquisition of the underlying asset and also in respect of the separate earnout rights. The Commissioner has the power under s.170(9) of the 1936 Act to reopen prior year assessments for a 4 year period. If the Commissioner had concerns about potential deferral benefits that might arise from such an approach, these could be resolved in a consultative manner. Market value practical issues 84. The following comments are relevant if the ATO persists with the approach taken in the Draft Ruling (which is not the advice of the Professional Bodies) and does not adopt the proposed market value concession discussed above. 85. The Professional Bodies note that the separate asset approach presents some complex market valuation issues, as well as raising significant potential for fundamentally different compliance approaches to be taken by buyers and sellers of assets. This is, of course, similar to the market valuation issues involved in relation to other areas of the capital gains tax. However, there would be merit in the ATO providing guidance on generally accepted approaches to the valuation of earnout rights. Examples used in Draft Ruling should be more comprehensive and complete 86. The Draft Ruling contains four worked examples. However, some examples are over simplified in some cases, and lack some much needed guidance. Example 1 (standard earnout with 3 potential payments) the market value of the earnout right is given as an amount of $400,000, which seems to be the sum of the market values of the separate payments. However, there is no guidance on how these values were determined. Example 2 (same as Example 1 but 2 payments made). The Draft Ruling does not clearly determine whether the earnout right is a single CGT asset or whether there are multiple CGT assets (it simply outlines the calculations required for both alternatives). The final ruling should provide clear guidance for distinguishing between the two outcomes. Example 3 (reverse earnout). The final ruling should provide guidance on determining that part of the sale price that is reasonably attributable to the creation of this (reverse earnout) right. Date of application 87. If the ATO was to adopt the approach taken in the Draft Ruling then the final ruling should only apply to contracts for the sale of business assets, shares in a company or an interest 16
in a trust entered into from the date of release of the final ruling (certainly no earlier than the release of the Draft Ruling). Taxation Ruling TR93/15 could apply up to those dates. 88. However, if the ATO were to adopt the recommendations made in this submission to remedy some or all of the problems with the separate asset approach, either by abandoning that approach in favour of the look-through approach or through the use of a market value administrative concession, then a retrospective application date may be appropriate. Escalation to Rulings Panel 89. The Professional Bodies request, given the breadth of issues raised in this submission, this Draft Ruling should be subject to internal whole-of-ato consultative processes, with the involvement of the Rulings Panel, to identify the interactions and the potential damage that could result from this approach. Approach to be adopted if a consistent view, operating effectively across the income tax law, cannot be determined 90. The Professional Bodies submit that it is pivotal for the ATO, in discharge of its responsibility to provide clear answers to the community, to deliver a fully considered integrated opinion in relation to the income tax treatment of earn-outs across the tax system, in a way that is properly responsive to the commercial underpinnings and intentions of the transaction. 91. If the ATO considers it is impossible to provide and integrated business oriented interpretative approach (under the look-through approach) to the tax treatment of earnouts (which would be very disappointing) then the Professional Bodies request that the ATO should: A. champion an initiative to approach government, together with the Professional Bodies, to ensure that a comprehensive look-through treatment is applicable to earnouts and reverse earnouts, together with such other administrative changes are as necessary to ensure that the technique produces consistent and clear outcomes; B. ensure that consultation on a legislative solution involves not only the Treasury advisory team dealing with CGT issues but also the groups responsible for core business tax development namely tax consolidation, capital allowances and the blackhole rules, in order to ensure that this strategic area of business capital expenditure does not have a suboptimal tax treatment designed to fit it into approaches used for CGT purposes, which are not properly responsive to Australia s need for clear, unambiguous tax treatment of business expenditures and business receipts; and C. withdraw the Draft Ruling pending a formal parliamentary policy approach being determined. 17