Yearning for Earnout Certainty

Abstract

In October 2007 the Australian Taxation Office (ATO) issued a draft Taxation Ruling (TR 2007/D10) which indicates the ATO’s current view of the capital gains tax (CGT) implications for vendors and purchasers in business transactions commonly known as earnouts and reverse earnouts. This paper provides an analysis of the approach taken in that draft ruling, particularly by reference to the existing CGT legislative provisions and their interpretation in case law. It compares the ATO approach in this draft ruling with the approach to these sorts of transactions taken in previous rulings, and also considers and compares the tax treatment of such earnouts in comparable overseas jurisdictions.

The paper suggests that the approach adopted in the draft ruling is not always defensible by reference to statute or case law, and that it has failed to deal with important legal implications. In adopting a “deconstructionist” or “separate asset” approach (in contrast to a “look-through” or “underlying asset” approach), combined with a slavish yet not always consistent adherence to the letter of the law, the ATO has presented tax practitioners and their clients with a host of practical problems of interpretation and implementation that did not previously exist. As a result practitioners have been left in a state of considerable uncertainty. The paper suggests potential solutions to these problems, and argues that the final ruling will have to adopt a significantly different position in order to remove this uncertainty.

Keywords: Taxation