Deferred consideration arrangements tipped as potential ATO target next year
Deferred consideration arrangements for the sale of businesses are on the rise following the COVID-19 period and the rules in this area can be complex, cautions HLB Mann Judd.
HLB Mann Judd tax director Peter Bardos said he is seeing an increase in the use of deferred consideration arrangements with recent business sales, with the COVID-19 period making it difficult to determine the true figures for a business.
“For people buying businesses now, we’ve got this two-year Covid period which makes it difficult to have certainty in the figures so we’re seeing a lot more deferred consideration where there’s an earnout or a share for share type rollover,” said Mr Bardos.
Earnout and deferred consideration arrangements can be used as a way of structuring the sale of a business to deal with the uncertainty about its value but the rules in this area can be complicated.
“Ensuring the tax treatment of [these arrangements] is correct can be quite complex so this may be an area where the ATO will focus its attention next year because it’s easy to get them wrong,” said Mr Bardos.
“The ATO is currently developing guidelines about back-to-back rollovers where people have been quite tricky in terms of structuring it in a way to try and get an appropriate tax outcome.”
The Tax Office issued an update back in July this year about the capital gains tax obligations with earnout and deferred consideration arrangements as part of its Guide to capital gains tax 2023.
The Capital Gains Guide reminded businesses that look-through CGT treatment will apply to certain earnout arrangements entered into on or after 24 April 2015.
“Under the look-through CGT treatment in Subdivision 118-I, capital gains or losses associated with look-through earnout rights are disregarded, and the financial benefits of the arrangement are instead applied to the capital proceeds or cost base of the underlying asset,” said the ATO.
The ATO said that look-through CGT treatment will generally apply to a contractual right to future financial benefits created under an earnout or deferred consideration arrangement if:
- The contractual right was created on or after 24 April 2015.
- The contractual right is a right to future financial benefits that are not reasonably ascertainable at the time the right is created.
- The right was created under an arrangement involving the disposal of a CGT asset.
- The disposal caused CGT event A1 to happen.
- Just before the CGT event, the CGT asset was an active asset of the entity that disposed of the asset.
- All of the financial benefits under the right are to be provided within five years after the end of the income year in which the CGT event happened.
- The financial benefits must be contingent on the economic performance of the CGT asset or a business for which it is expected that the CGT asset be an active asset for the period to which those financial benefits relate.
- The value of those financial benefits reasonably relates to that economic performance.
- The parties to the arrangement deal with each other at arm's length in making the arrangement.
“Where an earnout or deferred consideration arrangement does not satisfy these conditions, the contractual right or rights created under the arrangement are considered separate CGT assets,” the ATO said.
The ATO said that taxpayers who are subject to the Taxation of Financial Arrangement (TOFA) provisions in Division 230 of the ITAA 1997 should also consider whether their earnout or deferred consideration arrangement is a 'financial arrangement' subject to those provisions.
Mr Bardos said the ATO is also likely to be taking a close look at personal assets within businesses and whether they are genuinely being used in the business.
“I hear all the time business owners say ‘I’m going to buy this car through the business’ but really that’s only beneficial where assets are genuinely being used in the business,” he said.
“Quite often in my experience the compliance burden of having the car in the business outweighs any tax benefit.
“With the ATO now having greater access to data, I can see that as being another focus for the Tax Office.”
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