Courtesy of Goldsmiths LLP, UK leaders in accountancy practice sales and support
'Earn-outs' are likely to become increasingly popular when entrepreneurs sell shares in companies.
Commercially they make sense, especially in the current economic climate. The purchaser is protected from paying 'over the odds' if profits subsequently dip and the vendor is protected from selling their shares too cheaply should results subsequently pick up.
Now that we have entrepreneurs' relief, such earn-outs are likely to be structured as payable in cash. The tax treatment of such 'earn-outs' is complex but often beneficial.
Technically the earn-out is a chose-in-action, which is a separate asset and, on the sale of the original shares, the vendor has to estimate the value of this chose-in-action on Day 1. When the earn-out is satisfied, there is a disposal of this chose-in-action resulting in either a subsequent gain or loss.
If the earn-out was satisfied in instalments (perhaps it was a five-year earn-out with a computation made each year), there would be a series of part-disposals of the chose-in-action, each one capable of generating a gain or a loss.
Long ago, in pre-taper relief days, cash earn-outs were given conservative valuations on day one so as to gain the advantage of deferring as much of the gain as possible to later years when the earn-out was earned.
Now, with entrepreneurs' relief we are likely to see aggressive valuations of earn-outs on day one, so as to maximise the amount taxable at 10%. Any gain made on disposal (or part disposal) of the chose-in-action cannot attract entrepreneurs' relief and so will be taxable at the prevailing rate at the time (currently 18% or 28%).
It makes sense therefore for vendors to transfer part of the chose-in-action to a spouse (or civil partner) to take advantage of their annual CGT exemption (and possible lower tax rate) on their share of the later gain.
But there will be occasions when earn-outs do not live up to expectations and so there arises a capital loss on the subsequent disposal (or part disposal) of the chose inaction.
In these circumstances, it is possible to make a claim under section 297A TCGA 1992 that the subsequent loss can be carried back and set against the original gain arising when the chose-in-action was acquired.
Beware though if the whole or part of the 'earn-out' has been transferred to a spouse (or civil partner) and a subsequent capital loss arises. A claim under section 279A TCGA 1992 doesn't work for them - because they have no original gain against which to set the subsequent capital loss and can only carry forward the capital loss.
There are practical solutions to this type of problem and an experienced tax adviser should be able provide the relevant business tax advice..
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