Federal Budget 2010: Entrepreneurs need to watch CGT changes

While the Federal Government’s 2010 Budget proposal for a 50% tax savings discount and a standard $500 deduction for work-related expenses grabbed most of the headlines, a key issue for businesses was the proposal on the CGT treatment of “earnout arrangements”.

Buried in Budget Paper No 2 [p 16], the Government has proposed to adopt a “look-through” approach to earnout arrangements which will no doubt be welcomed by business owners and practitioners who advise on the sale of businesses. Here are the major changes from the Federal Budget 2010.

CGT treatment of earnout arrangements

Basically, earnout arrangements are used to structure the sale of a business (or business assets) to manage uncertainty about the value of the business. Under an earnout arrangement, an earnout right may entitle the buyer or seller to additional payments depending on the subsequent performance of the business. That is, an “earnout right” is essentially a right to an amount calculated by reference to the earnings generated by an asset for a defined period following the sale of the asset.

Currently, an earnout right is treated as a separate CGT asset. The Budget Papers state that this treatment can result in “anomalous outcomes” for taxpayers where the actual payments under the earnout right differ from the amounts estimated at the start of the arrangement (eg. by reducing access to the CGT small business concessions).

Look-through proposal

The Budget proposal will look to treat “all payments under a qualifying earnout arrangement… as relating to the underlying business asset”. Presumably, this means that any later “adjustment” payments that are required to be made will be taken into account in determining both the capital proceeds received by the vendor on selling the business assets and the amount incurred by the purchaser for cost base purposes in acquiring the business assets (and, likewise, take into account similar adjustment payments in the case of “reverse” earnouts).

It would seem that relevant amendments will also be allowed to be made to assessments for the income year in which the business was sold.

Market value of earnout right?

Importantly, the proposals should do away with the nightmarish problem of trying to determine the market value of a right to receive a contingent amount. They will also (as indicated in the announcement) allow a vendor to qualify for the CGT small business concessions in respect of the payment – whereas presently the Tax Office takes the view that a “right to receive a contingent amount” is not an active asset for the purposes of qualifying for the concessions.

The proposals will also hopefully mean that the convoluted CGT consequences of earnout arrangements, as explained in Draft Ruling TR 2007/D10, will no longer be applicable – well at least not in relation to “qualifying earnout arrangements”.

The measure is proposed to have effect from the date of assent of the enabling legislation, “with transitional provisions available in certain cases from October 17, 2007”.

Finally, of course, the announcement begs the question of why wasn’t this approach to earnout arrangements adopted much earlier? Apart from making perfect practical (if not, technical) sense, it is also consistent with Tax Office’s “underlying asset” approach to the CGT treatment of compensation received from the right to sue. Note that Gordon Cooper and Chris Evans examined this issue in the recently published Thomson Reuters publication Cooper & Evans on CGT.

Other key Budget measures

Some of the other key measures proposed in the 2010 Budget include:

• 50% tax savings discount – from July 1, 2011, the Government will provide a 50% tax discount on up to $1,000 of interest earned by individuals (including interest income earned indirectly via a trust or managed investment scheme);
• standard deduction for work-related expenses – individual taxpayers will get a standard deduction of $500 for work-related expenses and the cost of managing tax affairs from July 1, 2012 (increasing to $1,000 from July 1, 2013);
• personal tax rates – no change to already legislated cuts to the individual tax rates for 2010-11. The main tax cuts already legislated to apply from July 1, 2010 will reduce the tax rate on incomes between $80,000 and $180,000 from 38% to 37% and increase the income threshold from $35,000 to $37,000 for the 15% tax rate. Also from that date, the low income tax offset will increase from $1,350 to $1,500 thereby increasing the effective tax-free threshold to $16,000 for people earning $30,000 or less;
• CGT: share sale facility – legislation will be enacted to allow Australian interest holders to utilise a broader range of CGT rollovers where an entity restructures using a share or interest sale facility for foreign interest holders, effective for CGT events happening after 7:30pm on May11, 2010;
• consolidated groups – rules relating to the calculation and collection of income tax liabilities from consolidated groups and MEC groups will be amended to allow an entity in a tax sharing agreement to leave a consolidated group or MEC group clear of any future income tax liabilities relating to the group; and
• cash economy – increased Tax Office funding to address small business operators who use cash transactions to avoid tax.