Earn out: ensure that you take tax advice

Understanding earn out structures in business sales

In recent years, there has been increasing use of “earn out” structures whereby on a sale of a company there is an initial amount paid on completion with a further sum or sums payable in future, dependent upon the performance of the company following sale.

An earn out arrangement can help reconcile the “price gap” being the difference between what sellers think the business is worth and what a buyer is prepared to pay for it.

By linking part of the price to future events or performance the risk is reduced for the buyer, who will only pay further monies to the extent the business performs as required post-acquisition and allows the seller to reap the rewards if it does.

Whilst there are a lot of commercial considerations around earn out arrangements — most of which are centred around what the relevant performance criteria will be and how they are to be measured — it is also extremely important that the sellers assess the potential impact upon their personal tax position (particularly where they qualify for Entrepreneurs’ Relief on the sale) as the tax treatment of earn outs can be complicated.

Navigating the complexities of earn out arrangements

In summary, where all or part of the consideration is deferred and cannot be ascertained by reference to circumstances at completion (which is the case for earn outs where the payment is based upon future uncertain events), the consideration for the disposal of the shares is treated as including the right to receive the deferred earn out payments.

This right to receive the further consideration, the “earn out right”, is treated as a separate asset and the present market value of this right at the point of sale must be assessed.

The value of this right is treated as part of the sale proceeds and chargeable to capital gains tax at the time of the sale (i.e. at the same time as the initial cash proceeds).

Care is required where the sellers are to remain employed by the company or the acquirer post-acquisition as HMRC could potentially argue that all or part of the earn out is disguised remuneration (employment income) and tax advice should be sought to ensure this risk is properly assessed and managed.

Assuming, however, the earn out is further sale consideration and paid in cash then once the amount of the earn out payment becomes known and is paid to the seller there is a disposal of the earn out right which may give rise to a further chargeable gain or allowable loss, depending on whether the amount received is greater or less than the market value of the right that was assessed and taxed at the time of the sale of the shares.

If the market value of the earn out right(s) ultimately proves to have been underestimated, any resultant capital gain (and, in this respect, there will be partial disposal of the right each time a payment is made in respect of that right) will be subject to tax in the tax year in which the amount becomes known and payable.

The tax implications of earn outs in business sales

Where the seller qualified for Entrepreneurs’ Relief on the sale of the shares, it is important to note that any such gain (or gains) will not qualify for relief as it arises on the disposal of a separate asset, the earn out right, not the shares. Any capital gains that arise on the disposal of the earn out right will therefore be subject to tax at the full rate.

As a result, the seller may be tempted to assume the maximum earn out will be achieved but must bear in mind that:

1. This will mean paying more tax upfront as it will be assessed as part of the initial sale proceeds; and
2. It is the present market value of the earn out that is to be brought into account at the time of sale and this should be discounted to reflect inherent uncertainty and time value of money.

If the earn out is to be paid over a number of years, HMRC would usually expect some discount to be applied to reflect that a right to receive £x in a year’s time is not worth £x now as the money could otherwise have been invested or put to use in the meantime (although at current interest rates there may not be any material discount).

Where there are multiple sellers, it will also be important to ensure that all sellers adopt a consistent approach in the valuation of the earn out right and preparation of their tax returns. It would, for example, increase the likelihood of an HMRC enquiry if one seller assumed the maximum possible earn out payment would be achieved in calculating the gain on the disposal of their shares whilst the others assumed no payment or only provided for a nominal sum.

To deal with these potential issues, it may be possible to restructure the sale so that the earn out is instead expressed as a deferred contingent payment. In effect, the price is set at the maximum sum payable (including the earn out) with £x (the initial consideration) paid on completion and a further £y (the earn out) payable on a specified date or dates contingent upon certain events or targets being met. From a tax perspective this rather subtle difference may help the seller to be able to claim Entrepreneurs’ Relief on the full amount without having to discount the present value.

Where on the other hand the market value of the right(s) to the additional consideration proves to have been overestimated, any resultant capital loss can generally be carried back and set against the gain arising on the disposal of the shares (even if that gain is in an earlier accounting period) thereby giving rise to a repayment of the overpaid tax.

The position is further complicated where the earn out is to be satisfied in shares or loan notes — although in such cases it is generally possible to elect for any non-cash earn out to be treated in the same manner as a cash earn out. This will mainly be relevant where the original sale of shares qualifies for Entrepreneurs’ Relief but any consideration shares or loan notes will not, as otherwise, it will be possible to simply pay tax only as when the consideration shares or loan notes are redeemed.

Conclusion

The use of earn outs can provide a practical solution to price disputes but it is essential that the terms of the earn out arrangements are thoroughly discussed and agreed. Earn out arrangements can also be tax-efficient but, as ever, each case will depend upon its individual facts and it is important to ensure that proper advice is sought at the earliest possible stage to ensure that anything that can help improve the tax position can be reflected in any agreed heads of terms.

If you are interested in finding out more about this or any other tax issue, please contact Haydn Rogan, a partner in the Corporate department on 0161 214 0517 or by email to haydn.rogan@weightmans.com.