Earnouts are frequently payments based on a formula connected to the company’s future profits, typically spread over three years based on EBITDA or other recognized indicators. The question of how these future sums should be taxed on the person selling shares after the contract for sale is finalized arises since the amounts that be paid out are unpredictable. We are more concerned with the timing of the unconditional contract for sale than payment dates, which are mostly irrelevant when determining the tax point for CGT.
If all of the deferred consideration was known at the time of the contract, then the sale consideration is just the total value of the transaction, regardless of when those future payments are made. If the additional payments are made for a longer period than 18 months from the date of disposal, HMRC permits the CGT liability to be paid in instalments.
How, then, do you handle earnouts whose future amounts are uncertain? This was taken into account in the Marren v. Ingles case before the House of Lords, where a future payment was conditional upon the company going public on the Stock Exchange within a certain period. It was impossible to predict the stock’s future price or, consequently, the earnout sum.
The problem was resolved by treating the uncertain right to the earnout as a “chose in action”—a legal asset whose estimated value was treated as part of the consideration at the time of sale—and disposing of the right in exchange for the listed shares when the company did list.
While the subsequent disposal of the “asset” is not eligible for the same relief, the initial selling of the shares may qualify for business asset disposal relief (BADR). However, any extra loss will be wasted if a carry back is chosen; therefore, it could be preferable to forego one altogether. Any loss on the sale of the asset can be carried back and offset against prior gains on the shares.
When the earnout “asset” is entirely future cash, a capital gain on the value of the earnout results in a “dry” CGT charge, meaning the vendor has no cash on hand to pay the tax. The solution to this issue is to make sure that the earnout is entirely satisfied by shares or loan notes, in which case the ‘asset’ is viewed as a deemed non-QCB instrument and gain is postponed due to the application of paper-paper rules. If there is a chance of losing BADR relief on the ensuing sale or redemption of the new securities, an option to disapply rules and consider it as a chargeable disposal may be made.
The loan notes may be corporate bonds that qualify or do not qualify (QCB or Non-QCB). When loan notes are exchanged for non-QCBs, they are classified as shares and the gain is postponed until the non-QCB loan note is sold or redeemed. Loan notes are non-QCBs if they are convertible or redeemable in a foreign currency and are handled as shares.
Since QCBs are not considered shares, a gain will result from the exchange of the earnout ‘asset’ for QCBs; however, this gain will not materialize until the QCBs are sold or redeemed.
As it is doubtful that the acquiring company will be the seller’s own company, BADR would typically not be an option when the loan notes are redeemed.
HMRC provides the option to spread the CGT payment over eight years or the actual deal term, whichever is shorter when the entire transaction is anticipated to take longer than 18 months. Legal paperwork is crucial since HMRC views this type of transaction as an employment-related securities transaction; if the earn-out shares or loan notes are obtained due to employment or potential employment, the earn-out right is chargeable to income tax.