Negotiating tax traps with ‘earn-outs’

Peter Rayney highlights some pitfalls to avoid when selling a company, where the deal involves an earn-out. 

Corporate sales taking place in the midst of the Covid-19 pandemic frequently include some form of ‘earn-out’ mechanism.  

Wary purchasers will only be willing to agree a deal based on the future (increased) profits or turnover when they are actually delivered by the target business. On the other hand, sellers tend to believe that they are selling their business ahead of its maximum profit potential.  

What is an earn-out? 

Earn-out arrangements provide a helpful solution to this so-called ‘price gap’ issue. By incorporating an earn-out as part of the pricing mechanism for the purchase of the shares or goodwill, the seller’s and purchaser’s requirements can be satisfied. 

Earn-out deals typically involve additional deferred consideration, which is calculated by reference to the actual two to three years post-acquisition profits of the target company or business.  

This article deals with a number of tax traps surrounding earn-outs. Before we examine these, it’s helpful to remind ourselves of the basic rules for taxing earn-out transactions.  

Taxing earn-outs: The basics  

Since earn-out consideration is unascertainable at the date of the contract, the basis for taxing it largely follows the principles laid down in the landmark tax case Marren v Ingles [1980] STC 500. The basic capital gains tax (CGT) treatment can be summarised as follows: 

• The seller’s CGT consideration comprises the ‘up-front’ sale proceeds and the market value of the right to receive the additional earn-out consideration, which would normally be discounted for its contingent and risky nature as well as the time value of money. 
• The earn-out right represents incorporeal property and is, therefore, an asset for CGT purposes (TCGA 1992, s 21(1)(a)). Thus, when the actual earn-out payments are received by the seller, they trigger subsequent CGT disposals since they represent capital sums derived from the right under TCGA 1992, s 22(1). 
• Marren v Ingles also established that the right is acquired at its market value when the original sale contract is executed. As there will often be several earn-out payments, each receipt (before the final one) will represent a part disposal of the right. The capital gain on each earn-out payment will therefore be calculated after deducting the part-disposal value of the right (based on the rules in TCGA 1992, s 42). 

In essence, the Marren v Ingles dicta fragments one economic transaction, such as a share sale, into (at least) two different CGT disposals, being: 

• the share sale itself; and 

• the part-disposals or final disposal of the earn-out right (which is triggered when the earn-out payments are received). These disposals do not qualify for business asset disposal relief (BADR) since they relate to the disposal of the right, as opposed to shares.  

A simplified example of the taxation of a typical earn-out transaction is shown below: 

Example: CGT on the sale of company shares with an earn-out 

On 2 May 2021, Ted sells 100% of his entire share capital in AC12 Ltd for an initial cash consideration of £1,500,000 and a three-year earn-out. He had originally subscribed for his 100 £1 shares at par in March 2016. 
 
The earn-out is based on the company’s profits for each of the three years ended 30 April 2024, based on a two times multiple of the company’s adjusted EBITDA for each year. The value of the earn-out right at 2 May 2021 is considered to be £800,000. 

Ted’s CGT liability on the sale of his AC12 Ltd shares is £497,500, calculated as follows: 

Earn-out satisfied in shares or loan notes in acquirer 

It is possible to avoid any ‘up-front’ CGT charge on the value of the right if the earn-out right can only be satisfied in the form of shares or loan notes in the acquiring company. In such cases, TCGA 1992, s 138 enables the seller to obtain a form of roll-over relief in relation to the future right.  

The legislation treats the right as a deemed non-qualifying corporate bond security (non-QCB). Provided the relevant conditions for a share for share/security exchange under TCGA 1992, s 135 are met, the seller’s deemed non-QCB security steps into the shoes of the ‘original shares’, with an appropriate pro-rata original base cost. The TCGA 1992, s 135 relief requires the transaction to satisfy the ‘genuine commercial purpose/no main tax avoidance objective’ rule in TCGA 1992, s 137, and hence a tax clearance under TCGA 1992, s 138 (and ITA 2007, s 701) is recommended.  

However, it is possible to elect out of the ‘deemed security’ treatment under TCGA 1992, s 138(2), which then brings the normal Marren v Ingles rules into play. 

Potential earn-out tax traps 

Based on experience on a wide number of earn-out based transactions, some of the more common traps that can arise are as follows:

1. Could HMRC regard the earn-out as employment income? 

HMRC is wary that some earn-outs may represent (in whole or part) a form of disguised remuneration, which should be taxed as employment income. Whether this is the case is a question of fact to be decided on the precise circumstances. Some of the factors to be taken into account include: 

whether the earn-out consideration fairly reflects the true economic value of the company/business being sold;  

whether the seller’s future earnings have been commuted as ‘capital’ earn-out consideration. This may be apparent from the level of actual salary or bonuses that is being paid to the seller(s) in the post-acquisition period and from any evidence surrounding the sale negotiations. 

whether the earn-out payment has been based on personal performance targets. 

Where the earn-out is conditional on the seller’s future employment, HMRC normally accepts this is not indicative of disguised remuneration, where this linkage is part of a reasonable requirement for the sellers to stay to protect the value of the business being sold. See HMRC’s Employment-Related Securities manual at ERSM110940 for further analysis. 

2. What happens if the earn-out is not based on a variable formula but is for a fixed amount? 

Earn-outs only fall to be taxed under the Marren v Ingles rules where the amount receivable cannot be ascertained at the date of the original disposal.  
 
If the earn-out is for a deferred fixed consideration (whether or not it is conditional), then it is taxed under TCGA 1992, s 48 instead. This means that the entire fixed deferred consideration is taxed up-front (without any discount).  

Thus, in the example above, if Ted had sold his company for £1,500,000 initial cash consideration and deferred consideration of £400,000 for each of the three years, provided the company posted EBITDA of at least £600,000, his taxable consideration in May 2021 would be £2,700,000 (i.e. £1,500,000 + (3 x £400,000 =) £1,200,000). However, if and when any of the deferred consideration is not received, TCGA 1992, s 48 has the facility for the taxable consideration to be reduced.  

3. Must a value for the earn-out right be entered on the tax return? 

It cannot be argued that the right to the earn-out is of little value, particularly where, in most cases, it forms the larger part of the sale consideration. Reasonable care must be taken to ensure the earn-out right is properly valued, enlisting the services of a valuation professional where this is appropriate.  

Broadly speaking, earn-out valuations are based on expected net present value principles having regard to the estimated cash flows from the earn-out (as determined at the original disposal date), discounted to present-day values.  

4. What happens if an earn-out to be satisfied in shares or loan notes contains an option to take it in cash? 

The TCGA 1992, s 138 ‘roll-over’ treatment referred to above requires the earn-out consideration to be discharged entirely by an issue of the buyer’s shares or loan notes. If there is any option for it to be satisfied in cash, this will prevent the s 138 relief from being accessed, and the earn-out will become taxed in accordance with the principles established in Marren v Ingles. 

Practical tip 

Self-assessment tax returns that feature a sale of an owner-managed business will often attract an HMRC enquiry, and failing to get the earn-out calculations right may attract penalties, etc. This is underlined by HMRC’s use of ‘nudge’ letters for the reporting of deferred consideration in October 2020.