Watch Out for your Earn-Out

Did you sell a company before 23 June 2010 and are due to receive further consideration based on the future performance of the company that you sold (a so-called earn-out)? If so, you could end up paying more capital gains tax than is necessary.

Earn-outs are most commonly linked to the profits of the company after its sale. They are useful. They can often be a way of bridging the gap between seller's expectation of what the shares are worth and the amount the buyer initially is prepared to pay for them. They are also helpful in taking risk away from the buyer of the shares.

When the profits are eventually known, the amount of further consideration is calculated. Rather than pay cash for that consideration, the seller often asked the buyer to issue loan notes to the seller for the relevant amount. This might seem strange. The loan notes usually cannot be cashed in for at least six months. That means the seller has to wait for his cash and also risks never being paid. Why would the seller want that? The simple answer is there was often a tax advantage to the seller in using loan notes to satisfy his earn-out right.

The loan notes effectively postponed the gain on the sale of the shares arising from the additional earnout consideration. So long as the tax rules did not change, the seller would typically expect the capital gains tax rate to be 18% on that additional consideration.

Unfortunately, there was an upheaval of the rules relating to the capital gains tax treatment of earn-outs with effect from The Budget on 22 June 2010. The additional consideration attributable to the earn-out right is now taxed at 28% for a higher rate taxpayer. This seems a little unfair, but remedial action might be available.

The seller who is a higher rate taxpayer can make a tax election which substantially reduces the rate of capital gains on the earn-out right. The election must be made on or before the first anniversary of the 31st January next following the end of the tax year in which the seller sold his shares. So if the shares were sold in, say, May 2009, the seller would have until 31 January 2012 to make the election.

If you believe you might be affected by the issues in this article or have concerns about other tax issues, please contact Nasim Sharf on 01482 337336, email nasim.sharf@rollits.com

Posted on: 10/02/2011

This article is for general guidance only. It provides useful information in a concise form. Action should not be taken without obtaining specific legal advice.

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