The nasty capital gains tax trap on business sales

3rd May 2016 | News

If you’re lucky enough to have a strong buyer for your business – and the price is right – you’re actually only halfway there. If the deal involves being paid an earn-out fee – whereby the full price will be paid to you only if you achieve future performance levels, then beware – the taxman is doing you no favours.

The problem with earn-out fees – which are common in small business circles – is that the Australian Taxation Office wants to tax the value of the future performance payment upfront, even if a business never succeeds in reaching the higher performance levels in the first place.

Brisbane-based tax partner of professional services firm BDO Mark Molesworth describes it this way: a small business acquired for a million dollars is offered the chance to be paid an extra $300,000 if it maintains sales and profitability over a certain agreed earn-out period. The ATO will tax the vendor on the extra $300,000 it hasn’t yet received and may never receive.

Mark Molesworth’s firm BDO has been fighting the provision.

“If you value the earn out at $300,000 – and the business doesn’t go so well – you will end up with a capital loss in 12 months time which you can’t offset against the capital gain of $1.3 million which you recognised on the sale,” says Molesworth. “You end up in a situation where you’re taxed initially on more than the cash you actually received and if things go badly for you, you might end up paying tax on more money than you ever received.”

Molesworth says BDO (among a host of tax experts and accountants) has been fighting this tax provision for around seven years. Governments have been flagging an amendment to this since 2010, but it is only in the past few months that draft exposure legislation has been tendered for industry comments. “We’ve waited a long time for them to get around to fixing this,” he says. “We’re looking for what we call ‘look-through’ treatment of capital gains. You pay the tax once you’ve received the money.”

Molesworth says that under present legislation a business which overpaid tax will not be recompensed. “This capital loss could be carried forward to offset other taxable capital gains, but could not be used to claim back tax paid in the year of the sale.”

Drue Schofield, a director at 4Front Accountants in Brisbane makes his own analogy: “If you sold a house for $500,000 and then the buyer agrees to pay 30 per cent more for it if that value goes up over the next year, you’d still have to pay the full CGT on $650,000 whether the value rose or not.”

Of course, this is not going to happen but Schofield says it shows how arcane the system is.

Tony Arena who runs BCI Business Brokers in Sydney, says it’s always a disincentive “to pay the tax now and get the money tomorrow” but said he didn’t see many earn-out situations.

“All the same, I don’t think this is a big tax issue. There’s one way of delaying that tax which is to take it into the next financial year. If we’re selling a business now and I can get the deal done into the next financial year. I’m delaying my tax liability by 12 months anyway.”

Arena says that if the earn-out tax legislation is amended, there is a PR benefit to the government, which has already shown its devotion to small business in the recent federal budget. “The government got positive feedback from a lot of sources from the Budget. So if they say here’s yet another thing to help small businesses out, the publicity they’ll get will be enormous.”

Bevan Roberts, CEO of business broker Link in South Australia, says the tax implications are a risk but earn-outs – and any payments that rely on the future performance in any business – should also be considered a risk.

“Where many businesses in the past may have had a slow burn of predictability, they don’t now. Change and the speed with which technology has accelerated change has made revenue and profit predictions far more difficult to make.

“As far as CGT and other tax implications are concerned we would always advise clients to seek the best advice for their circumstances. Most do, some don’t.”

There still needs to be re-thinking of the maximum earn-out period (BDO is seeking five years, not four as the draft legislation proposes) and it wants to see some consideration of the earn-out potential of things like patents – which have no current CGT treatment.

“We still have minor concerns about how it will fall out with the government, but with look-through CGT legislation there will be far greater certainty and fairness when people are selling their businesses.”