Some buyers are reluctant to hand over the full business purchase price in one go. Instead, they negotiate an ‘earn out’, paying some cash up front but deferring the rest of the payment.
Earn out is also known as ‘deferred consideration’. Buyers defer the consideration – sometimes subject to a condition being fulfilled, or to assess the business’s growth potential, or to ensure a smooth transition from its current owner or key staff.
Under earn out, the impact of your tax position will depend on how much you receive up front.
There is more information here on how up-front consideration is taxed.
Earn out cash – Ascertainable value
As discussed above, an earn out defers the consideration payable at the disposal of your business. You have been offered a future amount of cash for your business and as such, you are seen as being in receipt of a ‘right to receive future consideration’.
If this future amount is known, or fixed at the date of disposal, it will have an ‘ascertainable value’. This means that the amount you are due to receive, plus the initial up-front payment, is liable to Capital Gains Tax (CGT), even though you are yet to receive the cash.
As CGT is payable to HMRC on 31 January following the end of the tax year of your disposal, it is always possible that you will be taxed on something you do not yet have.
You may be able to take advantage of Business Asset Disposal Relief (BADR) on the earn out as if it were upfront cash.
Please note that no discount is applied to reflect the conditional nature of a disposal. CGT will still become due for the full amount, even though you may never receive the cash.
If the deferred consideration is not paid, specific provisions are available to reclaim the tax which has already been paid.
You can ask to pay your CGT in instalments if you receive the deferred cash more than 18 months after the disposal. Your tax instalment payments will be 50% of the deferred cash yet to be received.
In practice, with BADR rates at 10% and CGT at 20%, it is unlikely that instalments will be available.
Earn out cash – Unascertainable value
Sometimes, the earn out cash value will be `unascertainable’. The future payments are not known at the date of disposal because they are dependent on an unknown future event. For example, the payment is a percentage of the profits generated over a set period.
There is, of course, a possibility that you will be paid nothing. However, there is still a likely value associated with the opportunity to receive further funds.
This value is included in the disposal calculation, and CGT is paid on the amount. BADR may be available on this value.
When the future cash is received, this is a disposal of the right. If you receive more than you originally valued the right for, you have made a gain and CGT will be due on this. Under these circumstances, BADR will not be available. This is because you are no longer disposing of a ‘business asset’. Rather, you are disposing of a ‘right to receive future consideration’.
On the other hand, if you receive less than the original value, and were taxed on this at the original disposal, you have made a capital loss. You can either report this to HMRC as a capital loss to be used against other capital gains, or you can reclaim the CGT you paid at the original disposal date.
Earn out shares or loan notes
Earn out is not always in the form of cash. It can sometimes be future shares or loan notes.
As with upfront consideration, this will satisfy the ‘share for share’ exchange rules and there won’t be any immediate tax consequence. There will also be no tax implications when you receive the shares or loan notes.
The CGT on the earn out is deferred until you finally dispose of the new shares or loan notes at some point in the future.
If the earn out is in the form of Qualifying Corporate Bond (QCB) loan notes, this will count as a disposal and a chargeable gain will arise. This gain will then be frozen, and CGT will not be due until you finally dispose of the QCB loan notes.
As with other shares and loan notes, if you qualify for BADR, you can choose to bring the shares and loan notes into charge on the date you receive them. You would therefore pay CGT as it if were a cash earn out.
At this point, you may no longer hold 5% of the new company. This can be useful if you didn’t satisfy the BADR rules on future assets at the time you received the loan note. It means you may now qualify for BADR.
