Earn-outs are a common feature of M&A transactions and their inclusion can play a large part in deal negotiations. The commercial, financial, and legal aspects will drive the deal process and tax should always be considered alongside these. This is especially important for the vendor because with earnouts, the Irish tax analysis may not always be they would initially expect. Indeed, when it comes down to it, there may be other options which better suit the deal objectives for both parties.
Taxation of earnouts for the vendor
Generally, the full amount of the sale proceeds must be included in computing Irish Capital Gains Tax (CGT). Whether the receipt is uncertain or deferred does not matter. This means that monies held in escrow or post-completion working capital adjustments are taxed upfront. This also means that the value of earn-outs should be included in the CGT computation on sale.
But what amount should be included in this tax calculation? An earnout is contingent and usually calculated by reference to future business performance, with no guarantee of receipt or quantum.
The tax position is relatively simple if there is a maximum cap in the purchase agreement. The full amount of the earnout should be included for tax purposes, irrespective of the present-day value of the earnout right. If the amount ultimately received is less than the maximum, the vendor can claim a tax refund. So, whilst Irish law provides an element of tax certainty here, it gives rise to a cashflow mismatch as tax is paid upfront on proceeds that are not received. This is not ideal.
Future proceeds unknown
Matters get complicated where there is no maximum cap on proceeds. This can arise where consideration is wholly unascertainable for example a deal where Key Performance Indicators can be scaled with no maximum. For Irish tax purposes, this may give rise to (at least) two Irish tax triggers – the first on the initial sale and the next once proceeds are received. Each subsequent receipt will have a tax impact.
In practice it means this:
On the initial sale, the present-day value of the right to receive the contingent amount should be ascertained. This will be included in the first CGT computation. When the deferred consideration is eventually ascertained, a second CGT computation will be required. At that time, the actual deferred consideration should be compared with the present-day value used in the first computation. Any excess will then be subject to CGT. If proceeds are less than per original computation, the vendor will realize a capital loss. No tax refund will arise here – the capital loss only has value if there are other current year or future capital gains. Further CGT calculations will be required where proceeds are received on piecemeal basis. Each will require a “part disposal” tax computation which will all need to be tracked.
Unintended tax impacts
This approach may have other potentially unintended tax impacts. The second gain could be treated differently to the gain on original disposal of shares. This has a very real impact in these scenarios:
Even if the original gain on share sale qualifies for Irish tax relief the gain on receipt of additional proceeds may not. This can be significant where the original sale qualified for 0% Participation Exemption or indeed the 10% Entrepreneur Relief rate.
There is also a change in tax rate risk, with the additional proceeds are subject to tax rate in force at time of receipt. However, with the current rate at 33% (the highest in almost 20 years) this may be an academic point.
Some internationally mobile vendors may no longer be Irish tax resident so may not be within the scope of Irish tax on the additional proceeds.
Sometimes sellers will prefer an earn-out which defers payments to horizons in the future. Against that, other sellers may wish for the maximum upfront valuation to ensure full entitlement to the Participation Exemption or lower Entrepreneurs’ Relief rate. This can be a balancing act, especially also when the requirements of buyers are on the table.
One further word of caution - neither Irish tax legislation nor published Irish Revenue guidance specifically address the matter of unascertainable contingent consideration. Specific advice should always be obtained here.
The application of reliefs, exemptions can also have impact…
2. Alternatives to Earnouts
As an alternative to deferred cash proceeds, then the following options could be considered. These may achieve the same commercial objectives as earn-outs.
Share exchanges
A sale can be structured so that the vendors receive shares in the acquirer as full or partial consideration proceeds. The receipt of shares can potentially qualify for Irish CGT relief (via Section 586 Taxes Consolidation Act 1997). This is a deferral mechanism, essentially a form of rollover relief. On disposal of the new shares, the tax implications at that time will need to be determined - base cost in those shares will be the same as that in the original holding. This can be an effective route where the seller wishes to retain an equity interest in the enlarged business following the disposal. It may bring increased commercial exposure so will not be suitable for all.
Matters can become further complicated where an earnout itself is structured in the form of shares. In strictness, the roll-over relief will not apply but Irish Revenue may accept it in certain circumstances.
An additional word of caution where part of the consideration is Restricted Stock Units (RSS). Such instruments can be issued by US multinational and described as “Employee Share Schemes”. These are generally regarded as rights over shares so again, in strictness, rollover relief may not be available here.
Staged disposal or holding back shares, retaining a minority interest
A common alternative is for the vendor to simply retain shares in the company being sold (the Target). The subsequent sale of the retained shares will be a taxable disposal at that later point.
To safeguard the position, the purchaser and vendor can take out options over the retained shares. The option prices could be quantified by reference to the same criteria as the deferred consideration mechanism. This can achieve a full tax deferral on the deferred consideration with no commercial exposure.
The subsequent sale of the deferred shares will have its own CGT considerations at that point in time. The CGT rate then in force will apply. Entrepreneur Relief and the Participation relief may still be available to the vendors.
3 Other tax considerations for earn-outs
Individual vendors and continued employment
A seller who remains employed with the acquired entity post deal potentially risks post completion payments being classified as employment income. If any deferred consideration is in fact salary, income taxes will arise and the employer will be liable to account to Irish Revenue under the PAYE system. Such risks occur even where the consideration is non-cash, such as shares.
The tax analysis here will depend on the facts and the share sale documentation will be important. If monies are clearly consideration for the sale of the shares, then CGT treatment should apply. It will be helpful here if non-employed vendors have the same earnout entitlements.
Where the individuals continue to receive appropriate remuneration during the earn-out period, this is also supportive that deferred amounts are properly within the remit of CGT. In any case, there should always be a separate remuneration package for the additional services the individual vendors will perform. All parties to the deal should always ensure that this matter is taken into account as part of the negotiation process especially as the employer company will bear the initial tax risk here.
Recent anti-avoidance – private companies
Anti-avoidance measures were introduced in 2017 which operate to reclassify proceeds for disposal of certain shares as dividends where these monies are ultimately funded by the target company. These measures are broadly cast and could apply for example where earnout consideration is paid out of Target’s reserves.
Importantly, these rules only kick-in where the target and the acquirer are both private Irish companies (close companies).
Irish Revenue have confirmed that in their view “bone-fide [genuine commercial] financing arrangements entered into by a purchaser to fund the earn-out element of the consideration” will be outside the scope of the measures. However, unlike other anti-avoidance law, there is no ‘bona fide’ test which could allow a legislative basis to assert that the disposal transaction was not within the scope of these measures. While Revenue guidance is helpful here, it has no legislative force. This is being lobbied significantly and one would hope for formal amendment to confirm the point in the next Finance Act.
Corporate vendors and earnouts
Different tax considerations arise where the Vendor is an Irish corporate. Usually the Participation Exemption would apply to exempt any gain on share sale. Where this is the case, it will be particularly important to consider the tax impact of any subsequent earn-out or contingent proceeds.
In certain circumstances, a gain on receipt of additional earn-out proceeds would not qualify for the exemption. This can be the case even where the original disposal of shares was exempt.
Furthermore, if sale proceeds are partially satisfied by issue of shares, then this new holding may no longer meet the conditions for tax exemption. This can a common enough scenario where the acquirer is a large quoted group as the minimum shareholding requirement would not be met. This type of structuring could give rise to additional CGT costs for the vendor.
To simplify matters, rather than cash earn out, the retention of some shares in Target by the vendors might also be option. This could allow for piecemeal tax-exempt disposals
