Tax and Superannuation Laws Amendment (2015 Measures No. 6) Bill 2015

Bills Digest no. 70 2015–16

PDF version [586KB]

WARNING: This Digest was prepared for debate. It reflects the legislation as introduced and does not canvass subsequent amendments. This Digest does not have any official legal status. Other sources should be consulted to determine the subsequent official status of the Bill.

Leslie Nielson
Economics Section
27 January 2016

Contents

The Bills Digest at a glance
Purpose of the Bill
Structure of the Bill
Background
Committee consideration
Policy position of non-government parties/independents
Position of major interest groups
Financial implications
Statement of Compatibility with Human Rights
Key issues and provisions
Concluding comments

Date introduced: 3 December 2015
House: House of Representatives
Portfolio: Treasury
Commencement: Sections 1 to 3 commence on Royal Assent. Schedule 1, Parts 1 to 4 and Schedule 2, Parts 1 and 2 commence on the day after Royal Assent. Schedule 1, Part 5 commences immediately after the commencement of Schedule 2, Parts 1 and 2.

Schedule 2, Part 3 commences immediately after the commencement of Schedule 3 to the Tax Laws Amendment (New Tax System for Managed Investment Trusts) Act 2015. However, it does not commence at all if that occurs at the same time, or before, the provisions covered by Schedule 2, Parts 1 and 2 of this Bill commence.

Links: The links to the Bill, its Explanatory Memorandum and second reading speech can be found on the Bill’s home page, or through the Australian Parliament website.

When Bills have been passed and have received Royal Assent, they become Acts, which can be found at the ComLaw website.

The Bills Digest at a glance

Purpose

The purpose of this Bill is to amend the Income Tax Assessment Act 1997 and the Taxation Administration Act 1953 to:

change the capital gains tax (CGT) treatment of the sale and purchase of business involving ‘earnout’ rights and
introduce a new CGT collection mechanism, which will require a person or entity who buys certain Australian assets valued at $2 million or more, from a foreign resident to withhold and pay to the Australian Taxation Office 10 per cent of the purchase price. This proposed measure aims to improve the collection of outstanding CGT liabilities arising from such transactions.

Reaction

The Bill has received lukewarm support from industry (and some outright opposition) due to the considerable administrative difficulties that the proposed amendments may give rise to.

Parliamentary Support

The proposed measures had their origin in the 2010–11 Budget and as such were initiatives of the then Labor Government. It may be unlikely that the current Labor opposition would oppose these measures.

Dates of Effect

The changes to the CGT treatment of earnout rights is to apply to transactions concluded on or after 24 April 2015 (the day after the release of draft legislation). Protections for transactions concluded before that date, in reliance on previous policy announcements, also apply.

The proposed withholding tax measures are to take effect from 1 July 2016.

Purpose of the Bill

The purpose of the Tax and Superannuation Laws Amendment (2015 Measures No. 6) Bill 2015 (the Bill) is to amend the Income Tax Assessment Act 1997 (ITAA 1997) and the Taxation Administration Act 1953 (TAA 1953) to:

change the capital gains tax (CGT) treatment of the sale and purchase of business involving ‘earnout’ rights[1] so as to treat all payments under a qualifying earnout arrangement as relating or linked to the underlying business asset or assets and
introduce a new CGT collection mechanism, which will require a person or entity who buys certain Australian assets valued at $2 million or more, from a foreign resident to withhold and pay to the Australian Taxation Office 10 per cent of the purchase price. This proposed measure aims to improve the collection of outstanding CGT liabilities arising from such transactions.

Consequential or contingent amendments are also made to:

Income Tax Assessment Act 1936 (ITAA 1936)
Taxation (Interest on Overpayments and Early Payments) Act 1983 and
Tax Laws Amendment (New Tax System for Managed Investment Trusts) Act 2015, if enacted.[2]

Structure of the Bill

The Bill is divided into two schedules:

Schedule 1 deals with the CGT treatment of business sales involving earnout rights and
Schedule 2 deals with the proposed withholding arrangements on CGT liabilities arising from the sale of taxable Australia property by foreign residents.

Background

What is an earnout arrangement?

An earnout arrangement is a right to future financial benefits linked to the economic performance of the business or an asset after the sale of a business. There are two types of earnout arrangement: standard and reverse. A standard earnout arrangement has been defined as follows:

A standard earnout right usually requires the purchaser [of a business asset] to pay to the seller certain additional consideration, determined on the basis of a contingency such as the satisfaction of defined performance thresholds within a specified time period post-sale.[3]

While a reverse earnout arrangement is one where:

...the seller accepts a nominated sum by way of consideration, but undertakes to pay an amount or amounts to the buyer calculated by reference to the earnings generated by the asset during a specified period after completion of the sale.[4]

When are earnout arrangements used and what are their advantages?

Earnout arrangements are a practical, useful and common business tool in circumstances where there is uncertainty in valuing a business for the purpose of its sale. The difficulty in parties agreeing on or reasonably determining proper market value of a business occurs where the value is largely dependent upon uncertain future cash flows. In these circumstances, earnout arrangements also assist in valuing intangible assets of a business, such as ‘goodwill’, where their separate valuation prior to the sale of a business is problematic.[5]

Are they used in Australia and is their use growing?

A 2010 Treasury paper stated that earnout arrangements were a common and efficient way of structuring the sale of an asset where there was uncertainty about its value.[6] A more recent article has described these arrangements as ‘very common’.[7]

The most recent Taxation Statistics show the following information on completed earnout arrangements for the 2012-13 financial year:

Table 1: Earnout Arrangements from Taxation Statistics: 2012–13

Entity	Individuals	Companies	Funds
Number of Transactions	65	45	5
Total Capital Proceeds ($m)	83.7	65.9	0.8
Transactions producing a taxable capital gain	55	40	5
Taxable capital gain ($m)	23.3	19.6	0.24

Source: ATO Taxation Statistics[8]

The statistics in Table 1 suggest that individuals, most likely selling small and medium sized businesses, are the most prevalent users of these arrangements. Unfortunately, the Taxation Statistics do not have comparable prior year information that allows a judgement on whether the use of these arrangements is growing.

Current treatment under tax law—why are these amendments being proposed?

In the absence of legislation dealing specifically with earnout rights, normal CGT rules apply. Thus the current tax treatment of both standard and reverse earnout rights is set out in Draft Taxation Ruling TR 2007/D10.[9] Mostly, each earnout right is treated as property provided by a purchaser to a vendor at the time the earnout arrangement is entered into, thereby giving rise to a taxing event for a vendor where no cash exchanged hands. Thus each earnout right is treated as a separate CGT asset, depending on the circumstances. That is, the earnout rights are treated as CGT assets separate and distinct from the original purchase transaction. This then requires the earnout right to be valued and it may form part of the sale proceeds (where the right is provided by the buyer). The expiration of the right will then trigger a separate CGT event. Also, certain CGT concessions that would otherwise apply to the sale of business assets may not apply to this separate CGT event. In some instances however, the total arrangement, including earnout rights, may be considered as a single CGT asset, with the exact and individual circumstances of each set of arrangements determining which is the case. The practical operation of this ruling therefore gave rise to a confusing and complex basis on which to assess such arrangements for tax purposes.

Specific problems have arisen in the application of TR 2007/D10:

in some circumstances a CGT liability/event for the seller can arise where no actual consideration had been received
where a capital gain accrues to the seller, through the value of the earnout right being less than the payments actually received, there is no mechanism for the CGT discount (i.e. the 50 per cent discount) to be applied to that capital gain where the earnout right lasts less than 12 months. Nor does the small business active asset concession[10] apply to earnout rights
where a capital loss has been experienced by the seller, due to the market value of the earnout right being higher than the cash received, there is no mechanism to offset that loss against the capital gain accrued in the original transaction and
for the buyer, there are no CGT consequences for the amount paid out under an earnout arrangement. Such amounts paid out are not added to the asset’s cost base, thereby potentially increasing the CGT liability if and when the asset is later sold by the buyer.[11]

Earnout Arrangements—Announcement and policy development

In May 2010 the then Labor Government announced that legislation would be introduced to apply look-through CGT treatment to qualifying earnout arrangements in the sale of business assets.[12] Treasury released a discussion paper on the topic at the same time and received submissions from interested parties.[13] This measure was included in the 2010–11 Budget, but legislation was not later introduced into parliament.[14] In 2013 the Coalition Government decided to proceed with this proposed change.[15] Treasury released draft legislation on 23 April 2015 seeking submissions from interested parties.[16] Some of these submissions have been released by the parties themselves, but not by Treasury.[17]

Earnout Arrangements—Proposed treatment

The proposed measure disregards a ‘separate assets’ approach and adopts a look-through but only for particular earnout rights for CGT purposes.[18] Thus the application of the look-through approach is much narrower in its capture than that which was discussed in the Treasury discussion paper. The Explanatory Memorandum states:

A look-through earnout right is a right to future financial benefits which are not reasonably ascertainable at the time the right is created. The right must be created under an arrangement involving the disposal of a CGT asset that is an active asset of the seller, and the financial benefits under the right must be contingent on and reasonably related to the future economic performance of the asset (or a related business). [19]

A five year restriction also applies to the payments made under the right. The parties must also deal with each other at arm’s length.[20]

The ATO has summarised the proposed measure as one where, for eligible earnouts entered into on or after 23 April 2015:

the capital gains and losses arising from eligible earnout rights will no longer be recognised separately (as was the position under the separate assets approach) thus they will be disregarded and
the value of any financial benefit provided or received under a look through earnout right (LTER) is only included in and will thus affect either the capital proceeds arising from the disposal (for the seller) or the cost base of the acquisition (for the buyer) of the underlying asset to which the earnout arrangement relates.[21]

In practical terms this means:

a separate valuation of the LTER will not be required
the expiration of the LTER will in effect not give rise to a separate CGT event
only a provisional capital gain solely consisting of the fixed amount of consideration received will be determined on the day of the sale (as the sale proceeds on that day will not include the value of the earnout rights). Then in the future, when an earnout right is realised as a financial gain because contingent economic performance thresholds of the earnout are met, a revised capital gain will be have to be calculated (because the earnouts will affect the sale proceeds of the original transaction).[22]

Thus the amount of the sale proceeds accompanying capital gain need to be updated every year the earnout agreement is in existence. The key benefit of this approach is that it enables, in a defined circumstance, the ‘deferral of the payment of the capital gain on the eligible earnout rights by disregarding the value of the earnout right when working out the capital proceeds from the sale transaction at the date of sale.’[23] That defined circumstance is one in which there is sale of a business ‘where a genuine disagreement about the value of the business going forward is resolved by at least one of the parties agreeing to provided future financial benefits linked to the performance of the business’.[24] This enables the ‘treatment of a subsequent payment received by the seller because of the earnout right as part of the original capital proceeds—which may be subject to the small business CGT concessions.’[25]

The proposed changes apply to look-through earnout rights created on or after 24 April 2015. Transitional protection is provided to taxpayers that have reasonably and in good faith anticipated the changes to the tax law in this area as a result of the announcement by the former Rudd Government.[26]

Current tax law on capital gains arising from sale of Australian property by foreign residents

Under Subdivision 855-A ITAA 1997 a foreign resident can disregard a capital gain or loss unless the relevant CGT asset is a direct or indirect interest in taxable Australian property, or relates to a business carried on by the foreign resident through a permanent establishment in Australia.[27]

Where a foreign resident makes a capital gain on the sale of taxable Australian property, they are required to pay normal CGT. The Explanatory Memorandum notes that this particular requirement has a very low compliance rate; however, there seems to be a lack of explanation as to why this tax collection problem has not been addressed earlier by the Parliament.[28]

Taxable Australian property includes:

a direct or indirect interest in taxable Australian real property
- under section 855-20 ITAA 1997 this can include real property situated in Australia (including a lease of land, if the land is situated in Australia) or a mining, quarrying or prospecting right (to the extent that the right is not real property), if the minerals, petroleum or quarry materials are situated in Australia
an asset used in carrying on a business through a permanent establishment in Australia and
any rights or options in respect of these assets.[29]

Withholding tax on Australian property sales by foreign residents—Proposed amendments

Schedule 2 of the Bill seeks to establish a withholding tax regime. Under this regime, where a foreign resident sells taxable Australian property the purchaser is responsible for the payment of this withholding tax at a rate of 10 per cent of the purchase price. The foreign resident would still be liable for the balance of any unpaid CGT arising from the sale of this property.

This proposal does not apply to:

property sales by a foreign resident worth less than $2 million
property that is used in carrying on a business through an Australian permanent establishment[30]
shares listed on a stock exchange or
a situation where a withholding tax obligation already exists.

Withholding tax on Australian property sales by foreign residents—Policy announcement and development

The proposed amendments were announced in the 2013–14 budget. The following process then occurred:

the Abbott Government announced that it would proceed with this proposed change, which was originally put forward by the former Rudd Government[31]
Treasury released draft legislation in May 2014 and invited submissions[32]
a Treasury discussion paper was released in October 2014 and further comment from interested parties invited[33] and
draft legislation was released by Treasury in July 2015 and again, submissions were invited.[34]

Some of these latter submissions have been released by the parties who made them.

Committee consideration

The Senate Selection of Bills Committee has deferred consideration of this particular Bill until its first meeting in 2016.[35]

At the time of writing this Digest the Senate Scrutiny of Bills Committee had not commented on the Bill.

Policy position of non-government parties/independents

As at the date of writing this Digest neither Labor, the Australian Greens nor independent members of parliament have expressed a position on this particular Bill. However, given that the proposed measures were first put forward by former Labor Governments it may be unlikely that they would be now opposed by the current Labor Opposition.

Position of major interest groups

Earnout rights

The most recent set of comments by interested parties on the proposed amendments in relation to the CGT treatment of earnout rights were given in relation to the draft legislation released by Treasury on 23 April 2015. Generally, published comments on this draft legislation were concerned about various detailed aspects of the proposed amendments. Only one published response gave general support for the proposed changes, with one opposing the introduction of the proposed amendments in the draft legislation.[36] Treasury has responded to these concerns in a ‘Summary of Issues’ document as well as changes in the final legislation submitted to Parliament.[37]

When the proposal was first made in 2010 one commentator noted that it would provide clarity in a confused tax practice area.[38]

Withholding tax on Australian property sales by foreign residents

The main reaction by interested parties to this particular proposal has been made via comments on the above mentioned draft legislation:

some submissions opposed the proposed arrangements on grounds of complexity and additional administrative arrangements not being justified by the revenue leakage that the proposal was meant to stem[39]
there are concerns on the potentially wide range of transactions to which the proposed amendments apply and[40]
two submissions supported the introduction of the proposed regime, but made a significant number of technical comments on the Exposure Draft legislation.[41]

Reportedly, the property industry had a negative reaction to the proposed measure announced in the 2013–14 budget citing concerns that the proposed change would ‘drive out foreign capital’.[42] Other concerns were that this particular change would cause confusion to foreign investors and leave Australia out of step with other countries’ arrangements, notably the United Kingdom.[43]

Financial implications

The Explanatory Memorandum notes that:

the proposed capital gains tax treatment of earnout rights will cost the federal budget some $20 million between 2015–16 and 2018–19 and
the proposed imposition of a withholding tax on purchases of property from foreign residents will increase revenue by $330 million over the forward estimates period.[44]

Statement of Compatibility with Human Rights

As required under Part 3 of the Human Rights (Parliamentary Scrutiny) Act 2011 (Cth), the Government has assessed the Bill’s compatibility with the human rights and freedoms recognised or declared in the international instruments listed in section 3 of that Act. The Government considers that the Bill is compatible.[45]

At the time of writing this Bills Digest, the Parliamentary Joint Committee on Human Rights had not commented on the Bill.

Key issues and provisions

Schedule 1—Earnout rights

Part 1

Item 1 of Schedule 1 inserts proposed section 112-36 into the ITAA 1997. This new section achieves several outcomes including:

exempting any look-through earnout rights (defined below) from the CGT consequences of the transaction (proposed subsection 112-36(1))
allowing either party in the transaction to revise their CGT self-assessment as earnout rights are concluded (proposed subsection 112-36(2))
allowing the Commissioner of Taxation (the Commissioner) to amend such assessments (proposed subsections 112-36(3) and (4)) and
allowing objections within 60 days to the Commissioner’s assessment (even if the taxpayer would otherwise be out of time) where a taxpayer is dissatisfied with an assessment as the Commissioner has not made an amendment due to a financial benefit provided or received under an earnout right (proposed subsection 112-36(5)).

Some submissions were concerned that these provisions are restricted to disposal of a CGT active asset that causes CGT event A1 to occur.[46] Proposed sections 116‑120 (item 3) and 118-565 (item 4) also depend on CGT Event A1, and no other CGT event, occurring.

In section 104-5 of the ITAA 1997, CGT Event A1 refers to the disposal of an asset. One submission to Treasury suggested that CGT events B1, D1, E2 and K6 should also be included in the operation of these new provisions, so that the full range of relevant CGT events related to these transactions could be covered by the proposed legislation.[47] CGT events C2 (cancellation, surrender and similar endings) and D1 (creating contractual rights) are included in these amendments by proposed section 118-575.

The remaining CGT events (B1, E2 and K6) may indeed occur at the same time as event A1, but they do not, of themselves, involve the actual sale of a CGT asset. If these latter CGT events were included in the operation of the new provisions a tax concession may be conferred where there was no actual sale of a business or related asset.

Under the proposed provision, every time an amount is paid or received under an earnout arrangement, prior year’s tax returns have to be resubmitted and tax liabilities readjusted. The Law Council of Australia has observed that this is time consuming and expensive.[48] Of course this is true, but it is difficult to outline an alternative given the uncertain and contingent nature of the payments in question, save exempting them from tax altogether. The Tax Institute has noted that the requirement for recasting CGT tax returns during the life of the earnout arrangements is an acceptable trade off to more complex solutions.[49]

Item 4 inserts proposed section 118-565 into the ITAA 1997. Proposed subsection 118-565(1) provides that a ‘look-through earnout right’ (LTER) exists if all the following conditions are met:

the right is a right to a future financial benefit that is not reasonably ascertainable at the time the right is created
the right is created where an active GST asset is disposed of, that is CGT Event A1 occurs
the financial benefit is provided no later than five years after the CGT Event happens (this period has been increased from four years in the draft legislation)
the financial benefits under a right must be contingent on and reasonably related to the future economic performance of the CGT asset or a business for which it is reasonably expected that the CGT asset will be an ‘active asset’
the value of the financial benefits reasonably relates to that economic performance
the value of the earnout payment must not be disproportionate to the benefits that could have been reasonably expected to result from the performance of the asset to which they are linked and
the parties are dealing with each other at arm’s length.

Proposed subsection 118-565(4) provides that a right to receive a financial benefit for ending a LTER is also a LTER if the benefits provided for ending the LTER are certain. (In other words, an LTER will also exist if all the conditions set out in proposed subsection 118-565(1) are met and a right is exercised to end the LTER in exchange for a definite financial benefit.)

An ‘active asset’ is defined in section 152-40 ITAA 1997 as an asset (whether the asset is tangible or intangible) owned by the taxpayer that is used, or held ready for use, in the course of carrying on a business that is carried on (whether alone or in partnership) by the taxpayer or their affiliate(s) or an entity connected with the taxpayer. The Explanatory Memorandum points out that ‘assets that are not active assets are not sufficiently linked to the conduct of a business to fall within the intended scope of the concession for earnouts’.[50] The current definition of ‘active asset’ would problematically exclude certain assets. For example, earnout rights framed around the satisfaction of non-economic performance criteria such as payment contingent on discovery of the existence or value of mineral resources, will not satisfy this requirement. Proposed section 118-570 (item 4) provides for additional ways in which an asset can be an active asset for the purposes of applying the above definition.

The text of proposed section 118-565 in the draft legislation is very similar to that put to Parliament in the Bill. Thus the comments on this proposed section in the draft legislation are very relevant to the proposed legislation now before Parliament. The outstanding issues appear to be:

the proposed LTER definition is too narrow, though submissions did not provide details of earnout arrangements that would fall outside the scope of this definition[51]
the proposed definition of an LTER is very complex and will require specialist assistance to apply. One submission suggests that the definition of an earnout arrangement in existing subsection 230-460(13) ITAA 1997, suitably modified, be used instead.[52] This subsection (which comes from that portion of the ITAA 1997 that applies to the taxation of financial arrangements) currently reads:

Proceeds from certain business sales

(13) A right to receive, or an obligation to provide, financial benefits arising from the sale of:

(a) a business; or

(b) shares in a company that operates a business; or

(c) interests in a trust that operates a business;

is the subject of an exception if the amounts, or the values, of those benefits are contingent only on the economic performance of the business after the sale.[53]

proposed subsection 118-565(2) specifies that an LTER arrangement does not meet, and is taken never to have met, the timing condition in proposed subsection 118-565(1) if:
- the arrangement includes an option to extend or renew
- the parties to the arrangement vary the arrangement or
- those parties enter into another arrangement over the relevant CGT assets

so that financial benefits could be, or are, provided over a total period of more than five years after the end of the income year in which the CGT event occurs.

The Explanatory Memorandum notes:

This requirement is not breached simply because one party or another may be late in providing a financial benefit under the look-through right, even if the other party tolerates this lateness.[54]

However, one submitter on the exposure draft of the legislation expressed concern that the situation may be different if a party agreed to a payment being deferred so that it occurred outside the five-year timeframe. That is, such an agreement could fall within proposed paragraph 118-565(2)(b) and therefore result in the arrangement ceasing to meet the LTER definition, whereas if the late payment was made without permission, the arrangement would remain an LTER. Thus two opposing outcomes could apply to the same circumstance (a payment received after the five-year period). The submitter considered that losing the benefits of the proposed amendments may be unfair in these circumstances[55]

there may be difficulty in applying these provisions to situations where the business being sold comprises of both active and non-active CGT assets, or an asset that may not be a CGT asset at all (for example specific commercial and technical information)[56] and
the Tax Institute contends that the criteria for benefits paid being contingent on the economic performance in proposed paragraph 118-565(1)(f) are too narrow, and there will be many arrangements excluded for no obvious policy rationale[57]
- the Law Council of Australia provides an example of a situation where this could occur, as follows:
When interpreting the requirement in paragraph (f) of the definition of look through earnout right in [proposed] section 118-565, do the financial benefits have to be contingent on the economic performance of either solely the sold asset (in item (i)) or in a business which uses the CGT asset and nothing else (in item (ii))? That is, what reading is to be taken of paragraph (f) where an asset is disposed and an earnout is to be calculated by reference to the asset sold and something else? This will be of particular relevance where the asset (which could include shares in a company) are sold into a broader group structure in which the acquirer sits and the earnout is to be calculated on the performance of the acquirer’s broader group. This will be common in practice as acquisitions are often undertaken with the object of obtaining synergies post acquisition with other operations conducted by an acquirer.[58]

Generally, Treasury’s standard answer to these issues is that they are seeking changes outside the announced intention of the policy in 2010.[59] To deviate too much from the original stated policy intention may adversely affect earnout arrangements that have been entered into since that time relying on the policy announcement in that year. On the other hand, if improvements may be made without adversely affecting already established arrangements, then Parliament’s consideration of this Bill is the appropriate opportunity for this to occur.

As noted above, proposed section 118-570 (item 4) specifies additional ways in which an asset may be an active CGT asset for the purposes of these amendments. Some commentators have complained that the draft legislation did not allow for interests in foreign entities to be active assets for these purposes.^{^[60]}Proposed subsection 118-570 allows for this to occur.

Under proposed section 118-570 an asset may be an active asset of an entity for the purposes of these amendments if all the following are satisfied:

the entity owns the asset at the relevant time (presumably the point of sale)
the asset is either a share in a company or an interest in a trust
the entity is either a CGT concession stakeholder[61] of the company in question or, if the entity is not an individual, it has a small business participation percentage[62] in the company or trust of at least 20 per cent
the company or trust has been carrying on a business since the start of the most recent income year
the company or trust is not a subsidiary member of a consolidated group and
the assessable income of the company in the most recent income year was greater than nil and at least 80 per cent of that income was not produced by financial instruments and assets (that is, it was not passive investment income).

This definition excludes companies that derive their income from holding financial assets, which is they are not ‘bricks and mortar’ companies.[63] This is consistent with the exclusion of these companies from the definition of active CGT assets in existing subsection 152-40(4) ITAA 1997. It has been argued that this exclusion would also preclude companies whose income is derived from certain software licencing companies whose licence fees may qualify as royalties.[64] Whether this exclusion is desirable is a matter for Parliament to decide.

The above requirement for the entity being sold to have at least a 20 per cent small business participation percentage has been seen as creating some potential problems for a buyer in certain circumstances, as follows:

The minimum 20% interest holding requirement, as currently drafted, will create considerable problems, particularly for a buyer. In many closely held companies, there will likely be multiple shareholders with interests exceeding 20%, but other senior employees with material shareholdings that are below 20%. The way the provisions are currently drafted, a buyer of 100% of the shares in the company would have to apply the new rules to the acquisition of the majority shareholders’ interests, but would be left in the current problematic situation for the purchase of the minority shareholders’ interests. There should be a ‘drag along’ rule, by which, as long as one accepting vendor qualifies under the ‘look-through earnout right’ rules, then all other accepting vendors under the relevant arrangement are also treated as having a ‘look-through earnout right’.[65]

It is notable that Parliament has recently passed an amendment that encourages employee share ownership in smaller companies, so it is more likely that the above situation would arise as time goes on.[66] Again, whether the above suggested ‘drag along rule’ is adopted is a matter for Parliament.

Part 2

This part deals with ensuring that the various small business CGT concessions are available to those receiving payments via look-through earnout rights when a CGT asset is sold. Briefly, these concessions are available if the following are satisfied:

the entity must be a small business entity or a partner in a partnership that is a small business entity, or the net value of assets that the entity and related entities own must not exceed $6 million
the CGT asset must be an active asset and
if the asset is a share or interest in a trust, there must be a CGT concession stakeholder just before the CGT event, and the entity claiming the concession must be a CGT concession stakeholder in the company or trust or CGT concession stakeholders in the company or trust must have a small business participation percentage in the entity of at least 90 per cent.[67]

Briefly, the four small business CGT reliefs available are:

an exemption from CGT if a taxpayer has held an active CGT asset for 15 years or more and retires or is permanently incapacitated[68]
if held for a lesser period the first $500,000 of a capital gain can be disregarded upon retirement[69]
when using the proceeds of a sale to purchase another asset a taxpayer can defer the capital gain raised by the sale of the first asset[70] and
CGT is not levied where the first $1.4 million (in 2015–16) of any sale proceeds are contributed to a superannuation fund.[71]

There have been some comments suggesting that the above-mentioned $6 million limit is too low where the amounts to be received via a set of look-through earnout arrangements is uncertain. That is, this $6 million limit could be breached inadvertently, if the asset being sold has an economic performance above expectations.[72]

Part 4

Item 38 applies the amendments in Schedule 1 Parts 1 to 3 in relation to look-through earnout rights created from 24 April 2015. This is the day after the draft legislation for this Bill was released. Item 39 protects taxpayers who have made arrangements based on previously announced policy (i.e. the May 2010 announcement) from adverse assessment under the proposed rules.

Schedule 2—Foreign resident capital gains withholding payments

The Explanatory Memorandum states:

Withholding taxes are amounts that a person (the payer) withholds from a payment they make to another person (the recipient). Withholding taxes represent the (sometimes estimated) tax liability of the recipient. Withheld amounts are paid to the Commissioner. There is currently no specific withholding regime for capital gains and related property transactions.[73]

Part 1

Item 1 of Schedule 2 inserts proposed subdivision 14-D into Schedule 1 of the Taxation Administration Act 1953 (TAA 1953).[74] Proposed section 14-200 imposes an obligation on the purchaser of certain property to make a payment to the Commissioner equal to 10 per cent of the first element of the cost base (normally the purchase price) where proposed section 14-210 applies (see below). This obligation applies where at least one of the vendors is a foreign resident for taxation purposes (see proposed paragraph 14-200(1)(b)).

There are various exceptions that are dealt with later, but proposed subsection 14-200(4) prevents this obligation applying if the amount otherwise payable is nil. It is not clear that the purchaser would be in a position to know if any CGT was payable as a result of the transaction and the Explanatory Memorandum is silent on this matter.

Proposed section 14-210 requires the purchaser to determine whether the vendor is a relevant foreign resident. A foreign resident for tax purposes according, to section 6 ITAA 1936, may include:

a person living outside Australia or
a person who is present in Australia for less than half the year and has an address outside Australia and does not intend to take up residence in Australia.

Beyond these seemingly simple categories the Explanatory Memorandum notes that the tax residency of an entity may be a complex legal and factual question and it may be difficult for a purchaser to reasonably decide this matter.[75] Proposed subsections 14-210(2) and (3) provide two additional ways that this question can be resolved:

the vendor gives the purchaser a certificate drawn up by the Commissioner under proposed section 14-220 or
the vendor declares that it is an Australia tax resident under proposed section 14-225 and the purchaser does not know that the declaration is false.

Otherwise, proposed section 14-210 applies if:

the purchaser knows that at least one of the vendors is a foreign resident
the purchaser reasonably believes that at least one of the vendors is a foreign resident or
the purchaser does not reasonably believe that the entity is a foreign resident , but
- at least one of the vendors has an address outside Australia or
- the purchaser is authorised to provide a financial benefit to a place outside Australia or
at least one of the vendors has a connection outside Australia specified in regulations.

The potential for the purchaser to make a mistake in applying these requirements is great. The purchaser may not be in a position to apply these tests reliably where they are dealing through intermediaries, such as estate agents and legal and financial firms. As such, a higher standard of care is required when entering into these transactions, with associated higher costs.

Proposed section 14-215 provides a number of exclusions from this obligation, amongst which is if just after the transaction, the market value is less than $2 million. It is important to note that this exclusion is not based on the purchase price. An asset’s market value may well be above $2 million immediately after the transaction, through no fault of the purchaser, but its purchase price was less than this amount. This exclusion may introduce an element of uncertainty in applying these provisions, especially during periods of rapid asset price inflation.

In his second reading speech, the Assistant Minister to the Treasurer, Alex Hawke states:

To ensure that this measure is appropriately targeted at those areas where revenue is at greatest risk, and minimises the impact on other property transactions, the measure does not apply to direct real property transactions below $2 million.[76]

It is unclear as to what is meant by ‘areas where revenue is at greatest risk’, if it is the case that revenue collection and compliance with the payment of CGT by foreign residents has been poor across the board. Given the resources the ATO spends on auditing Australian taxpayers, a question may arise as to why $2 million was chosen as the threshold or trigger amount and not some lower amount so as to maximise revenue collection. The Explanatory Memorandum states:

The purpose of this exclusion is to minimise compliance costs, alleviating the need for purchasers to undertake the preliminary compliance obligation of determining the residency status of the vendor. This exclusion will ensure that the amendments are clearly inapplicable to most residential property sales.[77]

Part 2

Item 30 applies amendment made by Parts 1 and 2 of Schedule 2 to acquisitions made on or after 1 July 2016. Several submissions on the draft legislation noted that complex administrative systems would have to be established and an education campaign undertaken for a smooth introduction of the proposed changes. Consequently, a couple of submissions proposed a later application date of 1 July 2017.[78]

Concluding comments

The forgoing has not been a complete guide to the administrative difficulties that the two proposed measures may raise. One response may be further alteration of the legislation. Perhaps a more practical response would be to ensure that the Australian Taxation Office provides sufficient additional explanatory material, taxation rulings or administrative guides to meet the legal and accounting industries’ outstanding concerns.

Members, Senators and Parliamentary staff can obtain further information from the Parliamentary Library on (02) 6277 2500.

[1]. In simple terms an earnout right or arrangement is one in which sale or purchase of a business or business assets involves the calculation and payment (usually to the seller) of additional consideration contingent on the business being sold, meeting or exceeding (within a given time period) certain predetermined performance targets which are linked to the performance of the business or assets after sale.

[2]. Parliament of Australia, ‘Tax Laws Amendment (New Tax System for Managed Investment Trusts) Bill 2015 homepage’, Australian Parliament website, accessed 22 January 2016.

[3]. N Santinon, L Efthivoulou and C Clarke, ‘Tax law: Earnout rights: Dealing with certain uncertainty?’, Bulletin (Law Society of South Australia), 37(7), Aug 2015, p. 36, Informit database, accessed 4 January 2016.

[4]. C Evans, ‘Yearning for earnout certainty’, Tax Specialist, 11(5), June 2008, p. 294, Informit database, accessed 4 January 2016.

[5]. Ibid., p. 305; N Santinon et al., op. cit., p. 36.

[6]. Treasury, Capital gains tax treatment of earnout arrangements, proposals paper, Treasury, Canberra, May 2010, p. vi, accessed 4 January 2016.

[7]. A Varrasso, ‘Earnout arrangements: finally, some clarity on tax’, Wolters Kluwer Tax Chat, blog, 5 May 2015, accessed 4 January 2016.

[8]. Australian Taxation Office (ATO), ‘Capital gains tax: Selected items, by entity, 2012–13 income year’, Taxation statistics 2012–13, data.gov.au website, 8 April 2015, accessed 4 January 2016. .

[9]. ATO, Income tax: capital gains: capital gains tax consequences of earnout arrangements, Draft taxation ruling, TR 2007/D10, 17 October 2007, accessed 4 January 2016.

[10]. An ‘active asset’ is an asset that is used or held ready for use in the course of carrying on the business, and can include goodwill. A seller can reduce the capital gain on an active asset by 50 per cent if they have owned the asset for 12 months or more.

[11]. N Santinon, et al., op. cit.

[12]. N Sherry (Assistant Treasurer), Look-through treatment for earnout arrangements to simplify sale of business assets, media release, 12 May 2010, accessed 5 January 2016.

[13]. Treasury, ‘Capital gains tax treatment of earnout arrangements’, op. cit.

[14]. Australian Government, Budget measures: budget paper no. 2: 2010–11, 2010, p. 16, accessed 5 January 2016.

[15]. A Sinodinos (Assistant Treasurer), Integrity restored to Australia’s taxation system, media release, 14 December 2013, accessed 5 January 2016.

[16]. Treasury, Tax and Superannuation Laws Amendment (2015 Measures No. 4) Bill 2015: CGT treatment of earnout rights: Exposure Draft, [23 April 2015], accessed 5 January 2016.

[17]. See for example: The Australian Private Equity and Venture Capital Association Limited (AVCAL), Submission to Treasury, CGT treatment of earnout rights: Exposure Draft, May 2015, accessed 5 January 2016.

[18]. Schedule 1, Item 4, proposed sections 118-560 and 118-565, ITAA 1997.

[19]. Explanatory Memorandum, Tax and Superannuation Laws Amendment (2015 Measures No. 6) Bill 2015, p. 11, accessed 5 January 2016.

[20]. Ibid, p. 20 and 22.

[21]. ATO, ‘CGT: Look-through treatment for earnout rights’, website, 17 December 2015, accessed 27 January 2016.

[22]. EdwardsMarshall, ‘Proposed ‘look-through’ approach for earnouts’, EdwardsMarshall website, 1 October 2015, accessed 18 January 2016.

[23]. Ibid.

[24]. Explanatory Memorandum, p. 12.

[25]. EdwardsMarshall, op. cit.

[26]. ATO, ‘CGT: Look-through treatment for earnout rights’, op. cit.

[27]. Income Tax Assessment Act 1997, accessed 5 January 2016.

[28]. Explanatory Memorandum, op. cit., p. 44.

[29]. Ibid.

[30]. Explanatory Memorandum, op. cit., p. 49.

[31]. A Sinodinos (Assistant Treasurer), Integrity restored to Australia’s taxation system, media release, 14 December 2013, accessed 5 January 2016.

[32]. Treasury, Tax and Superannuation Laws Amendment (2014 Measures No. 3) Bill 2014: foreign resident CGT integrity measures: Exposure Draft, [13 May 2014], accessed 5 January 2016.

[33]. Treasury, Non-final withholding tax on transactions involving taxable Australian property, discussion paper, The Treasury, Canberra, 31 October 2014, accessed 5 January 2016.

[34]. Treasury, Tax and Superannuation Laws Amendment (2015 Measures No. 5) Bill 2015: Foreign resident capital gains withholding payments: Exposure Draft, [8 July 2015];

B Billson (Minister for Small Business), Release of draft legislation for the foreign resident capital gains withholding tax measure, media release, 8 July 2015, both accessed 5 January 2016.

[35]. Senate Selection of Bills Committee, Report, 16, 2015, The Senate, 3 December 2015, p. 4, accessed 5 January 2016.

[36]. See Chartered Accountants Australia and New Zealand, Submission to Treasury, CGT treatment of earnout rights: Exposure Draft, 14 September 2015;

The Tax Institute, Submission to Treasury, CGT treatment of earnout rights: Exposure Draft, 26 May 2015;

Law Council of Australia, Submission to Treasury, CGT treatment of earnout rights: Exposure Draft, 22 May 2015;

Pitcher Partners, Submission to Treasury, CGT treatment of earnout rights: Exposure Draft, 25 May 2015 (this submission opposed the Exposure Draft’s provision on the grounds of complexity);

BDO (Accountancy Group), Submission to Treasury, CGT treatment of earnout rights: Exposure Draft, 21 May 2015 (this submission gave general, if qualified, support for the proposed amendments in the Exposure Draft). All accessed 5 January 2016.

[37]. Treasury, Tax and Superannuation Laws Amendment (2015 Measures No. 4) Bill 2015: CGT treatment of earnout rights: Exposure Draft, op. cit.

[38]. K Burgess, ‘Capital gains changes create confusion’, Australian Financial Review, 13 May 2010, p. 25, accessed 6 January 2016.

[39]. Law Society of New South Wales, Submission to Treasury, Foreign resident capital gains withholding payments: Exposure Draft, 11 August 2015; Property Council of Australia, Submission to Treasury, Foreign resident capital gains withholding payments: Exposure Draft, 7 August 2015; Law Council of Australia, Submission to Treasury, Foreign resident capital gains withholding payments: Exposure Draft, 12 August 2015, all accessed 5 January 2016.

[40]. Allens Linklaters, ‘Focus: withholding tax on the sale of Australian property by foreign residents exposure draft legislation released’, Allens Linklaters website, 28 July 2015, accessed 5 January 2016; Law Council of Australia, ibid.

[41]. Charted Accountants of Australia and New Zealand, Submission to Treasury, Foreign resident capital gains withholding payments: Exposure Draft, 7 August 2015; Australian Bankers Association, Submission to Treasury, Foreign resident capital gains withholding payments: Exposure Draft, 7 August 2015, both accessed 8 January 2016.

[42]. S Danckert, ‘Tax threat to $34bn investment’, The Australian, 16 May 2013, p. 25, accessed 6 January 2016.

[43]. R Harley, ‘Tax hits foreign home owners’, Australian Financial Review, 18 May 2013, p. 13, accessed 6 January 2016.

[44]. Explanatory Memorandum, op. cit., pp 3–4.

[45]. The Statement of Compatibility with Human Rights can be found at pages 41 (earnout rights) and 70 (withholding tax) of the Explanatory Memorandum to the Bill.

[46]. Pitcher Partners, Submission to Treasury, CGT treatment of earnout rights: Exposure Draft, op. cit., p. 4;

BDO (Accountancy Group), Submission to Treasury, CGT treatment of earnout rights: Exposure Draft, op. cit., p. 1;

Chartered Accountants Australia and New Zealand, Submission to Treasury, CGT treatment of earnout rights: Exposure Draft, op. cit., p. 2.

[47]. BDO (Accountancy Group), op. cit., p. 1. Briefly, CGT event B1 refers to use and enjoyment of the asset before the title passes to another party, event D1 refers to the creation of contract rights, event E2 refers to the transfer of a CGT asset to a trust and event K6 refers to the sale of pre CGT shares or trust interests.

[48]. Law Council of Australia, Submission to Treasury, CGT treatment of earnout rights: Exposure Draft, op. cit., p. 2.

[49]. The Tax Institute, Submission to Treasury, CGT treatment of earnout rights: Exposure Draft, op. cit., pp. 2–3.

[50]. Explanatory Memorandum, op. cit., p. 13.

[51]. Chartered Accountants of Australia and New Zealand, Submission to Treasury, CGT treatment of earnout rights: Exposure Draft, p. 1; Tax Institute, op. cit., p. 2.

[52]. Pitcher Partners, op. cit., p. 4, (this submission opposed the enactment of the proposed amendments on the grounds of complexity).

[53]. Income Tax Assessment Act 1997, subsection 230-460(13), accessed 7 January 2016.

[54]. Explanatory Memorandum, op. cit., p. 20.

[55]. Chartered Accountants of Australia and New Zealand, Submission to Treasury, CGT treatment of earnout rights: Exposure Draft, op. cit., p. 4.

[56]. Ibid., p. 2; Pitcher Partners, op. cit., p. 4.

[57]. Tax Institute, op. cit., p. 3; BDO (Accountancy Group), op. cit., p. 2.

[58]. Law Council of Australia, op. cit., p. 3.

[59]. Treasury, Tax and Superannuation Laws Amendment (2015 Measures No. 4) Bill 2015: CGT treatment of earnout rights: Exposure Draft, op. cit.

[60]. Chartered Accountants of Australia and New Zealand, Submission to Treasury, CGT treatment of earnout rights: Exposure Draft, p. 3; Pitcher Partners, op. cit., p. 4.

[61]. Under section 152-60 ITAA 1997 a ‘CGT concession stakeholder’ is a significant individual in the company or trust (a significant individual in a company or trust is defined in section 152-55 as a person having small business participation percentage in the company or trust of at least 20%) or a spouse of a significant individual in the company or trust, if the spouse has a small business participation percentage in the company or trust at that time that is greater than zero. These definitions and the associated rules have been described as difficult to apply by those who regularly work in this area, see Pitcher Partners, ibid., p. 5.

[62]. Under section 152-65 ITAA 1997 a ‘small business participation percentage’ is the sum of both direct and indirect participation interests.

[63]. Chartered Accountants of Australia and New Zealand, Submission to Treasury, CGT treatment of earnout rights: Exposure Draft, op. cit., p. 5.

[64]. Ibid.

[65]. Tax Institute, op. cit., p. 4; also Chartered Accountants of Australia and New Zealand, Submission to Treasury, CGT treatment of earnout rights: Exposure Draft, op. cit., p. 6.

[66]. Tax and Superannuation Laws Amendment (Employee Share Schemes) Act 2015; see also Parliament of Australia, Tax and Superannuation Laws Amendment (Employee Share Schemes) Bill 2015, Australian Parliament website, accessed 7 January 2016.

[67]. ITAA 1997, section 152-5.

[68]. ITAA 1997, section 152-105 and 110.

[69]. ITAA 1997, Subdivision 152D.

[70]. ITAA 1997 Subdivision 152E.

[71]. ITAA 1997 Subdivision 152D and section 292-105. The limit is indexed, starting off at $1 million in the 2007–08 year.

[72]. Tax Institute, op. cit., p. 5.

[73]. Explanatory Memorandum, op. cit., p. 43.

[74]. Taxation Administration Act 1953, accessed 22 January 2016.

[75]. Explanatory Memorandum, op. cit., p. 54.

[76]. A Hawke (Assistant Minister to the Treasurer), ‘Second reading speech: Tax and Superannuation Laws Amendment (2015 Measures No. 6) Bill 2015’, House of Representatives, Debates, 3 December 2015, p. 14640, accessed 21 January 2016.

[77]. Explanatory Memorandum, op. cit., p. 50.

[78]. Law Society of New South Wales, Submission to Treasury, Foreign resident capital gains withholding payments: Exposure Draft, op. cit., p. 3; Law Council of Australia, Submission to Treasury, Foreign resident capital gains withholding payments: Exposure Draft, op. cit., p. 2.

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