When selling your business, understanding how earn-outs are taxed is crucial for avoiding costly mistakes. In particular, the tax treatment can differ depending on whether you're negotiating cash, shares or loan notes. Therefore, proper planning can help ensure compliance with HMRC and achieve a positive outcome. This article discusses the key considerations involved.
What is an earn-out? - Tax implications
An earn-out is essentially a contingent payment that the seller only receives from the buyer when specific performance targets are met. For example, this deferred consideration can take the form of cash, shares or loan notes. We explain these different forms of consideration and how earn-outs are taxed below.
Why are Earn-Outs are used?
Firstly, an earn-out can prove useful where the buyer does not have sufficient cash to pay the seller upfront. Alternatively, the seller and buyer may be unable to agree an upfront sale price because the buyer is uncertain about the future profitability of the business.
As a result, an earn-out can help bridge the gap between the price the seller wants and the amount the buyer is initially prepared to pay.
The different forms of earn-out
Establishing the correct consideration for the sale of a business isn't always straightforward. For example, loan repayments, earn-outs and deferred consideration can complicate matters.
This was illustrated in the case of Michelle McEnroe & Miranda Newman v HMRC. Due to confusion over the Sale and Purchase Agreement (SPA), the vendors underdeclared their sale proceeds. Consequently, this resulted in serious consequences with HMRC.
Payment of earn-outs in cash
As mentioned above, an earn-out can take many forms. Where the earn-out consists of deferred cash consideration, the tax treatment will depend on whether the amount can be ascertained.
Earns-Outs Paid as Shares
By contrast, where you receive an earn-out in the form of shares, the tax treatment can differ from a cash earn-out.
Where the relevant conditions are met, it may be possible to defer the capital gain. As a result, the tax charge may arise later when the shares are sold or otherwise disposed of.
Payment of earn-outs as loan notes
Similarly, if your earn-out is paid as qualifying loan notes, it may be possible to defer a proportion of the gain until the loan notes are redeemed.
However, it may not be possible to claim Business Asset Disposal Relief at a later dare on the earn out, Therefore, in certain circumstances, an election may be considered to crystallise the gain earlier.
The structuring of an earn-out
An earn-out can be structured in many different ways. However, the buyer and seller may have conflicting short-term objectives.
For example, a buyer may want to retain the seller to ensure a smooth transition and benefit from their expertise. Additionally, the buyer may want to retain the seller for a period to help protect the business from competition.
Conversely, a seller may want a clean break and immediate access to the sale proceeds. Furthermore, they may not want to remain involved with the business for an extended period.
Negotiating an earn-out
When you're negotiating an earn-out, flexibility and clarity are important. Therefore, you should consider the following points:
Summary – Key Points to Consider
In summary, the way an earn-out is structured can significantly affect the timing and amount of tax payable. Therefore, the potential availability of Business Asset Disposal Relief, tax deferral and the risk of future payments not being received should all be considered.
Depending on the circumstances, shares or loan notes may provide opportunities to defer the tax liability. However, the potential impact on Business Asset Disposal Relief should be considered carefully.
Ultimately, any earn-out agreement should be carefully drafted to ensure the terms balance your short-term objectives with the longer-term risks.
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