The Tax Characterisation of 'Earn-Outs'

• Published date: 01 September 2015
• Author: Julia Moore,Michael Rudnicki
• DOI: 10.10520/EJC177653
• Date: 01 September 2015
• Pages: 12-20

12 © SIBER INK

The Tax Characterisation of

‘Earn-Outs’

MICHAEL RUDNICKI • JULIA MOORE1

ABSTRACT

Earn-out payments are a common feature of business acquisition transac-

tions. An earn-out payment is a feature of the purchase price consideration for

the acquisition of a business. The earn-out payment is dependent on the fulf‌il-

ment of particular conditions, typically in the form of achieving prof‌it hurdles,

or contingent contracts being fulf‌illed by the entity acquired. In addition to

the earn-out, a f‌ixed upfront payment usually forms the remaining compo-

nent of the purchase price consideration. The tax complexities in relation to

‘earn-outs’ rest with addressing the tax characterization of the receipt and

payment thereof.

The article addresses the aforesaid characterization in the context of

comparative tax case law and is restricted to the tax implications for the seller

of a going concern business. Both the applicable South African case law and

comparative precedents from foreign jurisdictions are analysed in order to

identify the common law principles which may be applied to determine the

treatment of earn-out payments.

The South African case law which addresses receipts and accruals in the

form of ‘earn-outs’ is scant and is limited to a case decided in 1921 in the

Cape Provincial Division. The case dealt with the distinction between a receipt

for the sale of goodwill and a receipt for the use of goodwill. The court held

that a receipt representing compensation for the use of goodwill will not

assume the character of the related goodwill disposal which forms part of the

assets disposed of by the taxpayer. The receipt was held to be of a revenue

nature.

Foreign case law supports the position that the disposal of assets for

consideration in the form of an upfront f‌ixed payment and a payment contin-

gent on prof‌it hurdles does not detract from the character of the proceeds

relating to the underlying asset disposal. The relevant case law is conclusive

that the ultimate consideration may vary, either up or down, based on future

calculations, whether it be in the form of achieving particular prof‌it hurdles,

or whether specif‌ied contingent events materialise. The principle of intention

and purpose becomes relevant too when assessing the characterisation of the

earn-out.

1

Consultant KPMG, admitted attorney of the High Court of South Africa. LLB

(UCT); PGDip Tax Law (UCT).