In the broadest sense, an earn-out is a term used to describe a form of deferred consideration on M&A transactions, which is contingent on conditions or performance events occurring within a specified period after completion of a transaction. The contracting parties to an earn-out will normally be the purchaser and the seller of a business, being the parties to the share purchase agreement (SPA) that governs the terms of the transaction.

Although earn-outs are not always used, they are common during periods of economic uncertainty. This is because they align interests of the parties in the future value of the business, given uncertainty in future performance. A “good” earn-out structure is therefore one that results in the genuine achievement of the earn-out threshold(s) and payment of the earn-out consideration if the thresholds are met. 

Sale consideration or employment income?

While a seller will generally expect capital gains tax (CGT) to apply, earn-outs may, under certain circumstances, be treated as employment income for sellers who are or have been employees or directors of the target business. 

HMRC takes the view that, unless an earn-out received by an employee/director is further consideration for the sale of shares, it should be viewed as received by reason of employment. It has released official guidance that provides certain indicators. These indicators are not determinative, meaning that the tax treatment needs to be considered on a case-by-case basis. The key HMRC indicators of earn-outs being classed as sale consideration are as follows: 

1. The sale agreement clearly demonstrates the earn-out is consideration given for securities in the company.
2. The value of the earn-out reflects the value of the securities given up.
3. Third-party investors and employee/management shareholders receive any earn-outs on the same terms.
4. The earn-out is not a substitute for full remuneration for continued employment within the company.
5. The earn-out is not conditional on future employment (beyond a reasonable requirement to stay to protect the value of the company).
6. There is no personal performance threshold within the earn-out.

While there is no clear rule for when earn-out consideration may be considered employment income, tax advisers have developed rules of thumb in this area. These include elements such as the length of time the seller must remain an employee after the transaction has taken place. 

However, in order to reach an appropriate conclusion, a holistic assessment of all the factors around a particular disposal would need to be taken into account. For example, where third-party investors receive elements of the earn-out consideration on the same terms as existing management/employee-shareholders, this is typically a strong indication that HMRC should treat this as consideration for the sale of shares and not treat this as employment income. 

By contrast, “leaver” provisions, which cause selling managers to forfeit their earn-out payments if they are no longer employed at the due time, can risk affecting the CGT treatment where they are not clearly defined or go beyond protecting the value of the business.

The incremental cost of not achieving CGT treatment can be significant: employment income can be subject to combined income tax and employee national insurance contributions (NIC) for the individual at up to 47%, with a further employer NIC and apprenticeship levy (AL) cost on the employing business of up to 14.3%. This compares to CGT rates of 20%, reducing to 10% where business asset disposal relief (BADR) applies. 

Mitigating the risk of misclassification

In order to mitigate any potential risk, the sellers can apply for non-statutory clearance from HMRC, noting nonetheless that HMRC is not bound to reply to a clearance application unless there is a “genuine point of uncertainty”. There is also no statutory deadline for HMRC to respond (although it endeavours to respond within 28 days of submission). 

The SPA negotiations will be important for ensuring that purchasers are not left with any exposures. Purchasers typically seek SPA indemnities to ensure that the risk of earn-outs being taxed as employment income are placed onto the sellers. Nevertheless, there are legal limitations on the ability to push employer NIC and AL onto the individuals receiving an earn-out payment.

In light of the potential uncertainty, purchasers often include clauses in the SPA to provide protection such as:

• outlining a process for determining the status of the earn-out, including the requirement to seek a non-statutory clearance application;
• providing a dispute resolution process in the event of a disagreement;
• establishing which party will bear any tax costs and, to the extent that this is to be borne by the seller, to provide for an adjustment of the earn-out payment to enable effective recovery under any indemnity; or
• establishing which party will benefit from any corporation tax deduction that will accrue to the target as a result of the earn-out payment being taxable as employment income, and where possible under the SPA mechanics, provide for this in the price-adjustment mechanism.

To the extent the earn-out is not otherwise taxed as employment income, it should fall within the CGT regime. 

Managing the CGT position

CGT on earn-outs is mainly relevant to the SPA in the form of requests that the sellers may make for changes in the earn-out structure to accommodate their tax requirements. Indeed, there are various forms of deferred consideration, each of which has a specific CGT treatment, for example: 

• Where the consideration is 'ascertainable' at completion (eg, a fixed sum payable dependent on a particular future event), the CGT is normally payable upfront on the maximum amount of consideration. 
• Where the consideration is 'unascertainable' at completion, following Marren v Ingles [1980] UKHL TC 54 76, the sellers would be required to value the deferred consideration entitlement at completion and report this amount as taxable at the time of the sale, in their tax return for the period in which the disposal takes place. This tax is payable in this first tax return irrespective of the deferred consideration payment timing. Then, on actual receipt of the earn-out the individual will either be taxed on any additional consideration received beyond what was assumed in the initial tax filing or will crystallise a capital loss. 

Therefore, depending on the structure, the seller may have to pay tax on proceeds that are yet to be received and may never be received. To address the issue of unfunded CGT charges in general, a seller may ask for the earn-out to be satisfied in the form of an entitlement to securities instead of cash. Some or all of the earn-out gain may then be 'rolled over' into the earn-out right and subsequently into the securities. This defers the gain for CGT purposes. While of benefit to the seller, this may also be preferable for the purchaser as a mechanism for preserving its cash. There are various alternatives for how this may be structured with potential tax elections for those who prefer early tax charges, potentially at a lower rate. 

In certain circumstances, the parties can agree to alter the terms of the SPA after it has been signed, but before the right to unascertainable deferred consideration has been satisfied. Where this is the case, a tax liability may arise as this is treated as a disposal of the earn-out right by the seller. For these purposes, any new rights granted to the seller are the consideration for the disposal. In this event, provided certain conditions are met, the aforementioned security treatment can be repeated. 

Other taxes for the purchaser

Finally, stamp duty is another area that requires careful consideration in the SPA, given the potential tax implications for the purchaser who is liable for the tax. The basis on which the 0.5% stamp duty charge is payable on the earn-out element of a share acquisition will depend upon the precise terms of the earn-out. Indeed, consideration for the purposes of stamp duty includes cash, rollover securities and ascertainable deferred consideration (including where the SPA mechanism provides for a maximum and/or minimum amount of deferred consideration). 

As such, the financial structure of the earn-out including any caps on the payment and any wholly variable amounts will affect the extent of earn-out consideration that may be chargeable to stamp duty. It should further be noted that stamp duty is currently a definitive tax. This means that it is not possible to recover any excess if the cap is not reached. Therefore, while the purchaser will typically want to deliver certainty by capping the maximum amount payable for the business under the terms of the earn-out, the downside is that they will be paying stamp duty based on the maximum potential earn-out payment. 

Early action

The issues highlighted are not exclusive, but outline the complexities surrounding the implementation of an earn-out. Drafting an efficient earn-out structure is a complex task that usually requires professional tax advice, ideally at the outset of the transaction.

James E Moore, Partner, Transaction Tax, Grant Thornton UK LLP