Business transaction such as earn out, whereby a portion of the total consideration is postponed to a happening or non-happening of a future event has led to various speculations regarding its taxability. On perusal of the jurisprudence emanating in the jurisdictions of UK and USA, it aptly clear that the focus of the state has been to recover tax on such transaction in the year when the contract is actually entered into and the right to receive such future payment is created and not when the payment is actually received. However, in India there exist a dispute regarding the tax treatment of such transactions. Decisions of various courts have interpreted the taxability of earn outs in different manners. While one view has been that the capital gains tax shall be imposed on such transactions only when the future event materializes and the payment is received, the other view has been that the tax should be imposed when the right to receive such payment is created and not when the future event actually materializes.
Hence, the present article is attempt to resolve the ambiguity over the taxability of such transaction and for the aforesaid purpose this article is mainly divided into V sections; Section I mainly discusses about the general overview of the earn out transaction in Mergers and Acquisitions; Section II mainly analyses about the tax treatment of earn outs in UK and USA; Section III mainly sets out the ambiguity with regard to the tax treatment of such transactions in India; Section IV perceives to provide a solution and finally Section V sums up the conclusion.
In order to stay competitive in today’s global world, a common strategy for the companies is to actively seek merger and acquisitions1 Since, it facilities companies to make use of each other strengths which results in increased market shares and profitability that are vital for survival.2 Today, the typical merger or acquisition is quite strategic and operational in nature3 and price has become one of the paramount issues in its transaction.4 Because, under present scenario a business is not only acquired for what it has done in the past but for what it will deliver in the future.5 Therefore, higher-growth businesses and those at an earlier stage of development have become harder to project, since their future performance depends not only on assumptions about the economic environment but also on predictions of the success of the business itself in developing things like new technologies, additional customers, or new product offerings.6 Hence, the Buyer and the Target may not be able to come to an agreement on price because the Buyer simply does not believe the Target’s optimistic projections of the future financial performance of the business and thus to hoist the Target by its own petard of overly-optimistic projections, the Buyer may suggest that a portion of the consideration be deferred in the form of an earnout.7
Generally, an earn-out is a mechanism used in an M&A transaction whereby a portion of the purchase price is contingent and is calculated based on the performance of the acquired business over a specified time period following the closing. By acting as an equalizer8 earn-outs are intended to bridge a valuation gap between an optimistic seller and a skeptical, or cash strapped, buyer.9 As a risk mitigator, the earn-out can be used to hold a seller’s feet to the fire regarding its representations of the future value of the company and to help ensure against overpayment.10 They might also be used to retain and motivate key employees who were former owners of the acquired company.11
A typical earnout involves two stages. In the first stage, the payment is delivered to the seller at the time of the M&A announcement (in the form of cash, stock, or mixed payments), while the second (normally in cash and linked to the target firm’s realization of pre-specified performance goals) is delivered after a pre-determined period has elapsed following the M&A announcement.12 It may also take many forms, some are payable only if a certain performance threshold is achieved; others depend on average performance over several periods; and still others may involve periodic payments depending on the achievement of interim performance measures rather than a single, lump-sum payment at the end of the earnout period.13
During the period of 2005-2007 due to increased competition, many buyers were hesitant to incorporate earnouts as part of the purchase price because there was a meaningful risk that another buyer could win the deal by offering the full amount of the purchase price upfront.14 However due to unprecedented turn of the economy resulting in companies suffering from losses and reduced revenues. The credit markets have tightened and the economic climate has become more uncertain,15 which eventually has made earn-outs more prevalent in the current economic climate.16
The manner of taxability of contingent consideration such as earnout has been a matter of great debate. Because, since the right to receive such consideration arises only when the stipulated conditions are met, at a later point of time.17 There always arises an issue as to whether the contingent consideration involved in the sale of business should be taxed in the year in which the acquisition or merger takes place or in the year when it actually becomes payable. Further, when an employee is also a shareholder of the acquired target company, an issue can also arise as to whether an earnout payment that is contingent on continued employment represents compensation for the employee-shareholder’s services, or consideration for the employee-shareholder’s stock.18
Since, the Indian position regarding taxability of earn out considerations seems to be ambiguous. It is critical to analyse the correct position in comparison with the position upheld by the jurisdictions of U.K. and U.S.
In U.K. the principle legislation governing the taxing of earnout consideration is ‘Taxation of Chargeable Gains Tax, 1992’ (TCGA). Under the Act, the provisions relating to earnouts operate differently depending upon whether the deferred consideration involved is either capped (in the sense of being ascertainable at the time of the disposal of the original assets) or uncapped (unascertainable), and whether it is received in the form of cash or shares/debentures.19 Section 48 of the TCGA 1992, provides that, where the amount of the future consideration is ascertainable, the full consideration is subject to tax.20 Further in case of ascertainable future consideration the vendor may also be able to elect to pay the tax in instalments to take into consideration the delay in receiving the full amount of the consideration.21
Where the earnout is uncapped (unascertainable), the vendor's consideration is the initial cash sum plus the right to receive a future unascertainable amount.22 This principle was established in two tax cases: Marson v Marriage23 and Marren v Ingles.24 Both these cases were concerned with agreements for the sale of assets in which the vendor received a quantified amount of money plus a conditional and unquantifiable further amount payable at an unascertained future date. The point in dispute in both cases was whether any chargeable gain arose when the further amounts were received.25
In Marson v Marriage, Fox J held that Section 48 of the Taxation of Chargeable Gains Act 1992 applies when the sum to be brought into account represents ascertainable consideration, even when the right to it is contingent. It does not apply when the amount is unascertainable.26 However, subsequently a contrary view was taken by the House of Lords in the case of Marren v Ingles.27 In this case in 1970 the vendor entered into contract with the purchaser to sell shares in a private family company. The purchaser agreed to pay the vendor an immediate sum of £750 per share in cash plus an additional sum if the company was able to get listed on the Stock Exchange. Therefore, the consideration for the disposal included an earn-out element.28 It was determined by the House of Lords that a charge to tax could be imposed on an unascertainable consideration since, the vendor was receiving a chargeable asset, namely a "chose in action"29 which was not a debt and, accordingly, a charge could be imposed on receipt of this asset and again at the point when a capital sum was derived from the asset on the realisation of the earn-out consideration.30 Therefore, according to the principle established in this case, the disposal consideration for the target shares would have to include the market value of that earn-out right so that it would taxable at completion - at the entrepreneurs’ relief rate assuming the relevant conditions are met.31 But, since the earn out consideration is valued at an anticipated market rate. The actual disposal of the earn out consideration may result in either loss or excessive profits to the vendor. Therefore, the provision under TCGA dictates that when there is a loss on disposal it could be carried back against the gain on the original asset.32 And when there is an excessive gain it will be taxable at full rates and the vendor will not get the benefit of entrepreneurs' relief.33
Therefore, the position that emanates from U.K. is that, an earn-out right is an asset for the purposes of tax on capital gains. If shares are sold for consideration which includes a cash earn-out, the earn-out right forms part of the consideration for the shares, and must be valued to determine the tax payable.34 However, when the earnout is structured in terms of exchange by shares and debentures it is often satisfied in loan notes35 so that the transaction falls within S.138A, enabling it to benefit from the rollover provisions of S. 135. This would allow tax to be deferred until cash was realised under the loan-note.36
The principal legislation guiding the tax treatment of the earn out consideration is the Internal Revenue Code of 1986 (IRC). It is the domestic portion of federal statutory tax law in the United States, published in various volumes of the United States statutes at large, and separately as Title 26 of the United States Code (USC).37 The IRC contains all relevant rules pertaining to income, gift, estate, sales, payroll and excise taxes.38 Under the provisions of the Code, the tax treatment of the earn out consideration could be done through various ways such as (i) Open Transaction Doctrine (ii) Installment method
a. OPEN TRANSACTION DOCTRINE
Open transaction treatment permits a seller to defer recognition of gain on a sale of property until either the cash or consideration other than certain promises of future payment received exceeds his basis in the property.39 The principle with regard to the open transaction doctrine was developed in the case of Burnett v. Logan,40 in this case Edith Logan sold stock of a coal mining company in the year 1911 for a cash payment and the right to receive a 60 cent annually for every ton of coal mined by an affiliate in subsequent years.41 The respondent received this money over time, but claimed that no income tax should arise until she received the total amount of the sale of her stock equal to its value.42 The Commissioner of Internal Revenue ruled that the obligation to pay 60 cents per ton had a fair market value of almost $2 million, and hence it could be treated as a closed transaction so that the amount could be added to the sale of stock in the year 1911.43 The court of appeal held that it was impossible to determine the market value of the agreement in cash or in stock. The US Supreme Court upheld the findings of the court of appeal and held that any gain attributable to the right to contingent payments could not be measured until the contingent payments materialized and, therefore, was not realized in the year of sale.44 The Court treated the sale as an "open transaction." As such, Mrs. Logan's gain was deferred until the total payments she received exceeded the tax basis of the stock she transferred.45
It has been argued that, today open transaction treatment is disfavored by the IRS and courts46 and the government.47 For instance, In Bernice Patton Testamentary Trust v. United States,48 the plaintiff in the year 1990 entered into an agreement with the buyer for the sale of business of slaughter houses. The consideration for the sale of business was in cash for $317,140 plus a note of face value $507,424. It was agreed that the payment with regard to the note would only be made to the plaintiff if certain conditions materialized in respect of the net income of the business. On audit the IRS determined that the buyer's obligation had an ascertainable value equal to the face amount of the Note given to plaintiff. The plaintiff argued that the Note should not have been included when computing its 1990 income tax because it was uncertain when the Note would be paid in full. The court in these case held that although the future success of the business was in doubt at the time of sale, this alone is not enough to require open transaction treatment.
Further since the government has long argued for the “closed transaction treatment”. The provisions under the IRC code dictates that the amount realized from a sale or other disposition of property is the sum of any money received plus the fair market value of any property (other than money) received.49 The fair market value of property is a question of fact, but only in rare and extraordinary cases will property be considered to have no fair market value.50
b. INSTALLMENT METHOD
As per the provisions of the IRC, the term “installment method” means a method under which the income recognized for any taxable year from a disposition is that proportion of the payments received in that year which the gross profit (realized or to be realized when payment is completed) bears to the total contract price.51 Under the installment method, when property is sold but payment of part of the purchase price is deferred to later years, the seller does not recognize his entire gain in the year of sale, but instead recognizes gain as payments are received.52
The key difference between the open transaction doctrine and the installment method is that under open transaction treatment, the seller uses the cost recovery method. The seller is permitted to allocate basis to payments as they are received. The seller only recognizes gain after basis is completely exhausted. In contrast, in an installment sale the taxpayer must allocate basis.53 Therefore, gain is taken into account ratably over the course of the installment payments. Thus, if the seller sells an item with basis of $50 and a total contract price of $100 and reports gain under the installment method, half of each payment will be recovery of basis and half will be gain.54
Under section 453(a) of the IRC, a taxpayer shall report income from an installment sale under the installment method.55 However an election can be made to opt out of the installment method, but it could be made only on or before the due date prescribed by law (including extensions) for filing the taxpayer’s return of the tax imposed.56 The seller could either opt for the closed transaction doctrine or the open transaction doctrine. In the closed transaction doctrine, the portion of the seller’s amount realized attributable to the debt instrument will include the initial price of the no contingent component (if any) plus the fair market value (or “FMV”) of any contingent payments.57 Whereas in the open transaction when the value of property is indeterminable, a transaction remains open and the recognition of income is postponed until the value of the property can be established.58 However it is only in “rare and extraordinary” cases that the value of a payment stream will not be reasonably determinable.59 Also, once an election to opt out is made it can only be revoked with the consent of the secretary.60 Moreover, the installment method is not available for any installment obligation arising out of a sale of stock or securities which are traded on an established securities market.61
The provisions under the Income Tax Act, 1961 applies for the tax treatment of earn out consideration in India. Under the provisions of the Act, the term “income” is defined to include capital gains chargeable under section 45 of the Act,62 which mainly includes and any profits or gains arising from the transfer of a capital assets.63 Further, subject to certain exceptions the term capital assets have been broadly defined to include property of any kind held by an assesse whether or not connected with his business or profession.64
As per section 45 of the Act, capital gains tax must be assessed at the time of transfer of the capital asset, and not necessarily at the time when consideration is received by the transferor or the date of the agreement to transfer.65 However as per section 48 of the Act, the income chargeable under the head “Capital gains” shall be computed, by deducting, the cost of transfer and necessary expenditure incurred on transfer of the capital asset, from the full value of the consideration received or accruing as a result of the transfer of the capital asset66 Therefore, on a conjoint reading of both the provisions, it is crystal clear that for the calculation of the ‘capital gains’ tax the entire consideration for the purpose of contemplating the tax base needs to be calculated. Hence, the issue that arises is, as to whether the contingent consideration that depends on the happening or not happening of an event in the future will be calculated for the purpose of contemplating the “capital gain” in the year when the transfer takes place or in the year when it actually accrues.
In the case of Ajay Guliya v. Additional Commissioner of Income Tax,67 the appellant was a shareholder Orion Dialog Pvt. Ltd., which divested its shareholding to M/s Essar Investments Ltd. through a share purchasing agreement. As per the share purchasing agreement the appellant was entitled to total sum of Rs. 86.25 lakh out of which on the execution of SPA it received a sum of Rs. 60.00 lakh and was entitled to receive the remaining balance over a period of two years. By an assessment order the Assessing Officer held that the entire income accruing to the assessee was reckonable as capital gains in the year when the transfer took place. On appeal the Delhi High Court upheld the findings of the assessing officer and held that merely because the agreement provides for payment of the balance of consideration upon the happening of certain events, it cannot be said that the income has not accrued in the year of transfer. This view has also been reiterated by the Income Tax Tribunal, Mumbai.68
However, in the case of, The Commissioner of Income Tax v. Hemal Raju Shete,69 the assessee with other co- owners sold her shares in M/s. Unisol Infraservices Ltd. to M/s.Radha Krishna Hospitality Services (P) Ltd. in terms of an agreement. The agreement provided that assessee alongwith other co-owners of the shares of M/s.Unisol were to receive Rs.2.70 crores as initial consideration plus a deferred consideration based on a stipulated formula. However, since the total consideration (initial consideration plus total consideration) was capped at Rs.20 crores the Assessing officer proceeded to tax the entire consideration in the year when the transfer took place. The Bombay High Court in this case held that since the deferred consideration was based on a formula under the agreement and had not actually accrued to the assessee in the year when the assessment was done. Hence, there existed no occasion to bring the maximum amount of Rs.20 crores which could be received as deferred consideration to tax in the year when the transfer took place.
Therefore, on the aforementioned analysis of the two cases it is evident that there exists ambiguity with regard to the tax treatment of earn out consideration in India. Since, one view has been that the entire consideration involved in the sale of capital asset shall be considered for the purpose of capital gains tax in the year when the transfer takes place even though the deferred consideration accrues at a later point of time. While the other view is that only the consideration that actually accrues to the assesse on the sale of capital asset shall be computed for the purpose of capital gains tax and not the deferred consideration that shall accrue only in future based on happening of an event. Hence, it is incumbent to reach a viable solution.
It is argued that if the deferred consideration is computed as capital gain in the year of the transfer of capital asset then it would help the state to increase its revenue. However, at the same time it will be detrimental to the companies who would have to pay the market value of the future unascertainable profits, which even though, would been contemplated by them, eventually would not materialize in the year when the contract is entered into, but only at a future date. Therefore, it is essential that the balance needs to be maintained between the rights of state towards generating the revenue through collection of taxes with the ease of doing business.
Through various decisions of the court it has become crystal clear that, income accrues or arises when the assessee acquires the right to receive the income and therefore income may accrue or arise without its being received.70 Further, when the income is accrued then the same cannot be defeated by any theory of real income.71 For instance, where an agreement was entered into, to fell and remove 200 standing trees for a consideration of Rs. 7,25,000. In one year, the purchaser fell and removed 150 trees and paid Rs. 6,25,000. It was held that the entire sum of Rs. 7,25,000 was the full consideration even though only Rs. 6,25,000 were received by the assessee during that year and, consequently, capital gains would have to be calculated on that basis.72
However it has also been held that, if, on the facts of a particular case, computation under Section 48, is not possible the charge under section 45 fails because it cannot be effectuated.73 But, a mere practical obstacle to the valuation cannot defeat the charge of tax in respect of the gains arising. If the valuation by inspection and empirical examination is not possible, the other methods, of valuation have to be adopted. One has to go by the book value or go by the market value as on the date of acquisition with such adjustments as the circumstances may call for.74
Therefore, on aforementioned analysis of the case laws it crystal clear that the courts have interpreted the provision under the Income Tax Act in such a manner that the when the amount is ascertainable, then despite there being any actual payment to the assesse, the gains shall be the charged in the year when the right to receive the consideration has accrued and not when it is actually received. Therefore, in contemplating the charge on deferred consideration the assessing officer needs to consider as to whether the amount involved in the deferred consideration could be ascertained or not and whether there has been any accrual of right to receive such payment.
So for instance, if company ‘A’ sells its business to company ‘B’ for an initial consideration of 400 crores plus a deferred consideration for a sum of 20% of the annual profit made by company ‘B’ for a period of 5 years, subjected to a cap of 100 crores. Then in such a situation even though the total consideration, which is 500 crores would be ascertainable, the right to receive such amount would be in dispute, since it could be argued that even though the right to receive the amount is created when the contract is entered into, the amount would only be payable when company ‘B’ would be actually making the profits, which is always an uncertain event. Therefore, in such a situation it could be argued that the deferred consideration of 100 crores is difficult to be included in calculating the full value of consideration in the year when the contract is actually entered into.
Hence, in authors view the ultimate test that needs to be adopted in contemplating the charge on the deferred consideration shall be as follows;
It is argued that if all the three conditions are met then the assessing officer shall perceive to charge the deferred consideration in the year when the right to receive the future consideration accrues and not when the actual payment is actually received.
The present study enunciates that the earn out considerations have become widely prevalent in the current economic climate and have been used as a tool by the business entities to cope up with, the disputes which may emanate with respect to the value of consideration for the sale and purchase of the business in M&A transactions, between the buyer and the seller. Today since the market conditions have become more unascertainable and the credit facilities by banks have been regulated to the great extent, it is anticipated that the earn out considerations would be used more often in the future. Therefore, disputes with regard to taxing of such considerations are bound to occur. Hence, for a state like India which purports to be investor friendly, it is essential to adopt an approach by which rights of a business entity to carry the business smoothly is balanced with the right of the state to collect the tax on capital gains. Thus, one such approach could be to treat the charge on earn out consideration in the year when the right to receive such payment is accrued only when the total amount of the consideration could be ascertained and that there are high probabilities that such future event on which the consideration is based upon, is bound to happen.