Earnout tax and deferred consideration: What you need to know

When you sell a company, it’s common that some of the money (called “consideration”) isn’t paid right away. This could happen in two ways:

1. Deferred consideration: This is a type of delayed payment, when the buyer promises to pay you later.

2. Earnout: This is a performance-based future payment. With earnout, you’re paid more providing the company meets certain targets.

When it comes to the tax paid on consideration, matters can be complex. In this article, we’ll explain what you need to know.

The basics

When you sell your shares in a company, including any delayed or conditional payments, you have to pay Capital Gains Tax (CGT). But the way these payments are taxed depends on whether you know the exact amount you’ll receive.

When selling, the deal is typically outlined in your Share Purchase Agreement (SPA), meaning any future consideration payments are considered part of the same contract. So, from a tax point of view, they’re connected to the original transaction.

This is important, as it means your tax is determined at the point of signing your SPA – even if you’ll be receiving payment in the future, or if the payment is related to future business performance.

The two types of consideration payments

There are two types of consideration payments: ‘Ascertainable consideration’ and ‘unascertainable consideration’.

Consideration is ascertainable if its value is known. For example, your SPA states that if profits of the company exceed £1 million, you’ll receive £200,000. Even though this payment is dependent on future performance, its value is set. You’ll pay CGT on ascertainable consideration at the time of sale.

Unascertainable consideration is when you don’t know the exact amount you’ll receive. For example, your SPA outlines that you’ll receive 6% of all profits over £1 million – which isn’t an exact monetary value. In the case of unascertainable consideration, you’ll also pay CGT at the moment of sale, however that tax will be an estimate.

The challenges: Ascertainable consideration

Both ascertainable and unascertainable consideration have their challenges.

In the case of ascertainable payments, buyers can be reluctant to pay CGT on something which may not be received – effectively, paying tax on money you never get – or they may struggle to find the funds to pay this tax upfront.

However, there’s a common workaround in the form of a loan note. A loan note is effectively a promise from the buyer to pay a certain amount in the future, typically with some interest. The loan note is treated like a deferred form of payment, allowing the buyer to defer CGT on payments they haven’t received yet.

If for some reason the ascertation becomes irrecoverable, HMRC will refund the CGT you’ve paid.

The challenges: Unascertainable consideration

Unascertainable consideration is based on an estimated future value, so there’s a risk buyers may underpay or overpay CGT. Valuations are subjective, based on predictions of a business’ future profits or sales, as well as market conditions and the specific terms of the earnout, so it’s important to work with an expert you trust.

If you pay too much tax initially, you’ll need to claim back your overpaid CGT via an application. If you’ve paid too little, you may face another CGT bill in the future.

Payment in shares

Sometimes, instead of a cash payment, you’ll be paid in shares in the buyer’s company. In this case, there are some specific tax rules that apply – namely, the s138A Taxation of Chargeable Gains Act 1992. These rules create a ‘rollover’ position, where the CGT on the original transaction can be deferred until you sell these shares to satisfy the earnout.

Employment income

To add further complexity, if the earnout looks more like a bonus for working at the company after the sale (instead of part of the sale price), HMRC might class it as regular employment income. Employment income is taxed at a higher rate than CGT – up to 45%.

There are some grey areas here, and it depends on specific details of the deal. But, as an example, if the seller continues to work for the company after the sale, and the earnout is based on the company’s performance during this period. It may look like a performance bonus, rather than a payment for the sale of shares.

The good news is, you don’t need to assess your consideration payment complexities alone. We pride ourselves on expertise and efficiency at Burgess Hodgson, and can give you transactional taxation advice on these matters, along with many others. Ensuring you have total transparency over the decision that’s right for you – and are getting the most favourable terms.

Get in touch today, at info@burgesshodgson.co.uk