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How should earn-outs be taxed?

There are as many as four views as to how contingent consideration on sale of shares should be taxed

In many transactions of acquisition of companies, besides the fixed consideration payable for purchase of the shares, there is also an element of contingent consideration, commonly referred to as “earn-out", which may be also payable to the sellers in the future for acquisition of the shares, if certain performance targets are achieved. The manner of taxability of such contingent consideration has been a matter of great debate.

This is on account of the fact that the right to receive such consideration arises only when the stipulated conditions are met, at a later point of time. There are as many as four views as to how such contingent consideration should be taxed: not taxable at all; taxable as capital gain in the year of sale of the shares; taxable as capital gain in the year in which the right to receive such amount arises; or taxable as regular income in the year in which the right to receive such income arises.

Which is the correct view?

This peculiar situation arises on account of the fact that the income arising from the sale of shares of a company is generally taxable as capital gain. Capital gain accruing on transfer of capital assets is taxable in the year of transfer of the capital assets (in this case, shares), irrespective of the year in which the consideration is received. However, such gain is to be computed by reducing the cost of acquisition (or indexed cost) from the consideration received or accruing as a result of the transfer.

In this case, where the conditions would be met only in future years, the contingent consideration is neither received, nor has it accrued, in the year of transfer of the shares. Therefore, such gain cannot be taxed in the year of transfer of the shares. Further, there is no provision to tax additional consideration in such cases of transfer of shares, in a subsequent year when the conditions are fulfilled, but where there is no transfer of shares. On this logic, a view is being taken that such amount cannot be taxed at all.

The second view is that subsequently, when the consideration accrues, it becomes taxable as capital gains, but in the year of transfer of the shares, as capital gain is taxable only in the year of transfer. There are practical difficulties in this view, in the sense that it may not be possible to revise the return of the earlier year, when the right to receive such contingent consideration subsequently accrues. Therefore, the seller may end up being in default of payment of his taxes, for no fault of his.

The third view is that the contingent amount becomes taxable as capital gains in the year in which the conditions are fulfilled, and the right to receive such amount accrues. This, however, seems contrary to the scheme of taxation of capital gains envisaged by the law: that capital gains are taxable only in the year of transfer of the capital asset.

The last view is that such contingent amounts are income, and therefore, are taxable in the year in which such amounts are received, or in which the right to receive such amounts accrues to the seller. They would be taxed as other income, though they cannot be taxed as capital gains. Such a view, however, ignores the real character of the receipts: that these are amounts received as an additional consideration for the sale of the shares, and are, therefore, capital receipts to be considered for computation of capital gains.

There have also been conflicting decisions by High Courts on this vexed issue. The Delhi High Court has taken a view that such contingent amounts are taxable as capital gains in the year of sale of shares, while the Bombay High Court has held that such amounts cannot be taxed in the year of sale of the shares.

The very fact that there are four differing views on taxation of such amounts, and differing decisions of High Courts on the subject, clearly demonstrates a significant lacuna in the scheme of taxation of capital gains on sale of shares, where there is an earn-out clause. In a similar situation of compulsory acquisition of land, there is a specific provision in the law whereby the additional compensation, on enhancement of the compensation in appeal, is taxable in the year of receipt of such additional compensation. No such provision has been enacted in the case of earn-outs payable in respect of purchase of shares. Such clear distinction, only in the case of compulsory acquisition of land, would perhaps indicate that either the first or the second view (not taxable at all, or taxable in the year of transfer of shares) seems to be the correct views.

Earn-out provisions are common in most merger and acquisition transactions. Should there not be clarity on the manner of taxation of earn-outs? Leaving such an important issue open to multiple interpretations is a sure shot recipe for litigation, which is certainly not desirable. One, therefore, hopes that the government will bring about much needed clarity on this issue at the earliest.

Gautam Nayak is a chartered accountant.

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