The use of earn-outs is increasingly gaining momentum in India’s M&A space. Earn-out is a pricing structure used in business acquisitions, whereby a part of the purchase price is contingent on the performance of the acquired business over an agreed period of time post the acquisition. Earns outs meet two objectives. First, the wait and watch approach allows the buyer and seller to reach a mid-ground on the valuation of the business. Second, earn-outs allow the buyers to fund the acquisition from the future profits of the acquired business.
While the commercial merit of earn outs is widely acknowledged, the lack of clarity under the Indian income tax rules on the taxation of earn-outs has been a dampener for this pricing structure. The Delhi High Court has held that the sale consideration must be taxed in its entirety in the tax year in which the transfer of business takes place. However, the Bombay High Court has ruled that contingent payments received on sale should be taxed only on their accrual. If Delhi High Court’s decision were to be followed, the Seller would have to revise his tax return to give effect to any downward adjustment in the purchase price on account of failure to meet the earn-out related contingency, and where the permissible timeline for the revision of tax return has lapsed, the seller may find himself claiming capital loss.
In the midst of the confusion caused by such conflicting decisions, there is an overlay of Section 50D of the Income-tax Act, 1961. This provision allows the Indian tax authorities to impute the FMV of the capital asset transferred as the full value of the consideration for imposing capital gains tax, when the actual consideration received is indeterminate. There is a fear that tax authorities may treat earns outs as indeterminate consideration, and impute the FMV for computing capital gains. However, in case the ultimate consideration received by the taxpayer is in excess of such FMV, tax authorities may argue that the FMV offered to tax previously was incorrect. On the other hand, in case the ultimate consideration received by the taxpayer is less than the FMV offered to tax previously, tax authorities may not provide a refund absent a clear mechanism in the law to do so.
From the buyer’s point of view, earn-out payment and any adjustment to the purchase price on such account will have a bearing on the cost of acquisition of such asset for tax purposes. Needless to say, more complications arise in case the time period agreed between the parties for determining the earn-out is longer than the time period within which the buyer and seller may revise their tax returns.
Tax treatment of earn outs is the perfect example, where Government’s intervention has become necessary to resolve the ambiguity in the law. Budget, 2017 must resolve this issue given the Government’s larger agenda of according certainty in taxation and facilitating value enhancing commercial transactions.
(The article has been written by Amit Singhania, Partner, Tax & Gouri Puri, Principal Associate, Shardul Amarchand Mangaldas & Co. All the views expressed are personal)