Shareholder exits – when earn-out payments can trigger income tax

Earn-outs are amounts which a seller may potentially receive as the consideration for the sale of their shares, which are based on the future performance of the business. For example, an amount equivalent to 2% of profits above £500,000 for each of the two accounting periods following the sale of the shares. It must be clear throughout the negotiations between the buyers and the seller, and in the associated legal documents, that the earn-out forms part of the consideration being offered by the buyer for the shares being sold. The company making the payment post-sale, which is then under the control of the purchaser, is required to make a reasonable judgement as to whether all or any of the earn-out payment should in fact be subject to PAYE.

The consideration received by a business owner when selling the shares in their company can be made up of a number of components including:

Cash payable on completion Deferred consideration, which may be contingent on some event e.g. a future contract renewal Loan notes, preference shares and ordinary shares issued by the acquiring company An earn-out right

The differential between income tax and capital gains tax rates, which can currently be as much as 27% where Business Asset Disposal Relief is available, means that sellers are keen to secure capital gains tax treatment on as much of the consideration they receive as possible. 

HM Revenue & Customs are equally focussed on ensuring that any relevant amounts of the consideration received by the seller are subject to income tax. In the context of the sale of shares in a business, an income tax charge could generally arise under the following key areas:

As a result of a counter-action notice raised under the ‘transactions in securities’ anti-avoidance legislation As a result of a charge under the employment-related securities legislation Being correctly taxable as general earnings under the employment tax legislation

The question of the consideration for the disposal of shares being taxable as earnings was considered in Grays Timber Products Limited v HMRC ([2010] UKSC 4). The decision in this case supports the view that where an employee receives amounts for the disposal of shares that exceed the market value of those shares, the excess should be subject to income tax, not capital gains tax.

A common area of interest for HM Revenue & Customs in this regard is in relation to earn-outs, particularly where the former shareholder continues to be involved in the business post-sale.

What are earn-outs?

Earn-outs are amounts which a seller may potentially receive as the consideration for the sale of their shares, which are based on the future performance of the business. For example, an amount equivalent to 2% of profits above £500,000 for each of the two accounting periods following the sale of the shares.

As a component element of overall consideration for the purchase of a business, they can offer a commercial solution where a buyer and a seller cannot reach an agreement on a price.  This could be perhaps because the company does not have a recent proven track record of consistent profitability or uncertainty over the renewal of a significantly profitable contract.

HM Revenue & Customs outline their interpretation of the tax position in respect of earn-outs, and whether they should be treated as earnings, in their manuals (ERSM110940). 

It must be clear throughout the negotiations between the buyers and the seller, and in the associated legal documents, that the earn-out forms part of the consideration being offered by the buyer for the shares being sold.

The earn-out must relate to the capital value of the shares being sold and not the ongoing involvement of the seller in the business. Key indicators that would support this include:

Where the seller continues to be employed in the business, they receive a market rate remuneration package for their services Other shareholders who are selling their shares, but who have not been employed or, alternatively, do not continue to be employed post-sale, receive the earn-out on the same basis as the sellers who will remain in the business The earn-out does not contain performance targets which are particular to the seller of the shares The earn-out is not conditional on the seller’s continued employment in the business, over and above what is deemed acceptable in the circumstance to ensure a smooth transition and maintain the business’ value

There are some circumstances that will be a strong indicator that the earn-out, or at least part of it, should be reclassified as remuneration e.g. contracted bonuses being forgone in lieu of the earn-out.  However, in absence of this, it will be about considering the overall picture to determine the level of risk that all, or part, of the earn-out could be reclassified as earnings and therefore subject to income tax rather than capital gains tax. 

What do I need to consider in relation to earn-outs?

The company making the payment post-sale, which is then under the control of the purchaser, is required to make a reasonable judgement as to whether all or any of the earn-out payment should in fact be subject to PAYE. Understanding and agreeing the position with appropriate professional advice during negotiation is key to avoiding an unforeseen surprise for the earn-out holder(s) at a later payment date. 

As with all aspects of commercial transactions, tax is just one of the factors that needs to be considered. However, ensuring early involvement of relevant advisors is key to ensuring the commercial drivers for the earn-out are met whilst managing the tax risk for the relevant parties.

Mark Baxter is a tax partner at Mercer & Hole.

What is an earn-out – pros and cons of selling your business outright – Hollywood star Ryan Reynolds hit the headlines recently when he revealed he didn’t realise the sale of his business included an earn-out clause