Earn out Hierarchy Schedule Overriding Parent Accounting Guidelines
An explicit contractual hierarchy schedule overriding parent corporate accounting guidelines protects post-closing earn-out payouts from corporate overhead allocations.
Deferred Consideration Tax
Meaning
Taxation liabilities arising from future payments in an asset or share sale are recognized by the authorities when the right to receive the funds becomes certain. Deferred consideration tax applies to portions of the purchase price that are paid after the initial closing date, often linked to the performance of the business. The tax is calculated based on the value of these future payments, and the timing of the payment depends on the local tax laws.
Some jurisdictions require the tax to be paid upfront on the estimated value, while others allow for payment only when the cash is received. This liability stops applying once the final payment has been made and all tax returns for the relevant years are filed. Most sellers must carefully structure the earn out provisions to manage the cash flow impact of the deferred consideration tax.
The rate of tax is usually the same as the rate applied to the initial capital gain.
Valuation Adjustment
Determining the amount of deferred consideration tax is complicated when the future payment is contingent on the achievement of specific financial targets. A deferred consideration tax assessment often requires the seller to estimate the fair market value of the contingent right at the time of the sale. If the business fails to meet the targets and the payment is lower than expected, the seller may be able to claim a tax refund.
The tax authority examines the purchase agreement to understand the formula used to calculate the future payments. This formula often includes metrics such as revenue growth, profit margins or the retention of major clients. If the payment is guaranteed and not contingent, it is usually taxed immediately as part of the initial proceeds.
The distinction between a guaranteed payment and a contingent one is a major factor in tax planning for corporate exits.
Payment Timing
Cash flow management is a major concern for sellers who face a deferred consideration tax bill before they have received the actual funds from the buyer. A deferred consideration tax obligation can create a liquidity problem if the tax is due in the year of the sale but the cash arrives years later. Some tax systems offer a deferral of the tax payment until the cash is actually in the hands of the seller.
This relief is often subject to certain conditions, such as the seller not being a professional dealer in shares. The seller must track the payments and file supplemental tax returns as each installment is received. If the buyer defaults on the payment, the seller must seek a adjustment to the tax paid to avoid a loss.
This risk is often managed through the use of an escrow account or a bank guarantee to secure the future payments.
Indemnity Clause
Transactional lawyers include specific provisions in the sale agreement to address the allocation of risks related to the deferred consideration tax. A deferred consideration tax clause specifies which party is responsible for filing the tax returns and who bears the cost of any unexpected audits. The buyer usually agrees to provide the seller with the financial information needed to calculate the earn out and the associated tax.
If the tax authority challenges the valuation of the contingent right, the agreement defines how the dispute will be handled. The seller often requests an indemnity from the buyer if the buyer’s actions after the closing reduce the likelihood of the performance targets being met. This protection ensures that the seller is not taxed on a value that they never actually receive.
The agreement also addresses the impact of changes in tax law that might occur between the closing date and the final payment date. Clear wording is essential to avoid disputes over the net proceeds of the sale.