HMRC’s increasing scrutiny of earn-outs: Why it matters to both buyers and sellers

The Financial Times recently published an article suggesting HMRC are increasing their scrutiny of the tax treatment of earn-outs. This is an issue for both buyers and sellers and it is often a contentious point as to who should bear the risk of HMRC challenging the tax treatment of an earn-out. 

We have set out below:

• What an earn-out is.
• Why HMRC might challenge the tax treatment of an earn-out.
• How buyers and sellers respond to the risk of HMRC scrutinising earn-out arrangements.  

What is an earn-out?

When a seller sells their shares in a company to a buyer, they might not receive the full purchase price for the shares up-front on the day of completion. Instead, the seller might receive part of the purchase price after completion, such consideration may be called “deferred consideration” or an “earn-out”. This later consideration is often dependent upon and calculated by reference to the ongoing performance of the company.

This type of payment is often popular with buyers as it incentivises sellers to keep helping the company grow even after they no longer have a stake in the company.  

Why might HMRC challenge the tax treatment of an earn-out?

The reason HMRC might challenge the tax treatment of an earn-out comes down to the significant difference between the UK tax treatment of income and capital.

Shares in a company are typically treated as a capital asset for tax purposes, meaning any gains made on the sale of the shares is subject to capital gains tax (CGT). This means the difference between the purchase price received by a seller for their shares and the price which that seller paid to acquire those shares would usually be subject to CGT, which is currently charged at 24% (or 18% for basic rate taxpayers or to the extent business asset disposal relief applies).

In some cases though, HMRC will determine that an earn-out is actually being used to pass value to an employee seller as a reward for services to the company and so should be treated as employment remuneration rather than as further payment for the seller’s shares. This means the earn-out payment would be subject to income tax rather than CGT.

Income tax is currently charged at the rates of 20%, 40% or 45%, depending on whether the employee is a basic rate, higher rate, or additional rate taxpayer. National insurance contributions (NICs) are also payable by the employee at the rate of 2% or 8% (depending on the income tax rate), and by the employer at the rate of 15%.

How buyers and sellers respond to the risk 

If an earn-out is taxed as employment remuneration, the seller will therefore be taxed on the payment at the higher income tax and NICs rates. This could be an issue for the buyer as well, because HMRC can pursue the employer company (eg, the company which the buyer has acquired) for any unpaid income tax and employee NICs under the PAYE rules. The employer company would also typically be liable for any employer NICs arising on the payment.

Both the buyer and the seller will therefore want to limit the risk of HMRC treating the payment as employment remuneration. They can do this by ensuring that the following “key indicators” are met, which are the factors that HMRC will consider when determining whether a payment is in fact sale consideration (ie, subject to CGT treatment):

1. The share purchase agreement shows that the earn-out is consideration for the shares – in other words, it’s stated as being part of the purchase price.
2. The amount of the earn-out received by each seller reflects the value of their proportion of the shares.
3. The seller will be fully remunerated for their continued employment (ie, they will receive a full salary). This helps to demonstrate to HMRC that the earn-out is not compensation for the seller continuing to work for the company (as the seller is already being fully renumerated!).
4. Crucially, the earn-out is not conditional on the seller’s continued employment (beyond a reasonable requirement to stay to protect the value of the business being sold).  
5. No personal performance targets are incorporated into the earn-out drafting.
6. The sellers which won’t be employed after the sale will receive the earn-out on the same terms as the seller(s) that are employed after the sale.

HMRC will generally consider the above key indicators holistically. However, given recent reports suggesting that HMRC is increasing its scrutiny of the tax treatment of earn-outs, each of these factors should be considered carefully during negotiations and in the drafting of the share purchase agreement.

In practice, any potential income tax and NICs liabilities arising from an earn-out are often dealt with by including a specific tax indemnity in the tax schedule to the share purchase agreement, which allows the buyer to claim against the seller for any tax arising in respect of the payment of the consideration. This is often a contentious point with sellers resisting such an indemnity, particularly in cases where the buyer themselves has insisted on the earn-out/deferred consideration mechanism. As a compromise, the parties sometimes agree that the sellers will bear any income tax and employee NICs risk arising on the earn-out, but the buyer will bear the employer NICs risk.

How can we help?

It’s always worth thinking about the tax treatment of an earn-out or deferred consideration payment early on in the sale or purchase process, so that this can be dealt with in the share purchase agreement and to help avoid any surprises later. This is even more important now that HMRC is looking more closely at the tax treatment of these payments.

If you’re planning or negotiating the terms of a sale or purchase and you’re thinking of including this kind of payment, please do get in touch. 

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