n Business Tax and Company Law Quarterly - The Tax Characterisation of 'Earn-Outs'

Volume 6, Issue 3
  • ISSN : 2219-1585


Earn-out payments are a common feature of business acquisition transactions. An earn-out payment is a feature of the purchase price consideration for the acquisition of a business. The earn-out payment is dependent on the fulfillment of particular conditions, typically in the form of achieving profit hurdles,or contingent contracts being fulfilled by the entity acquired. In addition to the earn-out, a fixed upfront payment usually forms the remaining component of the purchase price consideration. The tax complexities in relation to 'earn-outs' rest with addressing the tax characterization of the receipt and payment thereof.

The article addresses the aforesaid characterization in the context of comparative tax case law and is restricted to the tax implications for the seller of a going concern business. Both the applicable South African case law and comparative precedents from foreign jurisdictions are analysed in order to identify the common law principles which may be applied to determine the treatment of earn-out payments.
The South African case law which addresses receipts and accruals in the form of 'earn-outs' is scant and is limited to a case decided in 1921 in the Cape Provincial Division. The case dealt with the distinction between a receipt for the sale of goodwill and a receipt for the use of goodwill. The court held that a receipt representing compensation for the use of goodwill will not assume the character of the related goodwill disposal which forms part of the assets disposed of by the taxpayer. The receipt was held to be of a revenue nature.
Foreign case law supports the position that the disposal of assets for consideration in the form of an upfront fixed payment and a payment contingent on profit hurdles does not detract from the character of the proceeds relating to the underlying asset disposal. The relevant case law is conclusive that the ultimate consideration may vary, either up or down, based on future calculations, whether it be in the form of achieving particular profit hurdles, or whether specified contingent events materialise. The principle of intention and purpose becomes relevant too when assessing the characterisation of the earn-out.

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