Securities Options: earn-outs: key indicators of earn-out being sale consideration
Key indicators in determining whether an earn-out is further sale consideration rather than remuneration are:
- The sale agreement demonstrates that the earn-out is part of the valuable consideration given for the securities in the old company
- The value received from the earn-out reflects the value of the securities given up.
- Where the vendor continues to be employed in the business, the earn-out is not compensation for the vendor not being fully remunerated for continuing employment with the company.
- Where the vendor continues to be employed, the earn-out is not conditional on future employment, beyond a reasonable requirement to stay to protect the value of the business being sold.
- Where the vendor continues to be employed, there are no personal performance targets incorporated in the earn-out.
- Non-employees or former employees receive the earn-out on the same terms as employees remaining.
The following factors may also be relevant:
- Negotiations between the seller and buyer as to the level of the earn out in relation to the value of the consideration given for securities in the old company.
- Any clearance that might have been obtained under Section 138 and Section 707 demonstrating the bona fide nature of the transactions, and the level of the earn-out linked to profitability or other key performance indicators of the business.
- Evidence that future bonuses were reclassified or commuted into purchase consideration would indicate that the earn-out was, at least partly, remuneration rather than consideration for the disposal of securities.
Where the earn-out is partly deferred consideration for the old securities and partly a reward for services or inducement to continue working for the business, then an apportionment of the value will need to be undertaken on a just and reasonable basis.
This guidance is only applicable to the computation of employment income under Part 7 ITEPA 2003 and has no bearing on the rules for Capital Gains Tax.