The “Deeming Fiction” For Taxing Earn-Outs

By Krishan Malhotra and Surabhi Singhi

With the recent increase in mergers and ac-quisitions activity in India, there has been a concurrent increase in the use of “earn-out” provisions in share purchase and business transfer agreements. An earn-out is an agreement stating that the seller of a business shall get additional compensation based on the sold business achieving certain future financial goals. Those goals could be an expectation of future earnings, business performance, or some other yardstick, such as turnover. In short, an earn-out is a form of deferred compensation or income for the sale and transfer of a business or its shares.

Taxation of earn-outs in India is based significantly on the “deeming” fiction created by statute, and poses several challenges including: the characterisation of income, year of taxability, quantification of deferred payments and revisions to purchase price depending on final amounts received.

”Deemed” connotes a circumstance where a particular receipt is not income but the law says that it shall be regarded as income; that is, the law departs from reality, constituting a fiction of law. The legal fiction may also relate to place, person or year of taxability.

Thus, under India’s Income Tax Act of 1961 income tax is levied on income received, ac-crued, or deemed to accrue or arise in India. The definition of “income” has been the sub-ject of considerable judicial scrutiny and in-terpretation, but there are two main schools of thought. One is that an essential attribute of income is that it is received on a periodic basis; the other focuses on the value the tax-payer receives or may derive.

One method for structuring earn-outs is for the seller to receive the earn-out payment under the aegis of an employment agreement with the Indian company, after the transfer of shares. In In Re Anurag Jain (277 ITR 1), the Authority for Advance Rulings (AAR), affirmed by the Madras High Court in 308 ITR 302, held that, in such cases, the contingent payments have a real nexus with the employment agreement and not with the purchase agreement, and that the contingent payments are nothing but an incentive remuneration for achieving a target. The periodical payment of consideration was regarded as salary income in the hands of promoters and was not regarded as payment received towards the sale of shares which would be taxable as capital gains. Therefore, in a circumstance where the deferred consideration is linked to services being performed, it is regarded as “ordinary income,” and where the deferred consideration is relatable to the shares, it is taxable as capital gains.

Section 45(1) of the Act provides that profits or gains arising from the transfer of a capital asset made in the previous year is subject to taxation under the capital gains tax, and shall be deemed to be the income of the previous year in which the income transfer took place. Thus, in the context of earn-outs, the Act creates a “deeming” fiction in order to tax such amounts in the year of transfer, irrespective of whether such gains have accrued to the taxpayer.

Recently, the Delhi High Court, in Ajay Guliya v. Ass’t Comm. of Income Tax (ITA No. 423/2012), held that in view of the “deeming fiction,” deferred consideration to a share-holder is taxable in the year of transfer. The decision seems to conflict with the general principles of accrual set forth by the Supreme Court in Comm. of Income Tax v. Ashokbhai Chimanbhai (56 ITR 42), where it was held that unless a right to profits comes into existence, there is no accrual of profits and no tax may be imposed. Section 45 of the Income Tax Act, however, imposes a tax on transfer of capital assets, through the fiction of “deeming” the gains as accrued and subject to taxation in the year of transfer. Moreover, as the failure to meet conditions or pre-agreed thresholds for payment of deferred consideration does not result in reversion of title of shares, the general principles of accrual are not applicable in the case of earn-outs.

Therefore, because the statute requires de-ferred consideration in respect of the transfer of shares or the business to be taxable as capital gains in the year of the transfer, the next and most immediate question that arises concerns the quantification of such gains. Certain M&A deals specify an amount as deferred consideration, which makes it easy to identify the taxable deferred income. However, where the deferred consideration is not specified, but depends on a future event such as performance of the company and future profits, the full value of consideration for computing capital gains is unascertainable.

Until 2012, if capital gains were indetermina-ble, the provisions for computing the capital gains would fail and provisions relating to capital gains would not apply. Comm. of In-come Tax v. B.C. Srinivasa Setty, 128 ITR 294. The Finance Act of 2012, however, has intro-duced a new provision for the taxation of earn outs, where, if the consideration to be paid for any asset is not determinable at the time of transfer of the asset, the fair market value of the asset on the date of transfer shall be considered the full value consideration for the purposes of the Income Tax Act.

Therefore, in case of earn-outs where the deferred consideration is unascertainable, the tax authorities will tax the gains based upon the fair market value of the asset in the year of taxability, even though if it is not certain that the seller will actually receive such an amount. Where the agreed upon conditions are not achieved, however, and the earn-out payments or deferred consideration are not paid, the seller may file a revised tax return (within the statutory time limit) showing the actual full value consideration received, and the consequent capital gains accrued on the transfer. There is no clear guidance on what happens when the time limit for filing a revised return has elapsed.

In conclusion, rules regarding the taxation of M&A-related transfers relating to earn-outs in shared purchase deals, requires greater clarity, as is the case with the law in many countries which have specific chapter(s) de-voted to taxation of earn-outs.

Krishan Malhotra is a partner in the firm Amarchand & Mangaldas & Suresh A. Shroff & Co., in New Delhi. He is the Head of Taxation and can be reached at kri-shan.malhotra@amarchand.com. Surabhi Singhi is an Associate with the tax practice group of the firm. She can be contacted at surabhi.singhi@amarchand.com.

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