Question:
In the earlier post, the concept of deferred consideration versus contingent consideration was analysed from a FEMA/ exchange control regulations for foreign inbound investments in India. How would deferred consideration be taxed, and how would it differ from contingent consideration?
Background:
In share acquisitions, it is not uncommon to structure payments either in the form of fixed, but deferred consideration, or variable, but contingent consideration (or earnouts), which would be payable upon achievement of certain pre-agreed milestones.
Conundrum:
Deferred consideration offers flexibility vis-à-vis outflow of cash flow by the acquirer, and earnouts incentivises the sellers to have skin in the game in search for additional consideration. Understanding the taxation of both these concepts is therefore critical.
Dissection:
Deferred Consideration:
Deferred consideration is when a consideration is fixed, but the payment is deferred – essentially, it’s a question of “when” and not “if”. Given that the consideration is determined upfront, albeit the receipt is deferred, the entire consideration effectively accrues on Day Zero when the shares are transferred. Ergo, irrespective of whether the consideration is received or not, or is deferred or otherwise, capital gains tax on sale of shares would be payable on the entire consideration i.e., upfront + deferred consideration.
Contingent Consideration:
Contingent consideration is when the total consideration is not fixed but is contingent upon the achievement of certain pre-agreed milestones – essentially, it is both a question of “if” and “when”. Given the uncertainty in payment, that portion of the total consideration which represents earnout cannot be said to accrue in the year of transfer of shares. Ergo, in the year of transfer of shares, only the upfront consideration accrued and received should be subject to capital gains tax. However, the current tax laws do not provide for taxation of earnouts in the year of receipts – i.e., whether the earnouts would be taxed as capital gains in the year of receipt, and therefore, lower rate of tax, or whether the same would be taxed as income from other sources, and therefore, maximum marginal rate of tax? The issue props up as there would be no “transfer” of shares in the year of receipt of earnout, since the shares would already have been transferred on Day Zero.