Avoid earnouts when substantial shareholding exemption is available

The issue

The substantial shareholding exemption (SSE) is a useful corporation tax relief which exempts corporate sellers from paying corporation tax on the disposal of shares in trading companies in a wide range of scenarios. The key requirements for this relief to apply are as follows:

1. For a continuous 12-month period starting within six years before a sale, the seller must have held 10% of the ordinary share capital, been beneficially entitled to 10% of the profits available for distribution and 10% of assets on a winding up.

2. From the start of the latest 12 month period above, the company must either have been a trading company or the holding company of a trading group.

3. There are certain additional rules which can make SSE also available in other circumstances, but I do not go into the details here.

Earnouts are taxed in a special way and will, in some cases, end up being taxable even where SSE applies.

Taxation of earnouts

An earnout is typically structured as additional consideration, which will be paid as a percentage of certain results that will only be known after the deal (an ‘unascertainable’ amount). The value of an earnout needs to be calculated and included as part of the disposal consideration and this ‘earnout right’ will then, itself, be treated as an asset which will be disposed of when the earnout proceeds are actually received.

Example

Holdco qualifies for SSE and sells its 20% share in Tradeco on 16 September 2025 for £20m and an earnout of 3x any 2026 EBITDA in excess of £6m. Ultimately, Tradeco does very well after the deal and makes EBITDA of £7.5m.

On 16 September 2025 Holdco values the potential earnout at £2m and so reports a disposal at £22m. It will pay no tax on this disposal because of SSE. By the end of 2026 Holdco knows that it will receive £4.5m for the earnout and so will be treated as making a gain of £2.5m on the earnout right. There is no SSE available on the disposal of an earnout right and therefore 25% corporation tax of £625,000 would be due in respect of this gain.

This example shows how, all things being equal, companies will want to justify as high a value as possible for earnout rights where SSE applies. This would limit the chance of a further gain arising on the receipt of the additional proceeds (as above).

However, the earnout does need to be valued based on the outlook (information available) at the date of sale and should not apply the benefit of hindsight (i.e. based on the knowledge of post-deal results).

WSM’s view

The structure of any earnout deal where SSE is involved should be looked at closely, because if a responsible valuation of the earnout right is performed, then there is always the prospect of a corporation tax charge when the earnout has been paid out. One possible route toward gaining more certainty over the tax position is to structure the consideration as deferred ‘ascertainable’ consideration, with clawbacks kicking in if certain results are not achieved. This should mitigate the risk of any gain arising from the ‘earnout payment’ because, when structured correctly, everything, including the deferred element should be taxable upfront – and therefore, everything is covered by SSE. This may also end up having stamp duty implications for the buyer and so may need to be subject to negotiation.