Earn-out payments – the timing of taxation in Germany

published on 20 January 2023 | reading time approx. 3 minutes

In M&A transactions it is common that the buyer and the seller have different visions as regards the future development of the target company. In order to reconcile the differing visions, the parties may agree on a so-called earn-out clause. Closely connected to the structuring of an earn-out clause is the question of the timing when the seller will have to tax subsequent purchase price payments made on the basis of an earn-out clause and when the buyer will be able to claim subsequent acquisition costs for tax purposes.

Earn-out as a purchase price mechanism intended to facilitate agreement between the negotiating parties

In company transactions, the negotiating parties may have differing visions as regards the future development of the target company. These divergent visions of the future development of the target are often based on deviating estimations as regards market potential, new technologies and the competitive environment of the target; such estimations are affected in particular by times of crisis and pessimistic forecasts. Quite often, divergent visions also result from the special position of the target company’s present owner and his personal influence on the business development.

In order to reconcile these differing visions of the buyer and the seller nevertheless, the negotiating parties may incorporate a so-called earn-out clause into the contract structure. An earn-out agreement is a purchase price mechanism where part of the payable purchase price becomes due only in the future and depending on the achievement of certain results. Thus, the agreed purchase price will consist of a fixed part and a variable part dependent on future performances (“earn-out”).

The value of earn-out payments usually depends on the target achieving certain results during an established earn-out period, usually after closing. This earn-out period is usually two to three years. The results are commonly measured based on various performance indicators (e.g. EBITDA, revenue, net profit for the period). Here, it is sometimes essential to minimise any possibilities for the buyer to exert influence on the determination of the performance indicators. To this end, the earn-out conditions and calculation should be defined in the purchase agreement as precisely as possible.

Timing of future earn-out payments to be taken into account for tax purposes

Closely related to the specific structuring of future earn-out payments are possible consequences arising from tax law. This is usually important both for the seller and for the buyer. Decisive for both negotiating parties is the timing when subsequent purchase price payments will be taken into account for tax purposes.

For the seller it is of interest whether he can tax subsequent purchase price payments later in the future or take it into account still in the year of sale so that subsequent purchase price payments, if any, could e.g. be set off against tax loss carryforwards existing at the time of sale.

Basically, the actual receipt of the purchase price payment is irrelevant for the tax treatment of the capital gain generated by the seller. Instead, the point in time at which the beneficial ownership of the transferred (part of) business, partnership interest or share in a corporation is transferred is of relevance.
Where the purchase price does not comprise only components that depend on sales revenue and/or profit, earn-out payments received at a later time usually lead to a retroactive adjustment of the capital gain with effect in the year of sale. From a German tax perspective, this usually constitutes the so-called event with retroactive effect within the meaning of Article 175 (1) sentence 1 no. 2 of the German Fiscal Code (“Abgabenordnung”, AO) and tax assessment notices have to be modified accordingly. Sometimes, however, an event with retroactive effect is deemed to exist only if the legal ground for the earn-out payments to be made later is anchored in the original purchase agreement.
According to established case law, the situation may be assessed differently if earn-out payments are based only on factors that depend on sales revenue and/or profit. Usually the consequence of this is that it is impossible to refer with retroactive effect to the time of sale but later payments are taxed only at the time (tax assessment period) when they are effectively realised, i.e. at the time of receipt.

Unlike the seller, the buyer is usually interested in using the costs incurred as part of the transaction as quickly as possible in the form of write-off potential for future periods. Therefore, the benefit for the buyer will sometimes depend on whether the M&A transaction is structured as an asset deal or as a share deal. In particular in the case of an asset deal the question arises, apart from the allocation of subsequent purchase price payment to the existing business assets, at what point in time due to subsequent purchase price payments the depreciation basis for the acquired business assets should be increased and the related further write-off potential will unfold. In tax literature, most authors are of the opinion that in particular with earn-out payments that depend on sales revenue and/or profit such costs may not be taken into account as subsequent acquisition costs until the time of payment, i.e. when the conditions for earn-out payments are met. In contrast, a minority of authors assume a corresponding treatment of the acquisition costs as capital gains.

Conclusion

Earn-out clauses in a purchase agreement enable both the seller and the buyer to agree on a purchase price, especially in a situation where they have different visions of the development of the target company. The specific structuring of an earn-out clause as a purchase price mechanism entails possible tax consequences. Here, it should be verified already at the transaction level to what extent the timing of taxation of subsequent purchase price payments may be structured in the contract.