Earnout Structures and Tax Implications in India: A Detailed Guide

In mergers and acquisitions (M&A), earnout structures provide a mechanism to bridge the valuation gap between the buyer and seller. An earnout allows the seller to receive additional payments after the closing of the transaction, contingent on the performance of the business post-acquisition. This structure is especially useful when the future performance of the acquired business is uncertain or when the buyer and seller cannot agree on a fixed purchase price.

However, the use of earnouts introduces several tax considerations for both the buyer and the seller in India. In this article, we will examine earnout structures, tax implications, and the key provisions of Indian tax law that apply to these transactions.

What is an Earnout?

An earnout is a contractual arrangement where a portion of the purchase price is deferred and paid to the seller based on the future performance of the business being acquired. Typically, earnouts are linked to financial milestones, such as revenue, profit (EBITDA), or customer acquisition targets.

For example, a buyer might agree to pay INR 100 crore upfront for the business, with an additional INR 20 crore payable if the company meets a specified revenue target in the next two years.

Why Use an Earnout Structure?

1. Bridging Valuation Gaps: Earnouts help buyers and sellers reconcile differences in their valuation of the business. The seller believes the business will grow, while the buyer is cautious. The earnout ties future payments to that growth.

2. Incentivizing Seller Performance: If the seller stays on to manage the business post-acquisition, an earnout can serve as an incentive for them to work toward improving the business’s performance.   

3. Risk Mitigation for Buyers: For buyers, the earnout reduces the risk of overpaying for the business by making part of the payment contingent on actual performance.

How are Earnouts Structured?

Earnout structures vary depending on the nature of the business and the goals of both the buyer and seller. However, common structures include:

1. Revenue-Based Earnouts: Payment is tied to achieving specific revenue targets over a defined period (e.g., two years post-acquisition). If the company hits the revenue target, the seller receives additional compensation.

2. Profit-Based Earnouts: The earnout is contingent on meeting profit-related goals, such as EBITDA or net income. This structure incentivizes the seller to focus on operational efficiency, not just top-line growth.

3. Non-Financial Milestones: Earnouts can also be based on non-financial goals, such as customer acquisition targets, launching a new product, or securing regulatory approval.

4. Capped or Uncapped Earnouts: Earnouts can be capped at a certain maximum payout, or they can be uncapped, allowing the seller to receive substantial payments if the business significantly exceeds performance targets.

Tax Implications of Earnouts in India

Earnouts, while beneficial in aligning buyer and seller interests, introduce complexities in terms of taxation. The tax treatment of earnouts for both parties is governed by the Income Tax Act, 1961 and depends on how the payments are structured and characterized.

1. Tax Treatment for Sellers

For sellers, the key issue is whether the earnout payments are treated as capital gains or ordinary income, as the tax rates and implications differ significantly.

Capital Gains Tax: Earnout payments are generally viewed as part of the consideration received for the sale of shares or business assets. As such, they are subject to capital gains tax. Whether the gain is taxed as long-term or short-term depends on the holding period of the asset.

• Long-Term Capital Gains (LTCG): If the asset (such as shares) is held for more than 24 months, the earnout is taxed as long-term capital gains. The tax rate is 20% with indexation benefits.
• Short-Term Capital Gains (STCG): If the asset is held for less than 24 months, the earnout is taxed as short-term capital gains at the seller’s applicable income tax slab rate (which can go up to 30% for high-income individuals).

Deferred Taxation: In some cases, the tax liability may not arise until the earnout payments are actually received. This allows the seller to spread the tax burden over the earnout period, which may be two to three years. Under Indian tax law, the seller reports the earnout payments in the year they are received or become determinable.

Installment Sale Treatment: Earnout payments can also be treated as an installment sale, where the capital gains are calculated and taxed as the payments are received over the earnout period. This benefits the seller by spreading the tax liability across multiple years.

Contingent Consideration: Earnouts represent contingent consideration, which means the actual amount payable depends on future events (e.g., meeting a revenue target). In India, contingent consideration is taxed in the year the amount becomes determinable or is received, under the Income Tax Act.

2. Tax Treatment for Buyers

For buyers, the earnout is generally considered part of the purchase price. However, its tax treatment depends on whether it is classified as capital expenditure or revenue expenditure.

Cost Basis Adjustment: Earnout payments made by the buyer increase the cost of acquisition of the business or shares. This adjusted cost basis is used when calculating capital gains if the buyer later sells the acquired business or shares.

Tax Deductibility: In most cases, earnout payments are not immediately deductible by the buyer. However, if part of the earnout is structured as compensation for ongoing services provided by the seller (e.g., the seller remains with the company in an advisory role), it may be treated as a business expense and be tax-deductible under Section 37 of the Income Tax Act.

Withholding Tax (TDS): Buyers may need to deduct Tax Deducted at Source (TDS) on earnout payments, particularly when dealing with non-resident sellers. The applicable TDS rates depend on whether the payment is classified as income or capital gains. Section 195 of the Income Tax Act governs TDS for payments to non-residents, and rates may be reduced under applicable Double Taxation Avoidance Agreements (DTAA).

Cross-Border Earnouts and DTAA Considerations: If the seller is a non-resident of India, additional tax issues arise. Non-resident sellers may be subject to withholding tax under Section 195 on their earnout payments. However, India has Double Taxation Avoidance Agreements (DTAA) with several countries, which may provide relief from double taxation. For instance, under DTAA provisions, the earnout payments may be taxed at a reduced rate or exempted in India, depending on the treaty between India and the seller’s home country.

Capital Gains Exemption for Sellers

 Sellers in India can potentially reduce their tax liability by reinvesting the capital gains from the earnout. Sections 54 and 54EC of the Income Tax Act provide capital gains exemptions when gains are reinvested in certain qualifying assets, such as residential property or specified bonds.

• Section 54: Allows exemption of long-term capital gains if the gains are used to purchase or construct a residential house.
• Section 54EC: Allows exemption on long-term capital gains if the gains are invested in specified bonds, such as those issued by the National Highways Authority of India (NHAI) or Rural Electrification Corporation (REC).

Non-Compete Agreements and Earnouts

In some cases, the earnout may be linked to a non-compete agreement or service agreement. If the seller agrees not to compete with the business or provides ongoing services, the earnout payments tied to such agreements may be treated as ordinary income rather than capital gains, subjecting them to a higher tax rate.

Additionally, if the earnout is structured as deferred compensation, it could be subject to GST (Goods and Services Tax), depending on the seller’s role in the business post-acquisition.

Conclusion

Earnout structures in Indian M&A transactions offer flexibility but come with complex tax implications. Sellers must carefully consider how the earnout will be taxed—whether as capital gains or ordinary income—and plan accordingly. Buyers, on the other hand, need to understand the cost basis adjustments and potential TDS obligations.

Both parties should consult with tax advisors to ensure the earnout is structured in a tax-efficient manner, especially in cross-border deals where DTAA provisions might apply. With proper planning, earnouts can be a valuable tool for aligning the interests of buyers and sellers while managing tax liabilities effectively.

Contribud by – Krishnan Sreekumar

King Stubb & Kasiva,
Advocates & Attorneys

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