Earn-out agreements, also known as valuation adjustment agreements, possess characteristics of investment risk control and incentives for mid-to-senior-level management. They have gained favor among a significant number of capital market investors and are increasingly prevalent in business transactions. However, due to the current lack of specific tax regulations addressing the income tax issues related to earn-out agreements, a considerable number of tax problems and cases have arisen in practice. This article focuses on the individual income tax issues arising from earn-out agreements, including the determination of the taxation timing, the application of individual income tax deferral policies, and the tax and refund differences resulting from the application of "separate tax treatment" and "consolidated tax treatment."

I. Meaning and Types of Earn-out Agreements

In 2019, the Supreme People's Court defined earn-out agreements for the first time in the "Minutes of the Ninth Civil Law Working Session," stating, "Commonly known as 'earn-out agreements' in practice, also known as valuation adjustment agreements, they refer to agreements between investors and financing parties in equity financing agreements. These agreements are designed to address the uncertainty of the future development of the target company, information asymmetry, and agency costs in transactions. They include agreements on equity repurchase, monetary compensation, and other adjustments to the valuation of the future target company."

Earn-out agreements come in various forms. For ease of understanding, they are typically classified into three categories:

(I) Based on the payment time of the "conditional consideration," they are divided into positive earn-outs and reverse earn-outs. Positive earn-outs involve the acquirer prepaying the corresponding transfer payment, with additional consideration added if the target company achieves performance. Reverse earn-outs involve the acquirer transferring the entire consideration upfront, and if the target company fails to meet performance, the transferor needs to pay a certain compensation.

(II) Based on the form of compensation, they can be categorized as monetary compensation and equity compensation. In practice, to minimize investment risk, both forms of compensation may be applied simultaneously.

(III) Additionally, based on the different ownership percentages, earn-out agreements can be further divided into participating earn-outs and controlling earn-outs.

II.Case Study One: Successful Earn-out Agreement for Individual Shareholder, Recognition of Income Disputed

(I) Case Overview

Mr. Shi, one of the major shareholders of Company B, signed a "Profit Forecast Compensation Agreement" (hereinafter referred to as the "Earn-out Agreement") with Company A in 2014. Mr. Shi acquired shares of Company A and transferred his holdings of Company B to A, resulting in A holding 100% of B. The agreement included a commitment from Mr. Shi and other B shareholders to the net profit for the year in which the major asset restructuring was completed and the following two years. If the net profit did not meet the forecast, compensation to A was required. The compensation method involved using subscribed shares first and cash compensation if necessary. B exceeded profit expectations in 2014, 2015, and 2016, indicating a successful earn-out.

In May 2019, Mr. Shi applied to the tax firm for phased filing of his personal income tax, indicating the planned tax payment periods as 2017, 2018, 2019, 2020, and 2021. The tax firm, after review, determined that the tax obligation for Mr. Shi's non-monetary asset investment transaction occurred in September 2014, and his application in May 2019 did not meet the acceptance conditions in terms of both timing and content, deciding not to accept it. Dissatisfied, Mr. Shi appealed to the tax bureau for reconsideration, but the decision not to accept was upheld. Mr. Shi then filed an administrative lawsuit, losing in both the first and second instances. He applied for a retrial at the local higher people's court, which was rejected.

(II) Key Issues

Taxpayer's Argument: The taxation point for the earn-out agreement should be when the agreement is fulfilled. Mr. Shi argued that the confirmation of obtaining the equity should meet the following two conditions: firstly, transferring his holdings of B to A; secondly, actually obtaining ownership of A's shares. The final ownership of A's shares was conditional per the Earn-out Agreement, and the confirmation of Mr. Shi's taxable income should not be in September 2014 but after the completion of the Earn-out Agreement. As the "Announcement of the State Administration of Taxation on Issues Related to the Individual Income Tax Management of Non-monetary Asset Investments by Individuals" (Announcement No. 20 of the State Administration of Taxation in 2015, hereinafter referred to as "No. 20 Announcement") did not specify that failure to file within the designated time forfeits the right to deferred taxation, Mr. Shi believed that the tax authorities should accept the deferred tax filing.

Tax Authority's Argument: The taxation point for the earn-out agreement starts from the date of equity registration. According to tax laws, Mr. Shi completed a non-monetary asset investment transaction in September 2014 by exchanging his holdings in B with A, obtaining A's equity, and completing the equity registration in September 2014. The income from the non-monetary asset investment transaction occurred in September 2014. According to the No. 20 Announcement, Mr. Shi should have applied for deferred tax filing within 30 days from the date of the announcement. Mr. Shi's application significantly exceeded the stipulated deadline.

The court in the first instance, second instance, and retrial all supported the tax authority's viewpoint, stating that Mr. Shi's tax obligation occurred before April 1, 2015, and his application for phased payment in September 2019 clearly did not comply with the above rules.

(III) Case Study Two: Unfulfilled Earn-out Terms Lead to a Fine of 3.5 Million Yuan for Failure to Withhold and Pay Individual Income Tax by the Company

A and B are the shareholders of Z company, each holding 50% of the shares of Z company, have already paid in capital, in 2015 y listed company and A and B signed a gambling agreement, it is agreed that company Y shall acquire the shares of company Z at a price of 29 million, and that the transfer price of the shares of company a shall be paid within 20 days from the date of completion of the registration of the shares, the transfer of equity of B shall be paid to b in accordance with the fulfilment of performance commitments. As company Z did not achieve its promised net profit in 2015, the two sides signed a supplementary agreement to agree B to buy back 40% of company Z at par and complete the business registration in August 2016. In June 2022, the Inspection Bureau of Y company issued the“Notice of tax administrative penalty”, because y company did not withhold and pay personal income tax, a fine of more than 3.5 million yuan.

III. Confirmation of the Taxation Timing for Contingent Agreements

(I) Document No. 67 explicitly stipulates that the taxation timing is the effective date of the agreement.

Our country has not yet introduced specific laws and regulations to govern the issue of income tax on contingent agreements. In practice, tax authorities usually apply the "Individual Income Tax Law" and its implementing regulations, as well as the "Administrative Measures for Individual Income Tax on Equity Transfer Income (Trial)" (State Administration of Taxation Announcement No. 67 of 2014, hereinafter referred to as Document No. 67). If non-monetary asset investments are involved, the relevant provisions of the "Notice on Individual Income Tax Policies for Individuals' Non-Monetary Asset Investments" (Caishui [2015] No. 41, hereinafter referred to as Document No. 41) will be supplementary.

Article 20 of Document No. 67 stipulates: "If any of the following circumstances exists, the withholding agent or taxpayer shall declare and pay taxes to the competent tax authority in accordance with the law within 15 days of the next month: (2) the equity transfer agreement has been signed and become effective; (4) the judgment, registration, or announcement by the relevant state department has become effective." Document No. 67 does not use vague expressions such as "realization of equity transfer income" as the timing for declaring and paying taxes; instead, it clearly specifies the specific timing for individuals to declare and pay taxes on equity transfer.

(II) Document No. 41 does not affect the determination of the taxation timing for non-monetary investments.

Article 2, paragraph 2 of Document No. 41 states: "When an individual invests in non-monetary assets, the realization of income from the transfer of non-monetary assets shall be confirmed upon the transfer of non-monetary assets or the acquisition of equity in the invested enterprise." However, since "transfer of non-monetary assets" and "acquisition of equity in the invested enterprise" are actually two different timing points, especially in contingent agreements where these two points may be several years apart, Document No. 41 does not provide clarification. Moreover, since Document No. 41 and Document No. 67 are both departmental normative documents, Document No. 41 was issued in 2015, later than the release of Document No. 67, and its provisions only address income tax issues related to non-monetary asset investments, making it more targeted than Document No. 67. Therefore, some taxpayers in practice believe that the provisions of Document No. 41 should be applied, and the tax obligation should be confirmed when actually acquiring equity in the invested enterprise.

However, this viewpoint has not been supported when considering practical situations and cases. Firstly, Document No. 67 clearly stipulates the taxation timing for individual equity transfers and does not differentiate based on the nature of the property acquired. Distinguishing the taxation timing based solely on the different nature of the acquired assets does not conform to the principle of tax fairness. Secondly, Document No. 41 stipulates that "acquiring equity in the invested enterprise" includes acquiring with conditions attached. Therefore, the failure to achieve the contingency clauses in the contingent agreement and the subsequent return of the corresponding equity do not affect the "acquisition" of the equity. Document No. 41 does not explicitly state that both conditions of "transfer of non-monetary assets" and "acquisition of equity in the invested enterprise" must be met simultaneously, leading to a misinterpretation by taxpayers. Finally, contingent agreements often have long durations, and confirming the tax obligation at the point of achieving the contingent clauses would not guarantee the realization of national tax revenue and would increase the difficulty of tax authorities in taxation. Therefore, in practice, regardless of the form of investment used to sign contingent agreements, taxpayers need to complete tax declaration within the specified period after the agreement becomes effective or after the equity change is registered.

IV. Application of Personal Income Tax Deferred Taxation Preferential Policy

Another point of dispute in Case One is the application of the preferential tax treatment for deferred taxation of personal income tax. Article 3 of Document No. 41 stipulates: "Individuals should declare and pay taxes to the competent tax authorities within 15 days of the next month when the above-mentioned taxable behaviors (non-monetary asset investment behaviors) occur. If the taxpayer has difficulty in paying taxes in a lump sum, a reasonable installment payment plan can be determined and submitted to the competent tax authorities for filing. The individual income tax can be paid in installments within (including) a period not exceeding 5 calendar years from the date of the above-mentioned taxable behavior." In other words, individuals who invest with non-monetary assets, such as shareholders using non-monetary assets to invest, can apply for a maximum of 5 years of deferred taxation under the policy. In Case One, if Mr. Shi exchanges the equity of Company B that he holds for the equity of Company A, it meets the provisions of Document No. 41, and he can choose to apply for the deferred taxation preferential policy.

Document No. 20 elaborates and clarifies the application rules for deferred taxation. For example, Article 8 stipulates: "If taxpayers who need to pay personal income tax in installments for non-monetary asset investments, they should, within 15 days of the next month after obtaining equity in the invested enterprise, formulate a tax payment plan and submit to the competent tax authorities the 'Non-Monetary Asset Investment Installment Payment Personal Income Tax Filing Form,' taxpayer identity proof, investment agreement, proof of non-monetary asset assessment price, and relevant materials that can prove the original value of non-monetary assets and reasonable taxes and fees. For non-monetary asset investments that occurred before April 1, 2015, with a period not exceeding 5 years, have not yet undergone tax treatment and require installment payment of personal income tax, taxpayers should submit installment tax filing procedures to the competent tax authorities within 30 days from the date of issuance of this announcement." The document specifies the materials that taxpayers should submit when applying for deferred taxation and sets a deadline for filing for investments made before April 1, 2015. In Case One, the taxpayer clearly exceeded the filing deadline, so their filing application did not pass.

V. Taxation of Performance Compensation in the Case of Contingent Agreements Failure

(I) According to Circular No. 130, the two stock transfers in the contingent agreement should be "separately taxed."

According to the "Reply on the Issue of Individual Income Tax on Taxpayers' Retrieval of Transferred Equity" (State Taxation Letter (2005) No. 130, hereinafter referred to as Circular No. 130), the first paragraph stipulates: "According to the relevant provisions of the 'PRC Individual Income Tax Law' and its implementing regulations and the 'PRC Tax Collection and Administration Law,' if the equity transfer contract has been completed, the equity has been registered for changes, and the income has been realized, the individual who transferred the equity should pay individual income tax in accordance with the law. After the transfer is completed, if the parties sign and execute an agreement to rescind the original equity transfer contract and return the equity, it constitutes another equity transfer action. The individual income tax paid for the previous transfer action will not be refunded." In other words, if the equity change has been completed, the retrieval of the transferred equity should be treated as another separate equity transfer action and taxed separately. In Case Two, the tax authorities believe that when Party B initially sold 50% of the equity to Company Y and Company Y subsequently transferred 40% of the equity of Company Z to Party B at a fair price, these are two separate equity transfer actions that should be separately taxed. Party B should pay taxes on the income from the first transfer of equity, and Company Y should pay taxes again on the income from the transfer of 40% of the equity. According to Article 5 of Document No. 67, Company Y, as the withholding agent for the individual shareholder, did not fulfill its withholding obligation, and the tax authorities, in accordance with Circular No. 130 and relevant laws and regulations, penalized it, which is reasonable.

(II) In practice, some argue for "consolidated tax treatment."

Some scholars argue that "separate tax treatment" violates the true intentions between civil and commercial subjects. The parties to the contingent agreement only have the intention of a single capital contribution or capital increase transaction. If it is divided into multiple transactions only through the form of transactions, it violates the economic substance principle. At the same time, "separate tax treatment" can adjust the tax liability for the enterprise's fiscal year, potentially bringing tax avoidance risks and causing loss of national tax revenue.

Therefore, some argue that the performance compensation for contingent agreements should be handled with "consolidated tax treatment," considering multiple stages of the contingent agreement as one transaction. Taking Case Two as an example, using "consolidated tax treatment" would consider Party B as conditionally selling 50% of the equity to Company Y. Company Y should fulfill the withholding obligation, and if the performance is not met, Party B should compensate Company Y with 10% of the equity and the equivalent value of 40% of the equity, adjusting the equity acquisition price accordingly and reducing the taxable amount. Since there are currently no specific provisions supporting "consolidated tax treatment" for contingent agreements, and "consolidated tax treatment" often involves adjusting across fiscal years, it is challenging to implement effectively in practice. Therefore, there is still significant controversy in practice over whether to adopt "consolidated tax treatment" or "separate tax treatment," and the execution paths of tax authorities in different regions vary, leading to practical confusion.

(III) Personal income tax refund issues after the failure of contingent agreements

As mentioned earlier, using "consolidated tax treatment" would result in a reduction in the taxable amount, triggering issues of personal income tax refund. However, due to the lack of clear tax policies supporting the refund of individual income tax for contingent agreements, individual shareholders face difficulties in applying for tax refunds in practice. Additionally, since some local tax authorities do not support "consolidated tax treatment," taxpayers may also face challenges in applying for refunds.