I. Introduction

Variable purchase price components (so-called earn-outs) are a popular means in transaction practice to take into account the uncertainties in the valuation of a company or the different purchase price expectations between seller and buyer. In the case of an earn-out agreement, for example, the final purchase price is not finally determined either at the signing of the contract or at the closing of the company but is at least partially dependent on the future performance of the target company.
The buyer and seller then initially agree on a fixed purchase price (base purchase price), which is generally payable by the buyer on completion of the transaction. In addition, variable purchase price payments are agreed, which become due in the future once certain milestones of the acquired company have been achieved. This so-called earn-out is either agreed as a fixed amount or the amount is linked to a target figure in a certain ratio and is usually within a certain “corridor”.
Since earn-out payments are always dependent on the occurrence of certain future performance parameters that are not yet known at the time of the transaction, the question arises as to whether and, if so, how these variable purchase price components should be taken into account when determining the sale gain for tax purposes. This goes hand in hand with the question of the preferential treatment of sale gains, taking into account earn-out payments.
The BFH now had the opportunity to deal with the question of the time of taxation of earn-out payments and rejected the previously widespread administrative practice according to which such purchase price components are to be included in the determination of the sale gain as a so-called retroactive event. This now leads to further legal uncertainties with regard to the application of the special tax rate pursuant to § 34 para. 3 EStG.

II. General information on the time of taxation of sale gains

According to established case law of the BFH, sale gains pursuant to §§ 16 and 17 EStG, which include the sale of a business, part of a business or co-entrepreneurial share as well as the sale of shares in corporations of at least 1 % of the share capital, must generally be determined as at the reporting date. The relevant date is the date on which economic ownership of the object of sale is transferred to the purchaser. This applies regardless of when the purchase price is paid. This means that a calculation of the sale gain on the reporting date is generally also appropriate if the selling price is initially deferred and/or paid in installments.
In order to avoid hardship, case law has classified events that occur in a later assessment period and which economically lead to a reduction in the purchase price, e.g. the loss of a deferred purchase price claim, as a retroactive event within the meaning of § 175 para. 1 sentence 1 no. 2 German Tax Code (AO). This can lead to a change (reduction) in the original calculation of sale gains and thus to taxation according to the actual performance of the seller.
The subsequent increase in the purchase price can also be considered a retroactive event under certain circumstances. However, the prerequisite is that the legal basis for the payment made at a later date is contained in the original legal transaction.
This was previously assumed in the declaration practice for earn-out arrangements and the tax authorities also regularly took such variable purchase price components into account for the seller by retroactively changing the assessment of the year of the actual sale. This had the positive effect that earn-out payments (also retrospectively) were added to the sale gain that benefited from tax relief under §§ 16 para. 4, 34 EStG. However, this aforementioned practice was somewhat at odds with the case law of the BFH on sales and profit-related purchase price payments in the form of recurring payments.
The 8th Senate of the BFH had already ruled in 2002 (judgment of 14 May 2002, case no. VIII R 8/01) that such purchase price components are only taxable upon receipt. The main argument put forward by the court at the time was that immediate taxation would be precluded by the fact that the amount of this performance-related remuneration could not be foreseen when the contract was concluded, meaning that it could not be capitalized at the time of sale. Due to the lack of determinability of the sales price at the time of sale, a determination of the profit as at the reporting date is out of the question. As a result, the BFH also rejected a preferential treatment of the sales and profit-dependent purchase price components and justified its opinion with the lack of accumulation of the disclosed hidden reserves due to the subsequent and thus successive inflow taxation.
It has not yet been clarified whether the aforementioned case law on sales and profit-related purchase price payments in the form of recurring payments also covers earn-out arrangements.

III. Current decision of the BFH

In its decision of 9 November 2023, the BFH assumes a general applicability of the purchase price claims based on turnover or profit to the earn-out. This means that there is generally no consideration of the reporting date, i.e. no retroactive effect on the date of disposal. In this respect, the 4th Senate of the BFH argues that earn-out payments are conditional purchase price payments whose occurrence (at least in the case in question) was uncertain both in terms of reason and amount. Since the accrual of such purchase price components is not as good as certain when the contract is concluded, the principle of taxation according to economic performance, as in the case of sales and profit-dependent purchase prices in the form of recurring payments, prohibits the calculation of sale gains on the reporting date. The consequence of this is that such payments are not subject to taxation until they are received.
The BFH expressly left open whether it could assess the facts differently if only the accrual of a payment already fixed in terms of amount was made dependent on profit or turnover. A different assessment is at least conceivable because in this case the purchase price can be specified in terms of amount at the time of sale. For this reason, fixed purchase price amounts are currently linked to the occurrence of certain events in structuring practice, or conversely, a “fixed” purchase price is agreed, which then partially lapses again if the specific event(s) does/do not occur in the future.

IV. Consequences for the practice

First of all, it should be noted that the ruling can only have a negative impact on the sale of businesses, parts of businesses and co-entrepreneurial shares, as the so-called partial income method generally applies to shares in corporations, which means a considerable per se advantage.
The decision is currently not “for publication”, as the BFH assumes that there is no change to the previous legal situation. However, due to the possible implications of the ruling with regard to the preferential treatment under §§ 16 para. 4, 34 EStG, we expect the Federal Ministry of Finance to issue a statement.
In our view, the tax-free allowance pursuant to § 16 para. 4 EStG and the application of § 34 EStG should not be jeopardized in the case of earn-out arrangements, at least not for the fixed/secure purchase price component. As explained, this is to be understood as the base purchase price and thus as the lower valuation limit on which both the seller and the buyer were able to agree and which leads to the disclosure of all hidden reserves in the business assets sold. Since the full disclosure of all hidden reserves is a prerequisite for the application of the above-mentioned benefits, in our opinion there is nothing to prevent the corresponding claim, even if further purchase price payments are made at a later date.
However, it can be assumed that the earn-out payments will not benefit from retroactive inclusion in the calculation of the preferential sale gain, but that these variable purchase price components will be taxable upon receipt without the application of §§ 16 para. 4, 34 EStG.
It is conceivable that the tax authorities will grant protection of legitimate expectations in cases in which the facts of the case (i.e. conclusion of the purchase agreement) are implemented before the BFH ruling is published, based on the previous administrative practice according to which earn-out payments lead to a retroactive change in the assessment of the year of sale in accordance with § 175 para. 1 sentence 1 no. 2 EStG. However, we consider this to be rather unlikely, as there was no official statement from the tax authorities regarding the retrospective consideration of such variable purchase price components.
It is also conceivable, but in our opinion almost impossible, that the tax authorities will decide not to apply the above-mentioned BFH ruling. It would then have to explicitly endorse the retroactive (and therefore preferential) taxation of earn-out payments in a decree for the first time.

V. Structure recommendations

Due to the legal uncertainties described above, the conclusion of purchase agreements with earn-out components should be considered in light of the taxation consequences described.
As before, the agreement of earn-out payments always makes economic sense and is unobjectionable from a tax perspective if the seller is not a beneficiary under §§ 16 para. 4, 34 EStG. The BFH’s decision from November 2023 may even be advantageous here, as the taxation of inflows can offer progression advantages.
If, on the other hand, the seller is a beneficiary of §§ 16 para. 4, 34 EStG, it is advisable to obtain binding information on the question of eligibility until an official announcement is made by the tax authorities, although this can involve considerable costs, the outcome of which is uncertain and which can take a considerable amount of time.
Various alternative arrangements are discussed in the literature. For example, it is possible to attach a condition subsequent to the purchase price within the meaning of § 158 para. 2 German Civil Code (BGB) or to provide the buyer with a guarantee of quality in accordance with § 443 BGB, which leads to a subsequent reduction in the purchase price if certain success factors of the target company are not achieved. Whether the desired tax consequences can be achieved in this way, however, is also not certain due to a lack of relevant case law.