[Opinion] Taxation of Earn-Out Arrangements in M&A Transactions

Viswanath. D & Eshaan Singal – [2025] 174 taxmann.com 482 (Article)

I. Introduction

Earnout payments are often used in M&A deals to strike a balance between what the buyer is willing to pay today and what the seller believes the business is worth in the long run. Instead of locking in the full price upfront, a part of the deal is linked to how the company performs after the acquisition—whether it’s hitting revenue targets, improving profitability, or reaching specific milestones.

This approach not only helps bridge differences in valuation but also keeps the seller motivated to deliver strong results, especially if they continue to be involved in the business. It’s a practical way to manage risk while aligning both sides around the company’s future.

This article seeks to explore the income tax treatment of earn-out arrangements in India by examining key statutory provisions, judicial precedents, and the implications of such arrangements from the standpoint of characterization, timing of taxation, and deductibility.

II. The Legal Conundrum – Nature and Characterisation of Earn-Outs

A fundamental issue arising in the taxation of earn-out arrangements is the nature of the income – should an earn-out be regarded as part of the purchase consideration, i.e. a capital receipt, or should it be treated as income under the head “Salaries” or “Profits and Gains from Business or Profession” (PGBP), depending on the structure?

The Income-tax Act, 1961 does not contain a specific provision addressing the tax treatment of earn-outs. Therefore, the legal characterisation must flow from the general provisions.

If the earn-out is intrinsically linked to the transfer of shares or business assets, and is not contingent upon continued employment or service, it is argued to form part of the total consideration for such transfer, thereby qualifying as a capital receipt taxable under the head “Capital Gains.”

However, when the earn-out is linked to the continued involvement or performance of the seller in the business post-acquisition—especially if the seller is required to provide managerial or advisory services—there arises a strong argument for it being classified as income from employment or business, taxable under Section 17 or Section 28 of the ITA.

III. Earn-Outs Tied to Employment – Salary or Incentive Compensation?

Judicial authorities have adjudicated on this issue, with the Authority for Advance Rulings (AAR) and High Courts offering useful guidance.

In the case of Anurag Jain, In re [2005] 145 Taxman 413/277 ITR 1 (AAR), the AAR was tasked with determining the nature of certain contingent payments made to the promoter-seller under a business transfer agreement.

The AAR concluded

• that the contingent payments were in the nature of salary because they were directly linked to the applicant’s continued employment and performance as CEO under an employment agreement, rather than being genuine consideration for the sale of shares.
• The payments were conditional upon achieving specific EBITDA targets, and failure to meet those targets or termination of employment resulted in forfeiture or repayment of such amounts.
• Given that the employment agreement, share purchase agreement, and non-compete agreement were contemporaneous and interlinked, the AAR held that the contingent payments were structured as part of the sale consideration but were in substance incentive-based remuneration, taxable under section 17(3)(ii) as “profits in lieu of salary.”

This ruling was upheld by the Hon’ble Madras High Court in Anurag Jain v. AAR [2009] 183 Taxman 383/308 ITR 302, reinforcing the position that if an earn-out is conditional upon the seller continuing in the role of an employee, the consideration assumes the character of salary.

IV. Earn-Outs as Capital Receipts – Part of Purchase Consideration

Conversely, in cases where the earn-out is not contingent upon employment or post-sale service, but rather on financial or operational milestones of the business, it is more appropriately classified as part of the sale consideration. The AAR in Moody’s Analytics Inc., USA [2012] 24 taxmann.com 41/209 Taxman 404/348 ITR 205 (AAR – New Delhi), recognised this distinction and held that the contingent payment in question was part of the capital gains computation.

The AAR held that

• the earnout payment was part of the capital gains from the sale of shares because it was contractually structured as deferred consideration, linked solely to the financial performance of the target company, and not to any employment or service obligations of the seller.
• the seller was a Mauritian corporate entity with no continuing role in the business, and the earnout was calculated based on a formula in the share purchase agreement.
  This stands in contrast to the Anurag Jain case, where the contingent payment was tied to the individual’s continued employment and performance as CEO, and was therefore held to be “profits in lieu of salary” under section 17(3)(ii) of the Income-tax Act.

Our View

A key factor in determining the correct tax characterisation of an earn-out payment is the nature of the performance condition to which it is linked. If the earn-out is dependent on the performance of the business post-acquisition—such as revenue milestones, profitability, or customer retention—it is likely to be construed as a deferred part of the purchase consideration, taxable as capital gains under Section 45 of the Income-tax Act.

However, where the earn-out is linked to the personal performance or continued involvement of the seller in the business—such as achieving individual sales targets, managing operations, or continuing in an employment role—the payment may be recharacterized as salary or business income, depending on the facts.

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