Variable purchase price components linked to future performance milestones – so called earn-outs – are frequently used to bridge valuation gaps between buyer and seller. In a purely domestic setting, this is mainly a timing question: tax may shift into a later tax year and be subject to a higher or lower effective tax rate, but it stays within the same jurisdiction. 

This may change if founders leave Germany and become tax resident elsewhere by the time their earn-out materializes. Two jurisdictions may disagree not only about when the payment becomes taxable but also about which state has the primary taxing right. This makes it even more important to consider a potential relocation at the SPA stage rather than waiting until the earn-out begins to materialize.

While this article focuses on earn-out payments within share deals, similar considerations often arise in asset deals as well. The discussion further assumes that the earn-out payment is part of the purchase price rather than additional remuneration for services performed. Additional considerations, particularly regarding exit taxation, may arise if a founder remains invested following the exit.

I. Germany's Tax Treatment of Earn-Outs

a) General Principles

For sellers holding at least 1% of the shares in a corporation as private assets, capital gains are generally subject to the partial income regime, under which 60% of the gain is taxable and 40% is tax exempt, resulting in an effective income tax burden of up to approximately 27%. [1] The effective tax burden may vary depending on the seller's taxable income in the relevant years.

Capital gains are generally determined and taxed in the year of exit, irrespective of when the purchase price is ultimately paid. Later adjustments to the purchase price usually remain part of the original capital gain and are therefore treated as a retroactive event. In practice, the tax assessment for the exit year may be amended if such an event occurs. An exception applies to profit- or revenue-linked purchase price components, which are taxed only upon receipt. For earn-outs, the critical question is whether they should be viewed as part of the original purchase price or as falling within this exception.

b) Retroactive Event vs. Receipt-Year Taxation

Germany's Federal Fiscal Court (BFH) reaffirmed in a 2023 ruling [2] that earn-out payments that remain uncertain both as to entitlement and amount fall within this exception and are generally taxed in the year of receipt. The case concerned annual earn-out payments over a three-year period linked to future gross margins, under which the seller could receive anywhere between EUR 0 and approximately EUR 533,000 per year. 

The tax treatment of earn-out payments where the amount is already sufficiently ascertainable at signing and only payment remains conditional remains less clear. The BFH has not yet ruled on this type of earn-out and expressly left the question open in its 2023 decision.

Part of the available literature takes the view that such earn-out payments should be treated as part of the original gain rather than falling within the receipt-based exception. One reason cited is that earn-out payments often serve less to determine the purchase price than to verify whether the assumptions underlying an agreed valuation prove correct. Moreover, the BFH's reasoning for receipt-year taxation was expressly based on uncertainty both as to entitlement and amount. In contrast, at least parts of the tax administration appear to favor receipt-based taxation even where the amount of the earn-out is sufficiently ascertainable if the entitlement depends on future profit or revenue. [3]

This debate highlights that seemingly small differences in the design of an earn-out component, particularly the performance metric used and whether the amount is sufficiently ascertainable at signing, may ultimately determine its tax treatment. The practical implications will often depend on the seller's specific circumstances. For sellers contemplating relocation abroad after an exit, however, avoiding qualification conflicts between jurisdictions may become the overriding consideration, as the risk of double taxation can outweigh any domestic advantages associated with a particular tax treatment. 

II. Double Tax Treaty Considerations

The timing of taxation also matters across borders. A double tax treaty (DTT) corresponding to the OECD Model Treaty, which we assume to be in place for simplicity, applies only if the seller is resident in at least one of the two states and generally allocates taxing rights between them based on that residence. The key question is therefore when residence needs to be tested, as this will often determine which state is ultimately entitled to tax the gain.

From a German perspective, that point should generally follow the domestic taxable event. This view has been supported by the BFH in a different context. [4] Simply put, if the earn-out payment is treated as part of the original exit gain, the seller's residence at the time of closing should generally be decisive. If, by contrast, the earn-out payment is taxed only upon receipt, residence should generally be determined at the time of receipt, which may be after the seller has relocated abroad. For instance, if a seller was resident in Germany at the time of the exit, subsequently relocates, and only later receives payments under a retroactive-type earn-out, Germany should generally remain the relevant residence state for DTT purposes. 

While this reflects the German view, the other state involved may not necessarily reach the same conclusion. If it looks only to the seller's residence at the time the earn-out payment is made, both states could regard themselves as the state of residence for these purposes, creating a risk of double taxation.

A further question is which DTT allocation rule applies to the earn-out payment. In many cases, the earn-out payment will be treated as part of the sale proceeds and therefore fall under the treaty rules for capital gains (Art. 13 of the OECD Model Treaty), under which the seller's state of residence will generally have the exclusive taxing right. Other states may characterize the payment differently, with the same risk of double taxation.

Against this background, potential qualification conflicts should be addressed when designing an earn-out component, both in relation to the timing of taxation and the tax treaty treatment of the payment. Where different states arrive at different conclusions and double taxation arises, resolving the issue may require a mutual agreement procedure between the relevant tax authorities. In practice, this can be a lengthy process with an uncertain outcome, and the seller may be exposed to tax claims from both states on the same income in the meantime.

Finally, it should be noted for the sake of completeness that, if no DTT exists at all with the other state, an earn-out payment resulting from the sale of shares in a German-resident corporation generally remains fully taxable in Germany under the rules of limited tax liability, regardless of when the payment is made. This would be the case, for example, with respect to relocations to the UAE, Hongkong, Brazil, or Saudi Arabia.

III. Conclusion

For German-resident sellers contemplating relocation abroad after an exit, earn-outs deserve particular attention. Once a second jurisdiction is involved, the tax treatment of the payment gains a additional dimension: the design of the earn-out component may determine the taxation point and which state ultimately has the right to tax it.

It is therefore worth considering how the earn-out component is structured, for instance, whether the amount is fixed or variable, and how the jurisdictions involved are likely to view that structure. Commercial objectives will typically take precedence in practice, but if a relocation is envisaged, working through these tax questions during the transaction is often far easier than untangling competing tax claims once the earn-out payment is made.

1. ^ Excluding solidarity surcharge and church tax, if any.
2. ^ “Judgment of November 09, 2023, IV R 9/21: Taxation of ‘Earn-out Payments’ in Connection with the Sale of a Co-entrepreneur’s Share,” Federal Fiscal Court (Bundesfinanzhof).
3. ^ “Taxation of so-called earn-out payments (variable purchase price components); Impact of the Federal Fiscal Court ruling of 9 November 2023, IV R 9/21, BStBl 2024 II p. 510, on § 17 EStG,” NWB Database, Ministry of Finance Schleswig-Holstein of 20.08.2024 - VI 3012 - S 2242 - 131.
4. ^ “Judgment of 21 December 2022, I R 11/20: On the Taxation of Stock Options in the Event of a Change of Residence,” Federal Fiscal Court (Bundesfinanzhof)

Disclaimer: The views and opinions expressed in this article are those of the authoring team and do not necessarily represent the official position, opinion, or endorsement of Alvarez & Marsal. This content has been prepared for informational purposes and should not be relied upon as a formal A&M position on the matters discussed.