Earnouts in Indian M&A: Structuring, FEMA Limits, and Tax

Earnouts have become the most common way to close the valuation gap in Indian M&A, and also the most commonly misunderstood clause in the SPA. A buyer who sees a strong business but cannot underwrite the seller’s projected trajectory and a seller who refuses to accept the trailing-twelve-month number as final: the earnout is the logical bridge. What the term sheet does not explain is that the bridge runs inside a hard regulatory cage, produces a tax outcome that depends on drafting choices made months before closing, and fails to pay out in full more often than it does. This article covers all three dimensions: how earnouts are structured in the Indian context, what the Foreign Exchange Management Act, 1999 (FEMA) allows and forecloses in cross-border deals, and how the Income-tax Act treats contingent consideration when the assessment officer eventually gets there.

What is the maximum earnout that FEMA permits in a cross-border Indian deal?

Under Rule 9(6) of the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019, the buyer in a cross-border share transfer may defer up to 25% of the total consideration for a period not exceeding 18 months from the date of the transfer agreement. This cap applies whenever at least one party is a non-resident. The cap is measured against total consideration including the deferred portion, and the final amount paid must comply with the fair-value pricing guidelines under the NDI Rules. There is no approval route for going above either ceiling; deals that need more deferral must be restructured using compliant workarounds.

What exactly is an earnout, and why does the definition matter?

An earnout splits the purchase price into a fixed amount payable at closing and a contingent amount payable later, tied to the target’s performance over a defined measurement period. The buyer pays less upfront, the seller has a path to the valuation they could not get at signing, and execution risk is shared. That is the headline. Everything else is where the complexity lives.

The reason the definition matters: earnout, deferred consideration, holdback, and contingent value right (CVR) are not synonyms, and using them interchangeably in the SPA is one of the cleanest tells that the drafting is amateur. Each has a different FEMA treatment, a different tax trigger, and a different dispute profile.

A pure deferred consideration is a time-deferred payment of a fixed rupee amount. The seller knows the amount at signing; only the timing is deferred. Under the Ajay Guliya (2012 Delhi High Court) line of reasoning, the full consideration accrues in the year of transfer for capital gains purposes because the right to receive has crystallised.

A holdback, or escrow holdback, is consideration set aside at closing to cover potential indemnity claims or working-capital adjustments. It is the seller’s money, parked in escrow and released on the lapse of the indemnity window unless a valid claim is made. From a FEMA perspective, escrow holdbacks funded at closing count as paid consideration; the escrow instruction does not create a deferral.

An earnout, properly defined, is a contingent payment whose existence (not just timing) depends on future performance. The seller does not know the amount at closing; it could be zero, the full target, or anywhere in between. This is where the Bombay High Court’s 2016 ruling in Commissioner of Income Tax v. Mrs. Hemal Raju Shete produces a different tax outcome than the Delhi view: contingent consideration that depends on a formula tied to future events does not accrue in the year of transfer; it accrues when the right to receive crystallises.

A CVR is a tradeable security that pays out on a specified event. CVRs are rare in Indian deals, mostly used in listed-target transactions, and attract Securities and Exchange Board of India (SEBI) disclosure obligations most deal teams have not budgeted for.

Earnout mechanism comparison

Mechanism	Amount at closing	FEMA treatment	Tax-trigger timing	Dispute risk
Earnout	Unknown (formula-linked)	Deferred consideration; 25%/18-month cap applies	Contested: year of transfer (Delhi) vs year of accrual (Bombay)	High
Deferred consideration	Fixed and known	Same cap applies	Year of transfer on full amount (Delhi view)	Moderate
Holdback/escrow	Fixed; already paid notionally	Not deferred; funded at closing	Year of transfer at closing	Moderate
CVR	Formula or event-linked	Securities issuance under SEBI	At payout	Low to moderate

How to choose the right earnout metric

The metric choice locks in the tax profile, the manipulation surface, and the protection that drafting can realistically deliver. Getting it wrong at term sheet stage means the SPA can never fully save you.

Indian deals predominantly use one of four metric families.

EBITDA-linked earnouts remain the modal choice in PE-backed and strategic mid-market transactions. The buyer’s preference: EBITDA is supposed to reflect the target’s earning power rather than topline vanity. The seller’s concern: EBITDA is the most manipulable metric because the buyer controls cost allocation, intercompany pricing, accounting-policy choices, and integration-cost timing post-closing. Without a specific EBITDA definition in the SPA, the buyer can suppress the metric through parent-cost allocation and policy migration without technically breaching any covenant.

Revenue-linked earnouts are cleaner for the seller. Revenue is harder for the buyer to suppress because it sits above the cost line, and revenue-recognition standards (Ind AS 115) constrain timing manipulation. Buyers reluctantly accept revenue when EBITDA negotiations stall, but typically layer in a gross-margin floor to prevent revenue growth at the expense of profitability.

Gross-margin earnouts are a halfway position: they preserve the profitability-tracking property of EBITDA while removing the below-the-line cost manipulation surface. They work best in product-led businesses where cost of goods sold is product-specific and difficult to load arbitrarily.

Non-financial KPI earnouts are growing in India, particularly for tech and AI-target acquisitions where revenue and EBITDA are both unreliable at the time of closing. Metrics include monthly-active enterprise users, contract-retention rates, regulatory approval milestones (CDSCO, RBI), and customer-concentration benchmarks. The advantage: harder to suppress through accounting because the metric does not run through the P&L. The risk: triggers that depend partly on external events (regulatory approval, customer decision) create genuine uncertainty that neither party can fully control.

The structural format of the payout matters as much as the metric. A binary (all-or-nothing) earnout pays in full above a threshold and zero below it, which maximises the incentive to litigate at 98% of threshold. A sliding-scale earnout pays proportionally across a range, diluting the marginal dispute incentive. A hybrid structure (tiered bands with an over-performance kicker) is the practitioner default in complex deals.

One thing that rarely gets enough attention at term sheet stage: the over-performance kicker. If the target beats the earnout ceiling and the seller is still in management, the over-performance payment may attract salary characterisation under the Anurag Jain AAR line, because it looks like a bonus for continued service rather than contingent consideration for the share transfer. The kicker has to be decoupled from the seller’s employment to stay on the capital-gains track.

What does FEMA actually allow on deferred consideration?

This is the constraint that separates Indian earnout practice from the rest of the world. In Delaware, measurement periods routinely run three to four years and the deferred slice can be 30 to 40% of total consideration. In the United Kingdom, 24 to 36 months is standard. In India, the Foreign Exchange Management Act, 1999 (FEMA) and the NDI Rules impose a hard ceiling that cannot be contracted around.

The ceiling: under Rule 9(6) of the NDI Rules, in a transfer of equity instruments between a person resident in India and a non-resident, the buyer may defer up to 25% of the total consideration for a period not exceeding 18 months from the date of the transfer agreement. The cap applies to earnouts, holdbacks, escrows, post-closing adjustments, and any other mechanism that results in consideration not being paid at closing. The final consideration paid must comply with the fair-value pricing guidelines under the NDI Rules, which for unlisted targets means a discounted cash flow or recognised equivalent methodology produced by a Securities and Exchange Board of India (SEBI)-registered Category-I merchant banker.

The cap is not a default to be varied by consent. Deals that run above 25% deferred or beyond 18 months in a cross-border context are FEMA contraventions, exposed to penalties under Section 13(1) of FEMA 1999 of up to three times the transaction amount.

Resident-to-resident deals, where both seller and buyer are Indian residents and the target is Indian, are outside this FEMA constraint. They are regulated only by income-tax rules and the parties’ contractual framework. This means an Indian founder selling to an Indian strategic buyer can negotiate a 30-month earnout at 35% of consideration with no exchange-control exposure, whereas the same founder selling to a Singapore PE fund faces the 18-month/25% ceiling.

What changed with the January 2025 RBI Master Direction?

The RBI’s 20 January 2025 update to the Master Direction on Foreign Investment in India resolved a long-standing ambiguity about whether Foreign Owned or Controlled Companies (FOCCs) making downstream investments in India could use the deferred-consideration framework that already applied to direct foreign investors.

FOCCs are Indian companies that are owned or controlled by foreign entities. A typical PE deal structure has a Mauritius or Singapore fund holding an Indian intermediate holding company (FOCC) that, in turn, acquires Indian targets. Before the January 2025 Master Direction, the RBI had in 2023 issued notices to several FOCCs that had entered deferred-payment arrangements for downstream investments, flagging potential contraventions. The uncertainty meant most FOCC-led acquisitions either avoided deferred consideration entirely or relied on informal guidance from Authorised Dealer banks, which was inconsistent.

The January 2025 Master Direction now expressly states that arrangements permitted for direct investment under the NDI Rules, including investment through equity instrument swaps and deferred payment arrangements, are also available for downstream investments, provided they comply with the NDI Rules’ provisions.

The practical effect: FOCC-led downstream acquisitions can now use the same 25%/18-month deferred-consideration framework on the same regulatory basis as direct cross-border deals. An SPA executed after January 2025 for a FOCC-led acquisition should reference this Master Direction expressly in the consideration section. The form DI must be filed through the FIRMS portal via an Authorised Dealer bank within 30 days of the downstream investment.

Non-filing of form DI is a FEMA contravention. Deal teams that got comfortable with informal AD-bank guidance before January 2025 now have both a clear pathway and a compliance obligation.

Workarounds when 18 months is not enough

When the deal economics require a longer deferral window or a higher deferred share, practitioners use four main workarounds. Each has a different FEMA treatment, a different tax profile, and a different level of tax-department scrutiny.

Compulsorily Convertible Preference Shares (CCPS). The buyer issues CCPS to the non-resident seller at closing, with conversion or redemption tied to performance milestones. FEMA treats CCPS as equity (not deferred consideration), so the 25%/18-month cap does not apply. For tax purposes, the seller recognises capital gains on the share transfer at closing on the full consideration including the CCPS face value, with subsequent conversion or redemption events treated separately. The drafting must commit fully to preference-share rights and mechanics; a CCPS that looks economically identical to a cash earnout but is labelled equity does not automatically escape recharacterisation.

Retention bonuses. The buyer agrees to pay the seller a cash bonus tied to continued employment or directorship over a post-closing period. This is salary income under Section 17(3)(ii) of the Income-tax Act, 1961 (and the equivalent provision under the Income-tax Act 2025 for assessment years from 2026 onwards). FEMA treats it as a current-account salary payment outside the capital-account deferred-consideration ceiling. The trade-off: the seller pays at the top slab rate rather than at the 12.5% long-term capital gains rate, and the payment reinforces the salary-trap risk for the earnout component.

Consultancy fees. The seller provides defined services to the target or the buyer post-closing, paid at an agreed rate. FEMA classifies this as a current-account transaction (services rendered). The income is business or professional income under Section 28 of the Income-tax Act, not capital gains. The risk: if the consultancy does not involve genuine services rendered at arm’s length, the Reserve Bank of India and the Income Tax Department can both look through the arrangement and recharacterise it as deferred consideration.

Escrow holdbacks for indemnity purposes. A portion of the closing consideration is placed in a tripartite escrow at closing. For FEMA, the consideration has been paid at closing; the escrow instruction does not create a deferral. For tax, the seller recognises capital gains at closing on the full holdback amount, subject to release conditions. The catch: the release conditions must be structured around indemnity events (warranty breaches, specific liabilities), not around operational performance. An escrow that releases on EBITDA achievement is a disguised earnout, and both the RBI and the Income Tax Department treat substance over form.

Workaround comparison for cross-border deals

Mechanism	FEMA position	Tax head	Practical limitation
CCPS	Equity; outside 25%/18-month cap	Capital gains at closing + separate conversion event	Must commit to genuine preference-share rights
Retention bonus	Current account; salary	Section 17(3) salary; top slab rate	Reinforces salary-trap risk on earnout
Consultancy fees	Current account; services	Section 28 business income	Must involve genuine services at arm’s length
Escrow holdback	Considered paid at closing	Capital gains at closing	Release conditions must be indemnity-style, not performance-style

Form FCTRS filing on each earnout tranche

A compliance obligation that deal teams routinely miss: every earnout tranche paid to a non-resident seller after closing triggers a fresh Form FCTRS filing obligation under the Foreign Exchange Management (Mode of Payment and Reporting of Non-Debt Instruments) Regulations, 2019. Form FCTRS must be filed through the FIRMS portal via the Authorised Dealer bank within 60 days of receipt of the consideration by the non-resident seller. Each payment event is a separate reporting trigger; a single closing-date FCTRS covering the upfront payment does not cover subsequent earnout tranches.

Non-filing or late filing of FCTRS is a FEMA contravention under Section 13(1) of FEMA 1999, attracting penalties of up to three times the amount involved. Where earnout tranches are paid at 12-month and 18-month intervals, the parties should build FCTRS filing milestones into the post-closing compliance calendar alongside the earnout payment dates. The AD bank will require the SPA consideration clause and the earnout statement to support each filing. For the underlying FEMA compliance framework covering Form FCGPR, Form DI, and the compounding process for historical filing gaps, Treelife’s guide on downstream investment rules under FEMA covers the full compliance stack.

How Indian tax law treats earnout payments

The tax outcome on an earnout depends on three nested questions: what head of income applies, what year the consideration accrues, and what the applicable rate is. Each question is less settled than most deal teams assume.

What head of income applies?

The primary split is between capital gains under Section 45 of the Income-tax Act, 1961 (replicated in the Income-tax Act 2025) and salary income under Section 17(3)(ii) (profits in lieu of salary). The characterisation determines the rate differential: long-term capital gains on unlisted shares at 12.5% (post the Finance (No. 2) Act, 2024 amendments effective 23 July 2024) against individual salary income at up to 39% at the top slab.

The salary trap was set by the Authority for Advance Rulings in In re Anurag Jain (2005) 277 ITR 1 (AAR), affirmed by the Madras High Court in Anurag Jain v. AAR (2009) 308 ITR 302 (Mad). The AAR held that where a founder-seller was retained as CEO post-closing and the contingent payment was conditioned on continued employment alongside the target’s EBITDA performance, the payment was “profits in lieu of salary” under Section 17(3)(ii). The employment condition was dispositive; the performance-linkage alone did not save the capital-gains characterisation.

The capital-gains route was confirmed in a 2012 AAR ruling involving a foreign corporate seller with no continuing operational role in the target, where the contingent payment was tied solely to the target’s financial performance. The AAR held the payment formed part of capital gains under Section 45.

The practical decision rule: if the earnout is conditioned on the seller’s continued employment or directorship (the payment does not accrue if the seller leaves, regardless of target performance), the salary-trap risk is high. If the earnout accrue purely on target performance and remains payable whether or not the seller continues in any role, the capital-gains characterisation is defensible. The drafting must make this distinction explicit in the SPA, not leave it to implication.

The most common mistake in Indian earnout drafting is making the seller’s continued employment a “covenant” rather than a “condition precedent” and assuming that is enough to preserve capital-gains treatment. It is not. The Income Tax Department looks at substance: if the practical effect of the earnout structure is that the seller only collects if they stay, the salary characterisation may attach regardless of the label.

What year does the earnout accrue?

This is the question the Delhi High Court and the Bombay High Court have answered differently, and the Supreme Court has not resolved.

The Delhi High Court in Ajay Guliya v. Assistant Commissioner of Income Tax (2012) 209 Taxman 176 (Del) held that the full sale consideration, including contingent and deferred components, accrues in the year of transfer under Section 45. The reasoning: the right to receive is created at the time of transfer; the contingency affects when the rupees move, not when the right arises. For the seller, this is the worst outcome: tax due on the maximum earnout in the year of transfer, on cash not yet received, from a buyer whose balance sheet may deteriorate.

In Commissioner of Income Tax v. Hemal Raju Shete, the Bombay High Court declared that the complete consideration would not be regarded as received in the assessment year in which the transfer was made. When the earnout payment is made, the capital gains calculation will take place.

The Mumbai ITAT, in a subsequent ruling involving a cross-border fund seller with an EBITDA-linked earnout, applied the Hemal Raju Shete principle to a modern fact pattern, affirming that contingent consideration accrues only when the right to receive crystallises. This brings the Bombay approach into the contemporary PE-deal context.

The Supreme Court has not definitively resolved the split as of mid-2026. In practice, the applicable view depends on where the assessment officer has jurisdiction, which is determined by the seller’s residence at the start of the relevant assessment year. A seller whose assessment falls under Delhi’s jurisdiction faces the Ajay Guliya risk; a seller under Mumbai or Bombay jurisdiction has a stronger case for the Hemal Raju Shete position.

The Income-tax Act 2025 (effective for assessment years from 2026 onwards) has rewritten the statutory provisions on accrual and capital gains in new language, but without expressly resolving the High Court split. Practitioners expect the Ajay Guliya vs Hemal Raju Shete debate to re-litigate on the 2025 Act’s wording within the next two to three assessment cycles.

Tax characterisation decision framework

Seller scenario	Tax head	Controlling authority	LTCG rate (unlisted shares, post 23 July 2024)
Seller continues as employee/director; earnout tied to continued service	Salary	Anurag Jain AAR 2005; affirmed Madras HC 2009	N/A (slab rate, up to 39%)
Seller exits completely; earnout purely performance-linked	Capital gains (Section 45)	AAR (2012), foreign-investor ruling	12.5%
Capital gains; year of transfer (Delhi view)	Capital gains at closing year	Ajay Guliya, Delhi HC 2012	12.5% (cash-flow mismatch risk)
Capital gains; year of accrual (Bombay view)	Capital gains at accrual year	Hemal Raju Shete, Bombay HC 2016	12.5% (better cash-flow match)

TDS and Section 195

For a resident seller, there is no specific TDS on capital-gains payments from a share transfer. The seller pays advance tax or self-assessment tax on their own computation.

For a non-resident seller, Section 195 of the Income-tax Act, 1961 requires the buyer to withhold tax at the applicable rate on each earnout payment as it is made. The applicable rate on long-term capital gains for non-residents on unlisted shares is 12.5% post the Finance (No. 2) Act, 2024, subject to treaty relief under the applicable Double Taxation Avoidance Agreement. The buyer must compute the chargeable gain on each tranche, accounting for cost-base allocation, and remit the withholding separately for each payment. Errors in Section 195 computation attract interest under Sections 234B and 234C and potential penalty exposure.

Where the earnout is recharacterised as consultancy or service income, it falls outside the capital-gains withholding framework and into the salary or professional-income withholding provisions instead. GST at 18% also applies on service income, which does not apply to consideration for the share transfer.

The CCI deal-value threshold and earnout maximums

A regulatory dimension that most earnout discussions in India ignore: the Competition Commission of India (CCI) deal-value threshold, brought into effect via a gazette notification in September 2024 under the Competition Act, 2002.

The threshold: transactions with a deal value exceeding Rs 2,000 crore, where the target has substantial business operations in India, are notifiable to the CCI even if the traditional asset and turnover thresholds are not met. Deal value for this purpose includes the maximum potential earnout. This means a deal with a Rs 850 crore closing payment and a Rs 1,200 crore maximum earnout has a Rs 2,050 crore deal value and crosses the notification trigger, even if the business would not otherwise be notifiable on assets or turnover grounds.

The CCI filing requirement has a direct impact on deal timelines: notification suspends closing until the CCI grants approval, and the CCI has a 30-working-day Phase I review period plus a potential Phase II investigation period of up to 210 working days for complex deals. An unexpected CCI filing requirement can add two to six months to an otherwise straightforward timetable.

Practical implication: when drafting the earnout maximum, the deal team should model the CCI deal-value computation alongside the FEMA cap analysis. A deal that is just below the notification threshold on upfront consideration may cross it on earnout maximum. Structuring the earnout maximum below the notification-relevant ceiling, where commercially feasible, avoids this risk. If the deal is notifiable regardless, the parties should build the CCI timeline into the longstop date and closing condition structure from the outset.

SPA drafting: where the earnout is won or lost

The commercial terms of the earnout (metric, measurement period, ceiling) are typically locked at term sheet stage. The legal protection for the seller is built at SPA stage, across three clause families. Most sellers under-negotiate all three.

Defining EBITDA: the clause that decides the dispute

EBITDA is not a defined term in the Companies Act, 2013 or in any Ind AS standard. It is whatever the SPA says it is. In any Indian earnout arbitration, the EBITDA definition will be the primary battleground, and the dispute will turn entirely on how the definition was drafted and how it applies to specific post-closing cost items.

The five recurring EBITDA disputes:

Parent-cost allocation. After integration, the buyer’s parent allocates group costs (HR, IT, legal, finance, brand royalties) to the target. Each allocation reduces EBITDA without any change in the target’s operational reality. The drafting fix: expressly carve out parent-allocated costs unless they represent genuine arm’s-length charges for services actually rendered to the target on terms consistent with the target’s pre-closing arrangements.

Integration-cost normalisation. System migrations, severance, and office consolidation generate one-time costs. A well-drafted definition treats these as add-backs; a loosely drafted one absorbs them into EBITDA, reducing the seller’s earnout.

Accounting-policy consistency. If the buyer migrates the target’s accounting policies to the parent-group standard post-closing (revenue recognition timing, depreciation schedule, inventory valuation), EBITDA shifts mechanically. The fix: a “consistency with past practice” covenant that prevents accounting-policy changes during the measurement period without seller consent, except where required by Ind AS as in force.

One-time item handling. The buyer’s incentive is to narrow the definition of “one-time”; the seller’s incentive is to widen it. Without a defined list or a clear decision rule, each one-time item becomes a separate dispute.

Intercompany transfer-pricing flows. If the target buys or sells from sister entities at non-arm’s-length prices post-closing, EBITDA gets distorted. The fix: require all intercompany transactions to be at arm’s length, with the seller having audit rights to verify.

A model EBITDA definition carve-out for an Indian SPA:

“For the purpose of computing the Earnout EBITDA, the following items shall be excluded from costs and shall be added back if already deducted: (i) any management fees, royalties, IT charges, shared-service costs, or other amounts allocated by the Buyer or any Affiliate of the Buyer to the Target, unless such amounts reflect genuine arm’s-length consideration for services actually rendered to the Target consistent with the Target’s historical third-party arrangements; (ii) one-time integration and restructuring costs arising from or in connection with the Buyer’s acquisition of the Target; (iii) any adjustment arising from a change in accounting policy, estimate, or method adopted after the Closing Date, except as required by Ind AS as in force from time to time; (iv) amounts arising from intercompany transactions with the Buyer or any Affiliate of the Buyer that are not at arm’s length.”

Audit rights and information access

The seller’s ability to verify the EBITDA computation depends entirely on the information rights negotiated in the SPA. Without enforceable audit rights, the dispute becomes asymmetric: the buyer holds all data, and the seller’s only recourse is expensive post-hoc litigation with discovery obstacles.

The minimum package:

Monthly unaudited management accounts within 30 days of month-end. Quarterly management accounts within 45 days of quarter-end. An annual EBITDA statement for each measurement period, with supporting documentation (general ledger, intercompany invoicing, allocation schedules), within 90 days of period-end. A 45-day objection window during which the seller can raise specific disputes. A binding expert-determination mechanism (typically a Big Four or equivalent firm) for unresolved accounting disputes.

The audit right is only as useful as the seller’s willingness and capacity to exercise it. Build cost-recovery into the dispute clause: if the audit establishes that the buyer’s EBITDA statement overstated deductions by more than a defined materiality threshold, the buyer reimburses the seller’s audit costs.

Anti-manipulation covenants

The seller’s protection against post-closing buyer conduct that suppresses the earnout metric without genuine commercial justification. The standard covenant package requires the buyer to operate the target as a going concern in the ordinary course consistent with past practice during the measurement period, and prohibits the following without seller consent or independent accountant determination that the action will not adversely affect the earnout metric:

Material alteration of the target’s product or service mix. Termination or material modification of any of the target’s top-10 customer relationships by revenue. Change in pricing policy for products or services representing more than 10% of revenue. Change in accounting policy, estimate, or method. Allocation of costs from the buyer or any affiliate of the buyer that is not at arm’s length.

Indian courts will enforce express anti-manipulation covenants and award damages for breach under Section 73 of the Indian Contract Act, 1872. They will not, however, imply a broad duty of good faith as a substitute for express covenants. The implied-good-faith argument is a backup, not a first defence. Sellers who rely on the implied duty in lieu of properly drafted covenants routinely discover this the hard way at arbitration.

Payment security

The most under-negotiated protection in Indian earnout structures is the security for the deferred payment. The opening case most practitioners in this space recall is not dramatic fraud; it is a buyer whose balance sheet weakened between closing and the earnout trigger date, leaving the seller with an unenforceable contract claim against an entity with limited assets.

The protection menu:

Parent-company guarantee. The guarantee should be unconditional, irrevocable, demand-payable, and given by a corporate entity within the buyer’s group with audited financial statements and meaningful asset coverage. State expressly that the guarantor’s obligation is primary and joint-and-several with the buyer, not secondary.

Earnout escrow. A portion of the maximum earnout (typically 30 to 50%) placed in a tripartite escrow at closing with an Indian bank as escrow agent, held pending the measurement period outcome. For FEMA purposes, the escrow is funded at closing and does not create a deferral of consideration.

Letter of credit. An LC from a tier-1 Indian or international bank, callable on the earnout trigger date against a defined drawing certificate. The LC cost is typically a buyer obligation. The advantage over escrow: the buyer’s cash is released at closing; the bank’s credit substitutes.

Acceleration triggers. The SPA should specify events of default that make the maximum earnout immediately payable without condition: the buyer’s insolvency, change of control of the buyer, material breach of the anti-manipulation covenants, and breach of audit-rights provisions.

Set-off limitation. Unless the SPA expressly limits it, the buyer may withhold an earnout payment by asserting an uncrystallised indemnity claim. The seller’s position should be that set-off is permitted only against indemnity claims that have been (a) reduced to a binding award or agreed in writing, and (b) accompanied by written notice specifying the amount and basis. Unlimited set-off rights can effectively hold an earnout hostage to an indemnity dispute that has no resolution timeline. The interaction between earnout set-off rights and warranty indemnity escrow mechanics is covered in detail in Treelife’s guide on representations and warranties in investment agreements.

Representations and warranties insurance and earnouts. A listed or PE-backed buyer sometimes uses a Representations and Warranties Insurance (RWI) policy to cover warranty risk and then relies on the earnout to bridge the valuation gap. Sellers in these deals should understand that RWI policies in India typically exclude earnout disputes from coverage. An RWI policy protects the buyer against breach of seller warranties; it does not indemnify the seller if the earnout is not paid or if the EBITDA computation is manipulated. The seller cannot assume that the buyer’s RWI policy provides any indirect protection for the earnout. The security mechanisms above, parent guarantee, earnout escrow, and acceleration triggers, remain the seller’s only real protection.

Buyer-side accounting: why listed acquirers resist earnouts

Sellers frequently encounter resistance from listed Indian acquirers on earnout structures and attribute it to conservatism or negotiating tactics. The real driver is often accounting. Under Ind AS 103 (Business Combinations), a listed acquirer must measure contingent consideration (the earnout) at fair value on the acquisition date and remeasure it at fair value at every subsequent balance-sheet reporting date. Changes in the fair value of contingent consideration post-acquisition are recognised through the profit and loss account, not through goodwill. This means that if the earnout liability increases because target performance is tracking above expectation, the buyer records a charge to P&L in that quarter. If the likelihood of payment falls, the buyer records a gain. The result is P&L volatility during the earnout measurement period that affects reported earnings per share and can draw analyst questions at quarterly results calls.

Understanding this constraint helps sellers negotiate more effectively. A listed acquirer that resists a large earnout maximum is often managing P&L volatility risk as much as payment risk. Structuring the earnout with a tighter ceiling, a shorter measurement window, or a more binary trigger can reduce the fair-value remeasurement noise and make the structure more acceptable. The point is not to make concessions; it is to reframe the negotiation around the buyer’s actual concern rather than the stated objection.

Common mistakes that cost sellers earnout value

The following failures appear in Indian earnout disputes with enough regularity that they are predictable at drafting stage.

Treating the EBITDA definition as boilerplate. The EBITDA definition in many Indian SPAs is a single sentence: “EBITDA means earnings before interest, taxes, depreciation, and amortisation, computed in accordance with Ind AS.” This definition gives the buyer latitude to allocate parent costs, shift accounting policies, and classify integration expenses as operating items, all of which suppress the earnout without any specific covenant breach. Sellers who spend hours negotiating the metric and two minutes on the definition are handing value back.

Accepting employment-conditioned earnout without a salary-trap analysis. A founder who stays in management and accepts an earnout conditioned on continued employment is walking into the Anurag Jain AAR salary characterisation. The tax differential (12.5% capital gains vs up to 39% salary) is material on any earnout above Rs 5 crore. Tax counsel should review the structure before the term sheet is accepted, not after the SPA is drafted.

No security for the deferred payment. An earnout right against an SPV with no assets is worth the paper it is printed on. Sellers who take a parent guarantee should verify the guarantor’s audited financials and ensure the guarantee is drafted as primary, not secondary.

Ignoring the CCI deal-value threshold. A deal team that structures a Rs 2,100 crore earnout maximum without modelling the CCI notification trigger is creating an avoidable complication. The filing and approval timeline can disrupt the deal schedule significantly.

Failing to specify the dispute mechanism for EBITDA disputes. Default arbitration under the SPA’s general dispute clause applies to legal and covenant disputes. Accounting disputes over EBITDA computation should go to an independent accountant (expert determination), not an arbitral tribunal. The expert determination track is faster (60 to 90 days vs 18 to 30 months for arbitration) and more technically suited to the dispute. Sellers who do not insist on the expert-determination track for accounting disputes end up in expensive arbitration over what is essentially a P&L computation.

Conflating the leaver mechanics with the earnout trigger. If the SPA provides that any termination during the measurement period forfeits the earnout, the buyer has an unchecked incentive to manufacture a termination for cause just before vesting. The earnout should specify that a good-leaver termination (death, disability, termination without cause, resignation for good reason) does not affect the earnout accrual. The bad-leaver definition should be narrow: conviction of a criminal offence, gross misconduct, or material breach with opportunity to cure.

Not modelling stamp duty on deferred tranches. Share transfers in India attract stamp duty at 0.015% of consideration under the Indian Stamp Act, 1899 as amended by the Finance Act 2019. Many sellers assume stamp duty is settled at closing. The position on deferred consideration is that stamp duty crystallises on the instrument evidencing the transfer, but where consideration is payable in tranches after closing, the parties should confirm the stamp-duty treatment with their state-specific adviser, particularly for large earnout amounts where the tranche-level duty is a meaningful cost. Leaving this unresolved leads to disputes at payment stage.

Not securing a Section 281 certificate covering the earnout exposure. Under Section 281 of the Income-tax Act, 1961 (equivalent in the Income-tax Act 2025), any alienation of assets by a taxpayer after a notice of demand, assessment, or attachment proceeding requires prior permission from the income-tax authority, failing which the transfer can be treated as void against the revenue. Buyers in Indian share acquisitions routinely require a Section 281 certificate from the seller confirming no such proceedings exist. The gap that earnout structures create: the Section 281 position is cleared at closing, but if the seller faces a fresh income-tax demand or assessment order during the measurement period, a subsequent earnout payment could technically be exposed. The drafting fix is to require the seller to provide a refreshed Section 281 confirmation, or a no-objection certificate from the income-tax officer, at each earnout payment date. This is standard in high-value deals but routinely absent in mid-market earnout documentation.

Treelife practitioner note

In the earnout engagements Treelife has structured and reviewed, the most consistent finding is that the FEMA analysis and the tax characterisation analysis are done sequentially rather than together, which produces suboptimal outcomes for the seller. The FEMA question (how much can be deferred, in what form, over what window) constrains the structural options available. The tax question (which characterisation applies, and in which year does the gain accrue) determines the net-of-tax outcome. These two analyses need to run simultaneously at term sheet stage, not be handed off to different advisers at SPA stage.

On the FEMA side, the January 2025 RBI Master Direction has meaningfully improved the position of FOCC-led acquisitions. We have been advising clients on FOCC downstream structures to cite the Master Direction expressly in the SPA consideration section, specify the 25%/18-month cap compliance in the SPA recitals, and file form DI within the 30-day window. This removes the ambiguity that caused AD banks to reject filings in 2022 to 2024.

On the tax side, we consistently flag two things that non-specialist counsel miss. The first is the year-of-accrual question: sellers assessed under Delhi jurisdiction face the Ajay Guliya risk of a tax demand in the closing year on consideration they have not yet received; this needs to be modelled at deal stage, not discovered at return-filing stage. The second is the capital-gains rate: the 12.5% rate on unlisted share transfers is available only where the earnout is genuinely capital-gains income. Employment conditioning, even partial, risks pushing the payment into salary, which is a 2.5x to 3x rate differential. Both issues are addressable at deal stage with the right structure.

One pattern we have seen repeatedly in PE-backed exits: the earnout is the seller’s “real” consideration (the closing amount is below their walk-away number), but it is drafted as if it were a buyer discretion. No security, loose EBITDA definition, boilerplate anti-manipulation language. The seller accepts it because the headline number works and the advisers on both sides are under time pressure. Eighteen months later, the buyer’s cost allocations have reduced EBITDA by 15%, the earnout pays 40% of target, and the seller has a dispute case that is technically arguable but practically expensive. The protection that was available at SPA stage costs almost nothing to draft. The absence of it costs the seller crores.

FAQs

Q: What is the FEMA earnout cap for cross-border Indian M&A deals?
A: Under Rule 9(6) of the NDI Rules, the maximum deferred consideration is 25% of total consideration for a maximum of 18 months from the transfer agreement date. This applies to all earnouts, holdbacks, and post-closing adjustments in transactions involving a non-resident party.

Q: Does the 25%/18-month cap apply to FOCCs making downstream investments?
A: Yes, since the January 2025 RBI Master Direction clarified that FOCC downstream investments are subject to the same deferred-consideration framework as direct FDI under the NDI Rules. Before January 2025, this was a grey area and RBI had issued notices to several FOCCs. The Master Direction resolved the ambiguity.

Q: Are earnout payments capital gains or salary for the seller?
A: It depends on the seller’s post-closing role. If the earnout is conditioned on continued employment or directorship, the Anurag Jain AAR (2005) line characterises it as salary under Section 17(3)(ii). If the seller exits completely and the earnout is purely tied to the target’s performance, the 2012 AAR ruling on a foreign-investor fact pattern characterises it as capital gains under Section 45.

Q: What is the capital gains rate on earnouts for unlisted shares in FY 2025-26?
A: Long-term capital gains on unlisted shares transferred on or after 23 July 2024 are taxed at 12.5% without indexation under the Finance (No. 2) Act, 2024. Short-term gains (holding period under 24 months for unlisted shares) are taxed at the applicable slab rate.

Q: When is the earnout taxable: in the year of closing or the year of receipt?
A: This is contested. The Delhi High Court (Ajay Guliya, 2012) holds that the full contingent consideration accrues in the year of transfer. The Bombay High Court (Hemal Raju Shete, 2016) holds that contingent consideration accrues only when the right to receive crystallises. The Supreme Court has not resolved the split. Which view applies depends on the jurisdiction of the seller’s assessment officer.

Q: Does the buyer need to withhold TDS on earnout payments to a non-resident seller?
A: Yes. Section 195 of the Income-tax Act, 1961 requires the buyer to withhold tax at the applicable rate on each earnout payment to a non-resident. The rate on long-term capital gains for non-residents on unlisted shares is 12.5%, subject to treaty relief. Withholding is due on each tranche as it is paid, not only at closing.

Q: Is an earnout subject to GST?
A: Earnout payments characterised as consideration for the transfer of securities are outside GST (securities are excluded from the definition of goods under the CGST Act, 2017). Payments recharacterised as consultancy or service fees are subject to GST at 18%. The characterisation follows the substance of the arrangement.

Q: Can the buyer set off an indemnity claim against an earnout payment?
A: If the SPA permits set-off, yes. Sellers should limit set-off rights to indemnity claims that have been (a) reduced to a binding award or written agreement, and (b) accompanied by a written notice specifying the amount and basis. Unlimited set-off rights allow the buyer to effectively hold the earnout hostage to uncrystallised claims.

Q: Does the CCI deal-value threshold of Rs 2,000 crore apply to earnouts?
A: Yes. Deal value for CCI notification purposes includes the maximum potential earnout, not just the closing consideration. A deal with a Rs 850 crore closing payment and Rs 1,200 crore maximum earnout has a Rs 2,050 crore deal value and is notifiable if the substantial-business-operations-in-India test is met.

Q: What happens to the earnout if the buyer is acquired during the measurement period?
A: If the SPA does not address this, the earnout obligation transfers to the acquiring entity, but the seller has no guarantee that the new owner will operate the target in a way that preserves the earnout metric. The drafting fix is a change-of-control provision: either accelerate the maximum earnout on change of control, require substitution of the acquirer’s parent guarantee, or require seller consent to the change of control.

Q: Can a non-resident seller use Section 54EC or Section 54F reinvestment exemptions on earnout receipts?
A: Under the Hemal Raju Shete view (year of accrual), the reinvestment window under Section 54EC (specified bonds, within six months of the transfer date) and Section 54F (residential property) runs from the year in which the earnout accrues, not from the closing year. Under the Ajay Guliya view (year of transfer), the window runs from closing, potentially before the earnout cash is received. Non-residents should confirm eligibility for these exemptions with their tax adviser; treaty and FEMA remittance issues can complicate utilisation.

Q: What is the difference between an earnout and a CVR?
A: A contingent value right (CVR) is a tradeable security issued at closing that pays out on a specified event. CVRs are classified as securities, not contract rights, and attract SEBI disclosure and compliance obligations. They are used primarily in listed-target deals. For unlisted-target deals, the earnout structured as a SPA obligation (not a tradeable instrument) is standard.

Q: How long does an earnout dispute take in India?
A: Accounting disputes resolved by an independent accountant (expert determination) typically resolve in 60 to 90 days from the date of referral. Arbitration proceedings for covenant-breach or payment-default disputes at institutional Indian-seated forums (MCIA, DIAC) typically resolve in 18 to 30 months from the notice of arbitration. SIAC-seated arbitrations for cross-border disputes are comparable at 15 to 24 months.

Q: Can an NRI founder who returns to India post-closing claim the lower NRI treaty rate on the earnout?
A: Tax residency is determined year by year. An NRI who becomes an Indian resident during the measurement period is taxed as a resident for that year’s assessment. If the Hemal Raju Shete view applies and the earnout accrues in a year when the seller is resident, the treaty rate does not apply. If the Ajay Guliya view applies and the gain is treated as accruing at closing (when the seller was non-resident), treaty relief may be available. The answer is highly fact-specific and requires assessment of the residency position in each year.