How is an earn-out taxed?

An earn-out ties part of the purchase price to how the business performs after closing. It is a sensible way to bridge disagreement about future results. It is also one of the least predictable items in Canadian deal tax, because the same commercial arrangement can be taxed very differently depending on the words used in the agreement.

The default position can be unattractive

Absent specific relief, an amount contingent on future earnings may be treated as ordinary income to the seller rather than as proceeds of disposition of the shares. Ordinary income is fully taxable, while only a portion of a capital gain is included in income, so the difference is large. There is also a timing problem: the gain may need to be valued and recognized at closing even though the money is contingent and may never be paid.

The cost-recovery method, where it is available

The CRA has a long-standing administrative position permitting a cost-recovery method for certain earn-outs on the sale of shares. Where it applies, earn-out amounts reduce the adjusted cost base of the shares as they are received, and once that base is exhausted, further amounts are treated as capital gains. This generally produces a much better result for the seller than income treatment, and it defers tax until payments are actually received.

The conditions are specific and easy to miss

• The administrative position generally applies to a sale of shares of a corporation, not to an asset sale.
• The earn-out is generally expected to be genuinely tied to future earnings, reflecting real uncertainty about underlying goodwill.
• There is normally a maximum period over which earn-out payments may extend; confirm the current limit rather than assuming.
• Reverse earn-outs — where the price is set high and reduced if targets are missed — are treated differently and need their own analysis.
• The position is administrative, not legislated, which means it can change and it is not a guarantee.

Practical drafting points

Get tax advice on the earn-out clause before it is agreed, not after. Define the performance metric precisely, say who prepares the calculation and on what accounting basis, and set out a dispute mechanism. Address what happens if the buyer changes the business in ways that suppress the metric. Buyer and seller often have opposite tax preferences on whether an amount is characterized as purchase price, compensation for services, or a non-competition payment — each is taxed differently, and non-competition amounts have their own rules.