How is a seller taxed on an indemnity payment made after selling a business?

Section 42 of the Income Tax Act deals with an outlay or expense a seller pays or owes under a warranty, covenant or other conditional or contingent obligation given or incurred in respect of property it sold. If the outlay is paid or payable on or before a specified date, it reduces the proceeds of disposition. Otherwise it is deemed a capital loss when it is paid or becomes payable. A mirror rule covers an amount the seller receives or is owed as consideration for such an obligation. The section applies for the purposes of the subdivision of the Act on taxable capital gains and allowable capital losses.

The two timing branches

If the outlay is paid or payable on or before the specified date, section 42 deems it to reduce the consideration for the disposition. It is not treated as a separate expense under the obligation. It is deducted in computing the proceeds of disposition for the taxation year or fiscal period in which the sale happened. In any other case, the outlay is deemed to be a capital loss of the seller from the disposition of a property, at the earlier of the time it is paid or becomes payable.

What the specified date is

Subsection 42(2) defines the specified date. If the seller is a partnership, it is the last day of the seller’s fiscal period in which it disposed of the property. In any other case, it is the seller’s filing-due date for the taxation year in which it disposed of the property. So whether the outlay is paid or payable on or before that date decides which branch applies. Ask your tax adviser to confirm the date for your situation.

Why the branch matters

The CRA’s guide for individuals says to calculate a capital gain or loss, subtract the property’s ACB and any outlays and expenses incurred to sell it from the proceeds of disposition. A lower proceeds figure therefore changes the result for the sale year. The CRA’s page on capital losses says that, generally, an allowable capital loss must be applied against the taxable capital gain for that year, and a remaining loss becomes part of the net capital loss computation. BDC notes that the parties will agree who pays damages if a lawsuit goes against the company or an existing environmental issue flares up after closing. How an indemnification clause works explains that part of the agreement.

Whether your indemnity is caught

Section 42 applies to obligations given in respect of property the seller disposed of. It does not make every indemnity payment a capital loss. Whether a particular claim falls within it, including a share-sale indemnity paid by the selling shareholder rather than by the company, is a question for your tax adviser. Ask your adviser or the CRA how to report a payment and which year it belongs to.