Is an escrow holdback taxable to the seller when a business is sold in Canada?

Neither federal rule on this page uses the words holdback or escrow, so ask what the agreement says the money is: part of the price still to be paid, a deposit against claims, or something else. This page looks at two rules. The first is the capital gains reserve in the Income Tax Act. The second is the timing rule for GST/HST in the Excise Tax Act. This page covers the federal rules only.

The capital gains reserve

Under Income Tax Act s.40(1)(a)(iii), a taxpayer may claim a reserve, subject to s.40(1.1) to (1.4). The deduction may not exceed the lesser of two amounts. One is “a reasonable amount as a reserve in respect of such of the proceeds of disposition of the property that are payable to the taxpayer after the end of the year as can reasonably be regarded as a portion of” the gain; the other is a formula amount in s.40(1)(a)(iii)(D). Section 40(2)(a) says the reserve does not apply in some cases, listed below. The CRA says a reserve usually lets you report part of a capital gain by reference to the proceeds not yet received. Whether a particular holdback is “payable” after year-end is a question for the seller’s accountant or lawyer to answer from the agreement.

Limits on the reserve

The CRA says most people can claim a reserve on capital property, and that generally the maximum period for most reserves is four years. It lists longer periods for some transfers, such as transfers to your child of family farm or fishing property or of qualified small business corporation shares. The CRA says you generally cannot claim a reserve if you were not resident in Canada, or were exempt from tax, at the end of the year or at any time in the following year, or sold the property to a corporation you control in any way. Income Tax Act s.40(2)(a) also excludes sales to a corporation controlled by a person or group who controls the seller, to a corporation that controls a corporate seller, and to a partnership in which the seller is a majority-interest partner immediately after the sale. It is claimed on Form T2017. The CRA page covers capital property. It does not say a holdback that forms part of the price of inventory or services is treated the same way.

GST/HST on the held-back amount

Excise Tax Act s.168(1) makes tax on a taxable supply payable by the recipient on the earlier of the day the consideration is paid and the day it becomes due. The rest of s.168 overrides that general rule in set cases. Section 168(2) splits the timing where consideration is paid or becomes due on more than one day. For a sale of tangible personal property (other than on approval, consignment, sale-or-return or similar terms), s.168(3) makes tax on any consideration not paid or due by the last day of the month after the month ownership or possession is transferred payable on that last day. Section 168(5) has its own rule for sales of real property. Section 168(7) covers consideration the recipient retains, pending full and satisfactory performance, under an Act of Parliament or of a provincial legislature, or under a written agreement to construct, renovate, alter or repair real property or a ship or other marine vessel. Under s.168(9), a deposit is not treated as consideration paid until the supplier applies it as consideration for the supply. Ask your adviser which of these fits your agreement. Whether a joint election removes the tax from the sale altogether is a separate question.

What to ask

Ask the seller’s tax adviser how the agreement describes the held-back amount, when it becomes payable, and what each party reports. For the buyer’s side of holdbacks and CRA reassessments, see can a holdback cover the risk of a CRA reassessment of the seller.