Earn-out vs royalty payments

A seller who stays connected to a business after closing may be offered payments that look alike: an amount that rises or falls with the business’s results, paid month after month or year after year. Two labels for them are earn-out and royalty. They answer different questions. An earn-out is about what the sale price turns out to be. A royalty is about paying for the continuing use of something the seller still owns or controls. No source consulted defines a seller’s royalty as a sale-price structure, so this page treats it as a licence fee. The closest sibling page is vendor take-back vs earn-out, which compares fixed and contingent price. This page compares contingent price with a licence payment.

What an earn-out is

The CRA’s archived bulletin IT-426R describes an agreement where the proceeds of disposition are at least partially determined by an earnout clause, meaning the quantum of proceeds is determined by reference to future earnings generated by the underlying assets of the corporation. It adds that in that case it is usually impossible to determine the amount accurately within a reasonable time after the sale. BDC lists an earn-out, along with vendor financing, a phased transfer of ownership or a role as an executive, board member or advisor, as ways a seller can remain involved with the company afterward. The bulletin covers share sales only, so an asset sale needs its own advice.

What a royalty is

In this comparison, a royalty means a continuing payment for the right to use property. The Canadian Franchise Association describes a franchisee as paying a fee, typically an initial franchisee fee and ongoing royalties, to the franchisor for the right to use the franchisor’s trademarks and business system. A trademark licence is one legal structure that can carry such payments. Under Trademarks Act s.50(1), for the purposes of that Act, use of a trademark by an entity licensed by or with the authority of the owner has the same effect as use by the owner, if the owner has, under the licence, direct or indirect control of the character or quality of the goods or services. That is what the Act provides, and it does not say what any particular royalty deal contains.

Where they differ

• What is bought: an earn-out settles part of the price; a royalty pays for continuing use of a brand, system or other property
• Ownership: a licence leaves ownership of the property with the licensor, while a sale transfers it
• The base: an earn-out follows the future earnings or results the agreement names; a royalty follows whatever base the licence names
• Control: each agreement can give the payer or the recipient rights over how the business runs, so read those terms closely

The tax link to read carefully

Income Tax Act s.12(1)(g) includes in income from a business or property any amount received in the year that was dependent on the use of or production from property, whether or not it was an instalment of the sale price of the property, with an exception for instalments of the sale price of agricultural land. IT-426R says that, from a legal point of view, it is possible that para 12(1)(g) would apply to all payments made under an earnout clause, or that the total proceeds at the date of sale must include the value of the earnout rights. The bulletin says the CRA will accept the cost recovery method for a share sale under an earnout agreement where all its conditions are met; because the bulletin is archived, confirm the CRA’s current position before relying on it. Those conditions include that the vendor and purchaser deal at arm’s length, that the gain or loss is clearly of a capital nature, and that it is reasonable to assume the earnout relates to underlying goodwill whose value cannot reasonably be expected to be agreed at the date of sale. See also how an earn-out is taxed.

Which fits depends on

The factors are factual. If the payment buys part of the business, it looks like price. If it pays for continuing use of a brand, system or intellectual property, it looks like a licence fee. If the right is transferred at closing, that points one way; if the seller keeps ownership and licenses it, that points the other. Shares or assets sold, arm’s length dealing, how revenue or profit is measured, the length of the period and the control the payer keeps all shape the analysis. How s.12(1)(g) applies to your facts is a question for an accountant.