Author: Nancy Thandi, CPA, CA, MTax
Editors: Peter Weissman FCPA, FCA, TEP and Matthew Cho CPA, CA, TEP
It is not uncommon for the sale price of a business to be partially based on future events. In these cases, an earnout is often used as a mechanism to determine a portion of the sale price based on achieving certain results for a period of time after closing of the sale. For example, the parties may agree to an initial sale price of $5,000,000, with an additional $100,000 per year in any of the subsequent 5 years, if revenues increase by at least 5% in the year. To keep things “simple” we will assume shares, not assets, are being sold.
Unlike the defined portion of the sale price, taxed as a capital gain, the earnout portion is taxed as regular income in the year it is received because it is based on performance. In the above example, the vendor would report a $5,000,000 capital gain (assuming the shares have no cost base), 50% of which is taxable, in the year of sale and regular income of $100,000 (or less if the full earnout is not earned) in each of the subsequent 5 years.
In Information Bulletin IT-426R (now archived), the CRA details an administrative concession, referred to as the cost-recovery method, intended to allow earnouts to be treated as capital gains to the extent they exceed the tax cost. However, this method only applies to share transactions and several conditions must be met, including the submission of a formal request to use the cost-recovery method and a copy of the sale agreement with the vendor’s tax return for the year of sale.
Where the transaction does not meet the CRA’s conditions for the cost-recovery method (e.g., an asset sale) vendors should consider a reverse earnout. This technique sets a maximum purchase price that is later adjusted downwards if certain targets are not met. To the extent the full proceeds (including the reverse earnout portion) exceed the tax cost the vendor will report a capital gain.
In our example, the vendor and purchaser would set the purchase price to be $5,500,000. The purchaser would pay $5,000,000 cash on closing and issue a promissory note for the remaining $500,000. The vendor would agree to reduce the $500,000 receivable[1] from the purchaser by $100,000 in any of the subsequent 5 years, in which revenues do not increase by at least 5% in the year. Even though not all the proceeds are received in cash at closing, the full sale price is taxable in the year of sale, with no reserve being available for the reverse earnout portion.
To the extent a portion must be repaid under the reverse earnout, the vendor can claim a capital loss that can be carried back against capital gains in any of the prior 3 taxation years or carried forward indefinitely to be used against future capital gains. If the capital loss is recognized within the three taxation years after the year in which the capital gain was recognized, the capital loss can be carried back to offset the initial gain. To the extent the reverse earnout portion of the proceeds is forgiven after the three-year carryback period, the reduction in the sale price will generate a capital loss that can be carried forward indefinitely, but it cannot be carried back to the year of the sale.
Purchasers are often indifferent to the tax treatment of an earnout or reverse earnout because future adjustments, under both methods, simply change the tax cost of the investment (whether shares or assets), although there may be some complications with capital cost allowance if the cost of a depreciable property is adjusted subsequent to the sale. Their issues tend to be more business related such as timing of cash flow.
If you have situations involving earnouts, a Cadesky Tax representative would be happy to assist you.
[1] In some cases the reverse earnout amount is held in escrow to be paid out only to the extent the milestones are achieved.
