As mentioned in a previous Pitblado Law article, earn-outs can be a valuable tool in getting an M&A deal over the finish line. Sellers must be mindful that careful structuring of the earn-out is important to preserve beneficial capital gains treatment of the earn-out amount.
What is an Earn-Out?
An earn-out is a purchase price adjustment under which part of the sale price is paid after closing, usually based on future revenue, EBITDA, profits, or other performance measures. See Closing the Gap for more details.
For example, a seller may receive $5 million at closing and be entitled to an additional $1 million if the business achieves specified revenue targets over the next two years.
In a share sale, sellers generally want earn-out payments to be treated as additional proceeds of disposition on capital account because capital gains are typically taxed more favourably than ordinary income. In some circumstances, however, contingent payments may be characterized as ordinary income rather than capital proceeds and taxed at a higher rate.
CRA’s Administrative Approach for Earn-Outs on Share Sales
The Canada Revenue Agency (CRA) has provided administrative guidance that can preserve capital gains treatment in certain share sale transactions. The CRA’s administrative approach generally requires, among other things, that:
• the buyer and seller deal at arm’s length;
• the sale is on capital account;
• the earn-out relates to goodwill that could not reasonably be valued at closing; and
• the earn-out period ends within the prescribed time limit, generally no later than five years after the end of the taxation year of the corporation whose shares were sold.
Reverse Earn-Outs
A reverse earn-out is a purchase price adjustment mechanism commonly used in asset purchase transactions when the future performance of the acquired business is uncertain. Unlike a traditional earn-out, where the purchase price can increase if performance targets are achieved, a reverse earn-out establishes a maximum purchase price at closing that may be reduced if agreed upon post-closing targets, such as revenue or EBITDA benchmarks, are not met. This structure helps balance risk between the buyer and seller by protecting the buyer from overpaying while providing the seller with an opportunity to receive the full purchase price if the business performs as expected.
For tax purposes, the maximum purchase price is generally treated as the seller’s proceeds of disposition at the time of sale, even though a portion of that amount may ultimately never be paid. If post-closing performance targets are not achieved and the purchase price is subsequently reduced, the seller may be entitled to recognize a capital loss in respect of the reduction. The Canada Revenue Agency has indicated that, because the purchase price is fixed at a maximum amount at closing and can only decrease, reverse earn-outs generally do not raise the same income characterization concerns that can arise with traditional earn-outs.
Conclusion
The tax treatment of earn-out payments depends heavily on how the agreement is drafted and the resulting mechanism of the earn-out. A poorly structured earn-out can produce tax results that differ from what the parties expected.
In many share sale transactions, careful planning and drafting can help preserve capital gains treatment. In the context of an asset sale, consideration should be given to a reverse earn-out structure. Because the applicable rules are technical and highly fact-specific, tax advice should be obtained before the agreement is finalized.
If you are contemplating an earn-out as part of your purchase and sale transaction, please contact:
T: 204.956.3505
Note: This article is of a general nature only and is not presented as a comprehensive review of the law or as being exhaustive of all possible legal rights or remedies. This article is not intended to be relied upon or taken as legal advice or opinion. Readers should consult a legal professional for specific advice applicable to their own circumstances. We do not undertake any obligation to update this article to reflect changes in law that may occur in the future.