As we have
previously noted, earn-outs are becoming an increasingly common
part of M&A deals, and there are a number of
key commercial questions to consider when negotiating them. But
there are also tax consequences that must be considered when
Earn-outs link a portion of total purchase price to the
performance of the business following the acquisition. In effect,
the purchaser will hold back a portion of the purchase price, and
if specified targets are achieved, all or a portion of the
held-back purchase price will be paid to the seller. In
contrast, a reverse earn-out requires the purchaser to pay the
seller the entire purchase price up front. If specified performance
targets for the business are not met, the seller will be required
to repay a portion of the purchase price to the
purchaser. While the two approaches may end up with the same
before-tax result, the after-tax the outcomes can be quite
Treatment of earn-outs
Generally, earn-out payments are treated as income earned by
seller, and not as capital gains. As a result, the entire earn-out
payment will generally be taxable to the seller, rather than 50%.
There are, however, certain situations where the Canada Revenue
Agency (CRA) will, as a matter of administrative policy, treat
earn-out payments as additional proceeds of disposition, giving
rise to capital gains (50% which are taxable) when they become
determinable by applying the "cost recovery method".
The CRA's policy applies only to earn-outs on share
purchases where, among other things, the earn-out feature ends no
later than 5 years after the sale, the earn-out feature relates to
the underlying goodwill that the parties cannot reasonably
determine, and the seller is resident in Canada. If the "cost
recovery method" applies and the earn-out payments are to be
made after the payment amount becomes determinable, the seller may
be entitled to claim a capital gains reserve on the payment.
For the purchaser, the initial payment of the base purchase
price will generally establish the purchaser's tax cost in the
property it acquires. Any earn-out payments will generally increase
the tax cost of the property by the amount of the earn-out
Treatment of reverse earn-outs
The CRA's policy is generally to treat the upfront payment
of the purchase price as the seller's entire proceeds of
disposition on the sale. As a result, the seller will realize a
capital gain (or capital loss) on the cash received upfront, 50% of
which will be taxable to the seller. If the purchaser is then
required to repay a portion of the purchase price under the reverse
earn-out, the purchase price is generally treated as having been
reduced by that payment, thus reducing the capital gain (or
increasing the capital loss).
For the purchaser, reverse earn-outs are treated similarly to
standard earn-outs. The upfront payment of the purchaser price will
generally establish the purchaser's tax cost in the property.
Any amounts repaid by the seller under the reverse earn-out will
serve to reduce the purchaser's tax cost in the property. As a
result, the purchaser will generally end up in the same tax
position using either approach.
Earn-outs are a useful tool for ensuring that the actual value
of property acquired in a share or asset sale is reflected by the
final price. However, the tax consequences of earn-outs must be
considered in their negotiation. If a vendor is not able to receive
capital gains treatment on earn-out payments (as will be the case
in all asset deals, and in many share deals), a reverse earn-out
may be advisable.
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Pursuant to several recent legislative amendments and enactments, Ontario corporations holding a legal or beneficial interest in real property in Ontario are now subject to more onerous record-keeping requirements.
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