When negotiating a merger or acquisition (M&A), a key determination that does not always have a readily available answer is “what is the value or worth of the business or property in question?” When a vendor and a purchaser have difficulties coming to an agreement on the valuation of an asset, classical earnout and reverse earnout agreements can help bridge the gap.

What Are the Classical Earnoutand the Reverse Earnout

In a classical earnout arrangement, the buyer and seller agree on a base price the purchaser pays to the vendor for the property and set additional targets, usually tied to the performance of the property over several years. If the performance of the property meets the targets, then the purchaser pays the vendor additional amounts. For example, a vendor may sell a business to a purchaser for a base price of $100,000 with an agreement that the purchaser will pay an additional $20,000 to the vendor for each year that the business revenues increase by at least 10% over the next three years.

In a reverse earnout arrangement, the purchaser pays the vendor a maximum amount at the time of the sale, and when performance targets are not achieved, the vendor is obligated to reduce part of the price paid the purchaser. For example, a vendor may sell a business to a purchaser for abase price of $100,000 with an agreement that the vendor will return $10,000 to the purchaser for each year that the business revenues do not increase by at least 10% over the next three years. Call our top Canadian tax law firm and learn more about the taxation of classical and reverse earnouts.

Tax Consequences of the Classical Earnout and Reverse Earnout

A primary tax concern when a classical earn out arrangement is used is how the additional payments are characterized. Under s.12(1)(g) of the Income Tax Act, taxpayers are required to include in their income any amount that they receive that was dependent on the use of or production from property, including installment payments of the sale price of a property. If this applies, then the base price that the vendor receives from a sale would be considered proceeds of disposition forming part of the capital gain and taxed at one half the normal income rate; however, the additional payments could be characterized as income, and thus taxed at the full rates.

The CRA has provided administrative guidance that will allow the additional payments in a classical earnout arrangement to be considered capital gains when certain criteria are met under what the CRA calls the cost recovery method. Two key criteria are that the cost recovery method applies only to share sales and where it is reasonable to assume that the earnout agreement arises due to the difficulty of valuing the underlying goodwill at the time of sale. As such, the cost recovery method is not available for asset sales and for situations where difficulty in valuating the goodwill is not the reason for the earnout.

For reverse earnouts, the CRA has confirmed that their stance is that the entire initial base payment will be treated as a capital gain as long as there was a reasonable expectation at the time of sale that the reverse earnout conditions would be met. Where the vendor is required to make payments to the purchaser due to the failure to meet the performance targets, the vendor will be able to adjust the purchase price or claim a capital loss in respect of those payments. Additionally, this treatment of reverse earnouts is the same for both share sales and asset sales.

However, it is important to consider certain timing issues when contemplating a reverse earnout. Because capital losses can only be carried back for three years, a reverse earnout payment that occurs after three years will cause the vendor to incur a capital loss, but the vendor will no longer be able to carry back that capital loss to offset the capital gain incurred from the original sale. Furthermore, in a classical earnout, the vendor would not need to include any earnout payments into income until the payment is determinable. On the other hand, the vendor in a reverse earnout arrangement would need to bear the full tax liability at the time of sale.

A vendor may also receive an additional benefit where a reverse earnout arrangement is used for the sale of eligible capital property. As the maximum capital gain or income from the sale of the eligible capital property is realized at the time of sale, ss.89(1) allows a corporation to add the non-taxable portion of the capital gain to its capital dividend account. For share sales, a corporation can immediately issue a tax free capital dividend to its shareholders because the sale share will have caused a change in control and thus a deemed year end, and for asset sales, a tax free capital dividend can be paid out on the first day of the next fiscal year. If in a future date the reverse earnout agreement results in capital losses, the capital dividend account will be reduced accordingly, but the capital dividend will have already been paid out. As there is no immediate negative tax consequence to having a capital loss result in a negative capital dividend account balance, the vendor corporation may benefit from having been able to issue an inflated capital dividend. However, further capital dividends cannot be issued until the capital dividend account balance returns to positive numbers.

On the other hand, the tax treatment for the purchaser is rarely a major concern. Generally, for commercial purposes, the purchaser will prefer the classic earnout arrangement because the purchaser will only need to pay the base price upfront, and the additional payments, if they occur, will be deferred to the following years. With a reverse earnout arrangement, the purchaser will need to pay the entire amount upfront, which may be a greater financial burden on the purchaser. For tax purposes, the tax base of the property will increase as earnout payments are made under the classical earnout arrangement and will decrease as earnout payments are made under the reverse earnout arrangement. However, assuming the conditions are the same, the tax base of the property would be the same at the end of both earnout arrangements.

Tax Tip – The Best Earnout Arrangement Fits Your Taxation Needs

Both classical and reverse earnout arrangements can be useful tools in M&A transactions. If you are considering a share sale that qualifies for the cost recovery method, then a classical earnout can be preferable due to the deferred tax realization schedule. However, reverse earnouts are more widely applicable and can be used in asset sales without running into s.12(1)(g) and can provide additional benefits in potentially allowing for inflated capital dividends to be issued. Speak to one of our experienced Canadian tax lawyers to determine what transaction structure would be of most tax benefit to you.