A common issue that arises on the purchase and sale of a business is having the parties agree on the purchase price to be paid for property being acquired/sold (whether assets or shares or some combination of both). While the purchase price might be a fixed amount paid on closing, more often than not a contingent element is involved. This is largely due to both parties trying to bridge a perceived valuation gap in respect of the underlying business. There are many different types of contingent consideration, but one of the more common forms is an “earnout”. The following will briefly summarize some of the considerations associated with an earnout arrangement, including the tax treatment of earnouts, and in particular, earnouts in the context of vendors who are nonresidents of Canada.
An earnout arrangement is generally structured in two different ways: a “traditional earnout” or a “reverse earnout”. In a traditional earnout, a purchaser funds a defined portion of the purchase price on closing and agrees to pay the balance on condition that certain financial metrics are satisfied within an agreed upon timeframe. This serves as a way for the parties to agree on a purchase price in a case where the value of the business is unknown or difficult to ascertain at the time of the transaction. It also benefits a purchaser as it ensures that the vendors remain motivated to ensure the success of the business post-closing so that they can “earn-out” the rest of their purchase consideration.
In a reverse earnout, the purchaser chooses to pay the full purchase price to the vendors on closing, with the vendors agreeing to return a portion of the purchase price if certain financial metrics are not satisfied within a given period of time post-closing .
Tax treatment of traditional earnout
Amounts received by a vendor as an earnout payment may be required to be included in the vendor’s income for the taxation year in which the earnout payment is received. If such amounts are treated on income account, they would be fully subject to tax at ordinary income tax rates. Conversely, amounts that instead qualify as proceeds of disposition may be treated on capital account. In Canada, capital gains are only taxable at 50% of ordinary income tax rates. This distinction can lead to very different results for vendors and it is therefore important to correctly assess the treatment of earnout payments in line with the applicable rules.
Paragraph 12(1)(g) of the Income Tax Act (ITA) requires that “any amount received by the taxpayer in the year that was dependent on the use of, or production from property whether or not that amount was an instalment of the sale price of the property” must be included in that taxpayer’s income from a business or property. Since a traditional earnout will often only be payable to the extent certain financial metrics of a business are met, the traditional earnout will generally be viewed as being “dependent on the use of, or production from” the property of the business that was sold thus resulting in an income inclusion to the vendors under paragraph 12(1)(g). This is the case even though the earnout payment would also technically constitute deferred purchase price to the vendors.
On a share sale, one would assume that the traditional earnout would generally result in capital gains treatment to a vendor rather than income account treatment, which, as noted above, is typically less advantageous to a vendor since capital gains are only 50% taxable while income gains are generally 100% taxable.
On an asset sale, an earnout payment to a vendor would likely be treated on income account under paragraph 12(1)(g). However, under either an asset sale or a share sale, a purchaser will generally not be able to deduct any portion of the earnout payment notwithstanding that it may result in a current income inclusion to the vendors.
CRA administrative relief
Cost recovery method
The Canada Revenue Agency (CRA) has stated administratively that paragraph 12(1)(g) will generally apply to a share sale as well as to a sale of property. However, the CRA has also provided administrative relief from paragraph 12(1)(g) treatment to those vendors who realize proceeds on a share sale (but not on an asset sale). Specifically, the CRA has allowed taxpayers to use the cost recovery method to report the receipt of earnout payments in certain circumstances. The benefits of using this method are two-fold. First, taxpayers eligible for this method can generally treat earnout payments as capital gains in the year of receipt. Second, and subject to certain conditions set out below, taxpayers can also generally claim capital treatment on earnout payments received in subsequent periods. This ensures that taxpayers have the funds necessary to pay the tax in the year such payments are received / reported.
In order to qualify for the cost recovery method, the CRA generally requires the following conditions to be satisfied:
- The vendor must be a resident of Canada under the ITA,
- The vendor and purchaser must deal with each other at arm’s length,
- The gain or loss on the share sale must be “clearly of a capital nature”,
- The earnout feature has to relate to the underlying goodwill of the business, the value of which cannot reasonably be expected to be agreed upon by the parties at the time of sale,
- The earnout arrangement must have a term of no longer than five years; and
- The vendor must submit a formal request to use this method in its tax return for the year in question and provide a copy of the purchase and sale agreement to the CRA.
While the cost recovery method may provide relief to some taxpayers that meet the above conditions, this method is not often relied upon in practice for a few reasons (e.g. the earnout period is longer than five years, the earnout is not attributable to goodwill, possible reluctance by taxpayers to share the purchase and sale agreement with the CRA, etc.).
Reverse earnout
As mentioned above, a reverse earnout involves a payment by the purchaser of the maximum possible purchase price at closing, with any earnout payments being returned by the vendors to the purchasers in the event the relevant financial metrics under the earnout arrangement were not met. From a practical perspective, most reverse earnout arrangements involve the issuance of a promissory note, which would typically be settled for an amount less than its principal amount should any portion of the earnout need to be refunded to the purchaser.
From a tax perspective, a reverse earnout should not attract paragraph 12(1)(g) treatment. This appears logical when considering that under a reverse earnout, a vendor would need to report the entire purchase price (including the earnout) as proceeds of disposition for the taxation year in which the sale occurs. However doing this could result in a cash flow issue to the vendor since they would incur a tax liability on the maximum capital gain possible without actually receiving the cash required to fund the tax liability from the sale. Furthermore, the CRA has administratively stated that a capital gains reserve would generally not be available to shield the full capital gain realized in the year of sale when an earnout is involved. The reasoning primarily relates to the fact that an earnout is contingent and cannot be legally determinable until a future point in time.
It is for this reason that most reverse earnouts are generally structured with a three-year term. This is to allow vendors the flexibility to carry back any capital losses incurred in the second or third taxation year following the sale to offset the capital gain incurred in the year of sale should the maximum earnout not be paid (capital losses can only be carried back 3 years under paragraph 111(1)(b) of the ITA).
Nonresident vendors
A common question that comes up is what happens if a nonresident of Canada sells shares of a Canadian company that is subject to an earnout? Would the earnout payment by the purchaser be subject to Canadian withholding tax?
Share sale
Under Canadian tax rules, and subject to certain exceptions, a payment which is dependent on the use of or production from property in Canada, whether or not it was an instalment on the sale price of the property, may be subject to Canadian withholding tax of 25%. This provision could potentially apply to a nonresident of Canada who sells shares of a Canadian company subject to an earnout clause to the extent the shares are “taxable Canadian property” (TCP) for Canadian tax purposes. The definition of TCP includes shares of a private corporation where more than 50% of their value is derived from Canadian real property, or has been derived from such property at any time within the 60 months prior to the time of sale. If a nonresident disposes of shares that are not TCP, then no Canadian tax should be payable unless the nonresident of Canada either was employed in Canada or carries on business in Canada.
The CRA has provided administrative relief in the past in respect of share dispositions by nonresidents of Canada. Specifically, the CRA has taken the position that Canadian withholding tax should not apply to a sale by a nonresident of Canada of shares subject to an earnout arrangement, provided the following conditions are satisfied:
- The vendor and purchaser must deal with each other at arm’s length,
- The gain or loss on the share sale must be “clearly of a capital nature”,
- The earnout feature has to relate to the underlying goodwill of the business, the value of which cannot reasonably be expected to be agreed upon by the parties at the time of sale, and
- The earnout arrangement must have a term of no longer than five years (for the purposes of this condition, the CRA considers that an earnout feature in a sale agreement ends at the time the last contingent amount may become payable pursuant to the sale agreement).
In a case where the nonresident of Canada disposes of shares that are not TCP but still subject to an earnout, the CRA has also provided administrative relief by taking the view that earnout proceeds should be included as proceeds of disposition provided the same conditions are satisfied, namely:
- The vendor and purchaser must deal with each other at arm’s length,
- The gain or loss on the share sale must be “clearly of a capital nature”,
- The earnout feature has to relate to the underlying goodwill of the business, the value of which cannot reasonably be expected to be agreed upon by the parties at the time of sale, and
- The earnout arrangement must have a term of no longer than five years (for the purposes of this condition, the CRA considers that an earnout feature in a sale agreement ends at the time the last contingent amount may become payable pursuant to the sale agreement).
In either case, if the above conditions are satisfied, the CRA will generally not require a purchaser to withhold tax in respect of earnout payments paid on shares sold by a nonresident vendor.
Asset sale
Administrative relief would likely not be available for an earnout paid to a nonresident of Canada on an asset sale. Specifically, a payment to a nonresident of Canada which is dependent on the use of or production from property in Canada, whether or not it was an instalment on the sale price of the property, but not including an instalment on the sale price of agricultural land, may be subject to Canadian withholding tax of 25%. If applicable, this 25% withholding tax rate may be reduced to the extent relief is available under an applicable tax treaty.
The above principles should be kept in mind when structuring the purchase and sale of a business, particularly in a case where the vendors may be nonresidents of Canada.
