Sale of Business Considerations: Earn Outs

Where an earn-out has been negotiated it is not possible at the date of closing of the sale to determine the exact proceeds of disposition the vendor is to account for. For this reason mechanisms must exist to adjust the tax accounting for the disposition as the proceeds become known.

The treatment of an earn-out payment depends of whether it relates to the purchase of assets or the purchase of shares. This week we will review the earn-out payment where the purchase of shares is used.

Share Purchase

There are no rules in the Income Tax Act which deal specifically with accounting for an earn-out where shares are sold. CRA has an administrative policy, however, which can be applied and which permits the vendor to account for the disposition using the cost recovery method.

Under the cost recovery method, the vendor applies sales proceeds as they become known against the adjusted cost base of the shares sold. Once the cost base has been fully recovered, any addition proceeds are accounted for as a capital gain.

The CRA outlines its policies on this matter in IT-426. It provides that the cost recovery method can be used where:

• the vendor and purchaser are dealing with each other at arm's length;
• the gain or loss on the sale of shares of the capital stock of a corporation is clearly of a capital nature;
• it is reasonable to assume that the earn out feature relates to underlying goodwill the value of which cannot reasonably be expected to be agreed upon by the vendor and purchaser at the date of the sale;
• the earn out feature in the sale agreement must end no later than 5 years after the date of the end of the taxation year of the corporation (whose shares are sold) in which the shares are sold. For the purposes of this condition, the CRA considers that an earn out feature in a sale agreement ends at the time the last contingent amount may become payable pursuant to the sale agreement;
• the vendor submits, with his return of income for the year in which the shares were disposed of, a copy of the sale agreement. He or she also submits with that return a letter requesting the application of the cost recovery method to the sale, and an undertaking to follow the procedure of reporting the gain or loss on the sale under the cost recovery method.