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 structuring earn-outs.
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 different.
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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