The increasing popularity earnouts

November 10, 2022 | Neil Gurmukh

Due to the economic impact of the COVID-19 pandemic and the recent volatility of stock markets, we have noticed an increased perceived valuation gap between vendors and purchasers in the context of M&A transactions. As a result, contingent consideration arrangements are becoming increasingly popular solutions to address uncertainty.

Given its inherent flexibility, the earnout has emerged as the most popular form of contingent consideration arrangement. An earnout is generally understood to mean an arrangement whereby the purchaser pays to the vendor a base purchase price for a target business with the vendor being entitled to receive additional payment(s) from the purchaser over a specified period of time in the post-closing period depending on whether the target business achieves certain pre-determined targets or milestones during that period.

Given the increased popularity of earnouts, it is important for vendors to be aware of, and understand, the myriad of tax issues that can arise from their use.

The tax issues surrounding the use of an earnout largely relate to the existence of paragraph 12(1)(g) of the Income Tax Act (Canada) (the “Tax Act”). In accordance with paragraph 12(1)(g), a taxpayer is generally required to include in their income any amount received 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.

Administratively, the Canada Revenue Agency (“CRA”) has stated that, from a legal point of view, it is possible for paragraph 12(1)(g) of the Tax Act to apply to all payments made under an earnout. For a Canadian resident vendor selling the shares of a target business, the consequence of paragraph 12(1)(g) of the Tax Act applying to earnout payments is undesirable as such payments would be taxed as ordinary income (which is taxed at full rates) instead of as a capital gain (which is one-half taxable).

In circumstances where paragraph 12(1)(g) does not apply to an earnout, it is possible, according to the CRA, that a Canadian resident vendor would be required to include in their proceeds of disposition in the year of sale the fair market value of the earnout rights. This value can be difficult to determine.

Given the unsatisfactory results that can arise for vendors under both those approaches, the CRA has an administrative policy of allowing vendors of shares that are subject to an earnout arrangement to rely on the “cost recovery method” in reporting the earnout where all of the following conditions (which are described in Interpretation Bulletin IT-426R) are satisfied:

  1. The vendor and purchaser are dealing with each other at arm’s length.
  2. The gain or loss on the sale of shares of the capital stock of a corporation is clearly of a capital nature.
  3. It is reasonable to assume that the earnout 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.
  4. The earnout 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 earnout feature in a sale agreement ends at the time the last contingent amount may become payable pursuant to the sale agreement.
  5. The vendor submits, with their return of income for the year in which the shares were disposed of, a copy of the sale agreement. They also submit 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 as outlined below.
  6. The vendor is a person resident in Canada for the purpose of the Tax Act.

Under the cost recovery method, earnout amounts received are effectively treated as a capital gains in the year that the amounts become determinable. This is achieved by the vendor reducing their adjusted cost base of the sold shares as amounts on account of the sale price become determinable. Once such an amount on account of the sale price exceeds the adjusted cost base of the shares (as reduced by any previous such amounts), the excess is considered to be a capital gain that is realized at the time that that amount became determinable, and the adjusted cost base becomes nil. All such amounts that subsequently become determinable are treated as capital gains at the subsequent time.

The conditions to qualify for the cost recovery method in respect of an earnout are restrictive, with the result that it can be difficult for a vendor to avail themselves of it. For example, in light of condition (b) above, the cost recovery method is not available in the context of asset sales. Moreover, due to the flexibility of earnouts and the bespoke post-closing targets and milestones that can be agreed upon by vendors and purchasers (e.g., financial targets, stock exchange listings, new product launches, new customers, etc.), it can be difficult for vendors to satisfy conditions (c) and (d) above.

Where the cost recovery method is not available to a vendor in respect of an earnout, consideration should be given to using a “reverse earnout.” Under a reverse earnout, the purchase price is expressed as a maximum amount (inherently assuming all of the conditions or milestones are met), but the terms of payment will be such that only the base amount is payable at closing and the balance (effectively the earnout component) will be subject to reduction to the extent that the conditions or milestones are not achieved. As a result, from an economic standpoint (e.g., quantum, terms of payment, etc.), a reverse earnout replicates a traditional earnout.

According to the CRA, the entire amount received by a vendor under a reverse earnout should be capital and paragraph 12(1)(g) of the Tax Act should not apply where the maximum purchase price represents the fair market value of the property sold and there is a reasonable expectation at the time of the sale that the conditions or milestones would be met. Although the use of a reverse earnout may allow for capital treatment, it will accelerate the timing of the vendor’s income inclusion in respect of the earnout as the vendor generally will be required to include the maximum purchase price in calculating their gain or loss in the year of sale.

To the extent that the vendor does not ultimately receive some or all of the maximum purchase price under a reverse earnout, the vendor should be eligible to claim a capital loss in respect of the unearned portion (either in the year the milestone is missed if there are net capital gains in that year from other sources, or carried back and used to offset the vendor’s net capital gain realized in the year of sale, provided in the latter case that the term of the reverse earnout is generally limited to three years or less).

If you have any questions or would like any information regarding earnouts, please contact a member of the Miller Thomson LLP Corporate Tax group.

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