By Gregory M. Prekupec & Rahul Gupta

What happens when a buyer and seller cannot agree on how much a business is worth? One approach is for the seller to walk away from the deal with the hope a new buyer will agree with their valuation. To avoid the inefficiency which stems from this route, the parties can agree to an “earn-out” or “reverse earn-out” to bridge any gaps which may exist between the buyer and seller parties. Despite the reconciliatory nature of this approach, one must be made aware of its tax implications before pursuing it.

An earn out is a conditional payment of the purchase price which is subject to the corporation achieving certain metrics within a specified time-frame post closing. For instance, if the corporation achieves a certain EBITA threshold for the first three years after the acquisition. If the target achieves these targets, the seller receives the balance of the purchase price, as specified by the underlying purchase agreement. Otherwise, the funds flow back to the purchaser. In a reverse earn out scenario, the inverse is true. If the target does not achieve certain milestones, the seller returns a portion of the purchase price back to the purchaser.

In addition to the above, earn-outs/reverse earn-outs can also serve as a useful tool for each of the following scenarios:

A. Market or industry volatility;

B. The target is engaged in an experiential or novel venture (e.g., a new style of restaurant); or

C. The purchaser is unable to secure adequate financing to fund the acquisition.

The primary tax considerations for a seller in an earn-out or reverse earn-out scenario is whether the earn-out payments are treated as capital gains or ordinary income. Sellers prefer such payments to be treated as capital gains as only 50% of the amount received (i.e., the gain) is included in the seller’s taxable income; whereas, ordinary income treatment includes 100% of the payment in the same. Generally speaking, the Canada Revenue Agency’s view on the tax treatment of an earn-out can be based on how the transferred property is being used. Asset-based deals can reduce the risk of ordinary income treatment as income is being derived from the use of an asset, rather than ownership of a business (i.e., shares).