The default rule for a payment tied to future production or use is income, not capital gain. A specific administrative concession is what usually saves an earn-out from that result.
Short answer
By default, income — unless CRA’s cost recovery method applies. Paragraph 12(1)(g) includes in income “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”, and the cost recovery method that lets qualifying earn-out receipts be reported as capital gains instead is an administrative concession with its own conditions, not an automatic result.
Interpretation Bulletin IT-426R sets out when CRA will accept capital gains treatment on an earn-out: “Taxpayers may use the cost recovery method if the following conditions are met” — including that the vendor and purchaser deal at arm’s length, that the earn-out relates to goodwill whose value could not reasonably be agreed upon at the date of sale, and that the earn-out feature ends no later than five years after the taxation year of sale. Miss any one of the conditions and paragraph 12(1)(g) can take the payments as ordinary income instead.
Where the cost recovery method does apply, only half of the resulting capital gain is taxable under paragraph 38(a), the ordinary capital gains inclusion rate — a materially different result from ordinary income taxed at full rates on receipt. The vendor also has to affirmatively elect into the method by filing the sale agreement and a request with the return for the year of disposition; it is not the default treatment simply because a deal happens to include an earn-out clause.
One file shows a seller who reported six years of earn-out receipts as capital gains, where two of the cost recovery method’s conditions had not actually been met — and paragraph 12(1)(g) took the rest.
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