Anonymised, illustrative composite. A seller asked for a longer vendor note to ease the tax hit; the reserve that actually defers the tax caps out two years short of what the seller assumed it bought.
At a glance
A Manitoba-based specialty commercial printing business changed hands for $4,000,000, with the vendor agreeing to take back a $600,000 note — 15% of the price, within the illustrative range Deavo's own market commentary puts on Canadian vendor take-backs generally, an illustrative figure only and not a benchmark. With the vendor's cost base in the business long since written down, substantially all of that $600,000 represented taxable capital gain, not a return of capital.
The vendor's counsel opened with a seven-year note, on the theory that a longer repayment term would spread the tax hit further and ease the vendor into retirement income gradually. Nobody had yet checked the mechanism that actually lets a seller defer tax on a gain not yet fully collected: the capital gains reserve. See the vendor take-back note glossary entry for how the note itself works.
Section 40 of the Income Tax Act allows a reserve for proceeds “payable to the taxpayer after the end of the year,” but caps it at one-fifth of the gain multiplied by the number of years remaining in a five-year window — a straight-line schedule that forces recognition of at least 20% of the gain every year regardless of the note's own face term. On a $600,000 gain: 20% ($120,000) must be recognized in year one, cumulative 40% by year two, 60% by year three, 80% by year four, and the full $600,000 by year five. At the Act's one-half inclusion rate, that is $60,000 of taxable gain by year one and $300,000 by year five — whether or not the note has actually paid out that much cash by then.
A ten-year version of the same reserve exists, but only for a disposition to a child under the intergenerational transfer rules, to an employee ownership trust, or to a worker co-operative — none of which described a sale to an arm's-length third-party buyer.
The five-year cap is not a negotiating position; it is a formula in the Act, and it does not care what the note says. A seller can be paid over seven years and still owe tax on the full gain by year five — the reserve simply runs out two years before the cash does. Offering a longer note term buys the seller nothing in tax terms once the reserve has already maxed out; it only adds two years of collection risk on money the vendor has already had to pay tax on.
Once the buyer's tax advisor walked the vendor's counsel through the schedule, the seven-year ask dropped on its own. The note was restructured to a clean five-year term, which also happened to satisfy the senior lender's own closing condition — that no subordinate debt mature later than its own five-year facility. What had looked like the bank refusing to accommodate the seller's preferred term turned out to be the bank's schedule and the Act's schedule landing on the same number for different reasons.
For the mechanism this note sits alongside, see the subordination agreement glossary entry, and for how a different deal handled a subordinate lender's own inflexibility, the lender who required a bigger equity cheque.
Had the parties signed the original seven-year note without checking the reserve, the vendor would still have owed tax on the full $600,000 gain by year five — but two years' worth of the note's own scheduled payments would not yet have arrived. The seller would have been funding a real tax bill out of other resources, ahead of collecting the cash the note was supposed to provide for exactly that purpose. Aligning the note's term to the reserve's own five-year ceiling did not cost the seller a deferral they actually had; it just stopped them from believing they had two more years of one they didn't.
The mismatch was visible the moment the term sheet listed “seven years” next to a note the vendor was counting on for tax deferral. The reserve's own formula caps out at five years for anyone who is not selling to a child, an employee ownership trust or a worker co-op — a fact checkable from the statute before a single term was negotiated, not after the lender's own condition forced the same answer from a different direction.
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