The seller reported six years of earn-out receipts as capital gains. Two conditions of the Agency's own cost recovery method had not been met, and paragraph 12(1)(g) took the rest.
At a glance
The founder of a small Ontario logistics-software vendor sold all the shares of the operating company to a strategic buyer for $2.1 million in cash plus an earn-out of up to $1.8 million, measured on licence revenue from the acquired product line and payable annually over six measurement periods. The structure was negotiated to bridge a price gap on a product whose renewal rate neither side would underwrite. On the tax side the founder's accountant did what accountants sensibly do: reported each earn-out receipt as proceeds on capital account as it became determinable.
Every other file in this cluster argues about whether the earn-out pays. This one takes payment as given and asks what the seller keeps. The default statutory treatment of an amount whose size depends on how a property is used is not capital at all. Capital treatment for a share earn-out is an administrative concession, it has six conditions, and this sale failed two of them — one by a matter of months, the other by a letter nobody wrote.
The earn-out ultimately paid $1,430,000 of the $1,800,000 maximum, across six years. Reported as capital gains, half of that is included in income under s.38(a): $715,000. Reassessed as income under paragraph 12(1)(g), the whole $1,430,000 is included. The reassessments therefore added $715,000 to the founder's income across the six years, plus arrears interest.
The second loss is quieter and larger in some cases than the first. The founder had unused lifetime capital gains exemption room and shares that qualified as qualified small business corporation shares. An exemption against capital gains shelters nothing when the receipt is income. Every dollar of that room was still unused and now had nothing to attach to.
Paragraph 12(1)(g) of the Income Tax Act brings into 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…” The marginal note is Payments based on production or use, and the words whether or not that amount was an instalment of the sale price are the ones that matter: calling a contingent receipt part of the purchase price does not take it out of the paragraph.
Against that, the Agency's Interpretation Bulletin IT-426R offers the cost recovery method for shares sold under an earn-out. Its opening paragraph states the default plainly: “it is possible that paragraph 12(1)(g) would apply to all payments made under the earnout clause, or that the total proceeds of disposition as at the date of the sale must include the value of the earnout rights”. The concession then attaches six conditions, and this sale failed two.
Condition (d) — the five-year limit. The earn-out feature “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”, and the bulletin adds that the feature “ends at the time the last contingent amount may become payable pursuant to the sale agreement”. The measuring point is the corporation's taxation year end, not the closing date — and the acquisition of control produced a deemed year end at closing, so the clock started there. A sixth annual payment could become payable after that anniversary. Six measurement periods do not fit in a five-year box.
Condition (e) — the filing. The vendor must submit with the return for the year of disposition “a copy of the sale agreement”, a letter requesting the application of the method, and an undertaking to report on that basis. None of the three was filed. The concession is elective in substance and the election was never made.
Two further points are worth carrying even where the method is available. The reserve under subparagraph 40(1)(a)(iii) is itself capped — the bulletin states that “no part of the capital gain may be deferred beyond 5 years pursuant to subparagraph 40(1)(a)(iii) regardless of the fact that proceeds may not all be payable within a 5-year period”. And the exemption survives the method: where the shares qualified, “the taxpayer is entitled to claim the capital gains deduction to the extent permitted by subsections 110.6(2) or 110.6(2.1) respectively”. Capital treatment is what carries the exemption; losing it loses both.
The founder objected on the ground that licence revenue from a product line is not use of or production from property, lost the argument on the paragraph's plain words, and settled the interest. The buyer was indifferent throughout — the character of the receipt is the seller's problem, which is exactly why sellers must raise it during the negotiation of the structure rather than after it.
The fork that changes the governing provision. A reverse earn-out fixes the price at the maximum on closing and reduces it if targets are missed. On the wording of paragraph 12(1)(g) there is then no amount received that was dependent on the use of or production from property: the amount is fixed and the contingency runs downward. That is a change in the provision engaged, not a change in the commercial deal. Stated honestly: IT-426R does not address reverse earn-outs — it is confined to the cost recovery method for shares sold under an earn-out — and no published bulletin dealing with them was fetched for this file. The structure's advantage rests on the words of the paragraph, and it brings its own cost, because the seller reports the full gain at closing and must recover it if the price is later reduced.
Trimming the earn-out from six measurement periods to five, and filing three pages with the return of disposition, would have preserved capital treatment on $1,430,000 and left the exemption room usable. The sixth year contributed $180,000 of the total. The seller gave up half the tax character of $1.43 million to keep a sixth-year payment of $180,000, and nobody put that trade in front of him because the tax analysis happened after the term sheet.
The tell is an earn-out period expressed in years rather than measured against the corporation's taxation year end. Anything at or beyond five years is outside the concession before the drafting starts, and a deemed year end on the acquisition of control moves the starting line to closing, which most parties assume is generous and is in fact the tightest reading available. The second tell is a closing binder with no copy of the election letter in it.
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