Anonymised, illustrative composite. A software company capitalised two years of engineering payroll as an asset. The same money raised the earnings the price was a multiple of, and raised the balance sheet the price floor was measured against — while the corporate tax return said the opposite.
At a glance
A profitable Ontario software business sold shipment-tracking and dock-scheduling software to mid-sized carriers on annual subscriptions. Revenue was $4,180,000 and the vendor, its founder, was asking $6,390,000 — 6.0× an adjusted EBITDA of $1,065,000 built by the vendor's accountant. The buyer was a strategic acquirer with two similar assets already, and it began with a light quality of earnings review rather than a full diligence programme.
The missing salaries were on the balance sheet. An intangible asset described as “software under development” carried $1,480,000 — $740,000 in each of the two years — being the fully burdened cost of four engineers. Nothing had been amortised against it, because the accounting policy note said amortisation would begin when the product was placed in service, and the product had never been formally placed in service. It had, however, been sold to customers throughout both years.
That single treatment did two things to the price at once, and this is what separates it from an ordinary normalisation adjustment. First, $740,000 of cost that would otherwise have hit the income statement did not, so EBITDA — the number being multiplied — was $740,000 higher than the business earned. Second, the same $740,000 sat in the asset column, where the share purchase agreement's net-asset floor measured it. The buyer was being asked to pay a multiple of the money, and separately to credit the vendor with having it in the business.
Then the tax returns arrived. For both years the corporation had deducted the engineers' salaries in full in computing income. So on the financial statements the outlay was capital, and on the T2 it was current. The reconciliation of book income to taxable income showed the difference plainly once anyone looked at it; nobody had.
Reported adjusted EBITDA was $1,065,000. Strip the $740,000 of capitalised payroll out of the trailing twelve months and it becomes $325,000. At the same 6.0× multiple that is $1,950,000 against $6,390,000 — a $4,440,000 difference produced by an accounting policy, not by anything the business did.
The balance sheet moved the same way. The company presented net assets of $2,290,000 against a contractual floor of $2,100,000. Remove the $1,480,000 intangible and net assets are $810,000, $1,290,000 below the floor the vendor had warranted.
Neither side argued that all of the cost was period cost. Reconstructed from the engineers' own ticket history, $265,000 of the two years' work was on a genuinely new customs-brokerage module — a new asset by any reading — and $1,215,000 was maintenance, bug-fixing and incremental change to software already sold and already in service. On the trailing twelve months the split was $132,000 capital and $608,000 expense, giving a restated EBITDA of $457,000.
The tax hook runs in the opposite direction to the accounting one, and that is what made the position untenable. Income Tax Act s.18(1) opens: “In computing the income of a taxpayer from a business or property no deduction shall be made in respect of” — and paragraph (b) then names “an outlay, loss or replacement of capital, a payment on account of capital or an allowance in respect of depreciation, obsolescence or depletion except as expressly permitted by this Part”. Paragraph (a) is the mirror image, allowing “an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property”.
Read together, the two paragraphs force a single characterisation. If the engineering payroll was an outlay on account of capital — which is exactly what capitalising it asserts — then s.18(1)(b) denies the current deduction the corporation took, and the cost is recoverable only through capital cost allowance under s.20(1), which opens “Notwithstanding paragraphs 18(1)(a), 18(1)(b) and 18(1)(h)” and then permits “such part of the capital cost to the taxpayer of property, or such amount in respect of the capital cost to the taxpayer of property, if any, as is allowed by regulation”. If instead it was a current expense, the deduction is fine and the balance sheet is wrong.
Note what unit each rule governs. s.18(1)(b) governs the outlay — a particular payment, characterised once. It does not govern the financial statements, and there is no provision requiring a taxpayer's books and its return to agree on this point. What the divergence gives a buyer is not a legal breach in itself; it is a documented admission, in the company's own filings, that management had already formed the view that these salaries were period cost.
The buyer re-priced on the restated basis: 6.0× $457,000, settled at $2,750,000, a reduction of $3,640,000 from the asking price. The net-asset floor was rewritten to exclude internally generated intangibles altogether, so it could not be met with capitalised time. The $265,000 of genuinely capital work was left on the balance sheet and, because the corporation had already deducted it, a specific tax indemnity was added covering any denial of that deduction, uncapped and surviving until the reassessment period for both years ran out.
Paying 6.0× on $608,000 of payroll that should have been expensed is $3,648,000 of price for nothing. That is the visible half. The second half is the one buyers miss: the $1,480,000 intangible was also an asset the vendor was credited with delivering. Written off in the buyer's first post-closing year, it would have produced a $1,480,000 write-down against the buyer's own opening balance sheet with no route back to the vendor, because the purchase price true-up tests the balance sheet as delivered, and it was delivered exactly as warranted. The same dollar would have been paid for twice and recovered nought times.
Payroll expense that does not move while the payroll register grows. It takes one query: total employer cost per the payroll provider's year-end filings, against wages and benefits in the income statement, for each of three years. A widening gap between the two is capitalised time, and the size of the gap is the size of the adjustment.
The confirming tell is an intangible with no amortisation and no in-service date, sitting alongside a product customers are already paying for. Ask when the asset will begin amortising; if the answer is a date that has been moved before, the policy is doing work the business is not.
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