An earn-out is a portion of a business's purchase price that the buyer pays only if the business hits agreed financial targets after closing, so the seller is paid more for outperformance instead of the buyer paying full price up front for growth that hasn't happened yet.
The metric and the test period are entirely a matter of contract — revenue, EBITDA, gross margin, a customer-retention count — there is no statutory definition of an earn-out or a standard way to measure one, and how the metric gets calculated after the fact is a familiar flashpoint between buyer and seller once the business is no longer run by the person who sold it.
Where the tax treatment gets statutory is on timing. Because part of the price genuinely isn't payable until a later year, the seller can claim a capital gains reserve on the undetermined portion under ITA s. 40(1)(a)(iii), which lets a “reasonable amount” of the gain tied to “proceeds of disposition … that are payable to the taxpayer after the end of the year” be deferred, spread using a 1/5-per-year formula that caps the reserve at a maximum five years.
That five-year cap matters because it is easy to assume otherwise. A ten-year reserve exists elsewhere in the same section, but only for sales to a taxpayer's child, for intergenerational business transfers meeting the s. 84.1(2.31)/(2.32) tests, or for dispositions to an employee ownership trust — none of which describe an ordinary arm's-length earn-out sold to an outside private equity buyer. An earn-out on that kind of deal gets the standard five-year maximum, not ten.
A seller agrees to $3,000,000 at closing plus an earn-out of up to $1,000,000 if the target's EBITDA over the following two fiscal years clears an agreed threshold. Because the $1,000,000 isn't determinable or payable until each year-end target is tested, the seller claims a capital gains reserve under s. 40(1)(a)(iii) on the undetermined portion, recognizing that part of the gain as the earn-out periods close rather than all in the year of sale — capped at the ordinary five-year maximum, since this is an arm's-length sale to an outside buyer and none of the ten-year routes apply.
See also: Vendor take-back note · Share purchase agreement · Purchase price allocation.
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