An earn-out only works if both sides can compute the same number a year later without a lawyer in the room. Here is how to structure one under the rule that actually taxes it.
Key takeaways
STEP 01 OF 10
“Earn-out” does not appear in the Income Tax Act. What actually taxes a contingent payment is s. 12(1)(g), which 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” (with a carve-out for an instalment of the sale price of agricultural land). Read plainly: if a payment genuinely depends on how the business performs after closing, it is ordinary income in the year it lands in the recipient’s hands — not a capital gain spread back to the closing date. That distinction should shape every other term in this guide.
Contrast this with a fixed price paid in instalments — say $2,000,000 payable $1,200,000 at closing and $800,000 in two equal instalments over the following two years, with no metric attached. That is not an earn-out; it is a deferred purchase price, and the seller can instead use the reserve mechanism in s. 40(1)(a)(iii) (Step 4). The two structures tax the same dollar very differently, so decide honestly which one you are actually writing.
STEP 02 OF 10
The single most common reason an earn-out ends in dispute is a metric that requires judgment to compute — “adjusted EBITDA” with undefined add-backs, or “net revenue” that depends on how a shared cost centre gets allocated once the seller no longer controls the ledger. Anchor the metric instead to a number the buyer’s normal-course accounting already produces: gross revenue booked under an unchanged revenue-recognition policy, units shipped, or one product line’s invoiced sales.
Where the metric must be a margin figure, freeze the accounting policies that compute it (Step 3) instead of leaving “consistent with past practice” undefined — that phrase is the one that gets argued over in year two, once the person who used to apply it is no longer in the building.
STEP 03 OF 10
Write the exact policies — inventory costing method, revenue-recognition timing, which corporate overhead allocations apply and at what rate — into the agreement itself, not by reference to “GAAP” or “past practice.” A buyer who changes an accounting policy after closing, even for a legitimate operating reason, can move the earn-out metric without changing anything about how the business actually performed.
Also put the operating covenants in writing: a minimum marketing spend, no diversion of shared customers to another portfolio company, no forced cross-selling that suppresses the measured line. A metric with no covenants behind it can be starved without the buyer breaching a single letter of the agreement.
STEP 04 OF 10
If Step 1 concluded the payment is a fixed, merely-deferred price rather than a contingent earn-out, the seller can defer part of the resulting capital gain using the reserve in s. 40(1)(a)(iii)(C)-(D): the lesser of “a reasonable amount as a reserve” in respect of proceeds payable after the end of the year, and 1/5 of the gain multiplied by (4 minus the number of preceding taxation years since the disposition) — a maximum five-year spread. Worked example: on a $500,000 capital gain collectible in equal instalments over five years, the reserve claimed in year one can defer up to 4/5 of the gain ($400,000); by year four only 1/5 remains deferrable, and by year five the full gain must be recognized.
A ten-year version of the same reserve exists, but only for a disposition to a child meeting the tests in s. 40(1.1), an intergenerational transfer meeting s. 84.1(2.31) or (2.32), or a disposition to an employee ownership trust — never for an arm’s-length sale to an outside buyer, however the payment schedule is written. A genuine earn-out under s. 12(1)(g) gets none of this: each payment is ordinary income in the year received, regardless of how many years the schedule runs.
STEP 05 OF 10
Set a maximum total payout and, if the parties want the seller to carry less downside, a minimum guaranteed floor. An earn-out with no ceiling is an open-ended dispute waiting for a good year; one with no floor gives the seller nothing to rely on if the buyer under-invests in the acquired line.
Decide explicitly what happens to the unpaid balance if the buyer sells the business, changes control, or shuts down the acquired line before the term ends. Most sellers negotiate full acceleration of the maximum payout on a change of control, since a sale to a third party removes the seller’s practical ability to monitor or influence the metric going forward.
STEP 06 OF 10
Where the transaction is structured as a sale of the business’s assets rather than its shares, an earn-out payment is still part of the “consideration” for the supply. If the parties filed the joint election under ETA s. 167(1) covering “all or substantially all” of the property needed to carry on the business, no tax is payable on that consideration except the three carve-outs the election does not reach: a service still to be rendered by the seller, property supplied by lease or licence, and a sale of real property to a non-registrant buyer.
An earn-out tied to future business performance rather than a service the seller keeps performing falls inside the election, not outside it — but confirm which carve-out, if any, applies to your specific structure before assuming the entire payment is covered. See treadstonelaw’s HST-on-a-business-sale guidance for how the election is filed in practice.
STEP 07 OF 10
This is the point sellers miss most often. The lifetime capital gains deduction in ITA s. 110.6(2)(a)/(2.1) shelters up to $625,000 of taxable capital gain — the taxable half, under s. 38(a), of a $1,250,000 gross gain — and that figure indexes to the Consumer Price Index for taxation years beginning after 2025 under s. 117.1(2)(c); confirm the current indexed figure with the CRA before relying on a specific dollar amount.
The fixed, ascertainable proceeds recognized at closing can support an LCGE claim in the closing year. A later earn-out payment taxed under s. 12(1)(g) is business or property income, not a capital gain — it is not LCGE-eligible at all, however the purchase agreement labels it. A seller who is close to using up their LCGE room should understand, before signing, exactly which part of the price does the sheltering and which part does not.
STEP 08 OF 10
Name an independent chartered business valuator to resolve a disputed metric calculation, and specify the standard of report before a dispute exists rather than negotiating it under pressure afterward. CBV Institute’s practice standards, effective for engagements beginning on or after 1 January 2026, include an Expert Report family (Standards 310/320/330) built for exactly this: a CBV “retained as an expert to provide their independent professional opinion as to the quantum of financial gain/loss.”
Naming that standard in the agreement gives both sides a known, professional floor for how the number gets recalculated if they disagree, instead of litigating the accounting from a blank page after the relationship has already soured.
STEP 09 OF 10
Take the actual base price, the metric, the multiple or percentage applied to it, and the cap, and run the arithmetic before signing. Example: a $3,000,000 base price plus 1× the amount by which year-two gross revenue exceeds $4,000,000, capped at an additional $600,000.
If year-two revenue comes in at $4,450,000, the earn-out payment is the $450,000 excess × 1 = $450,000, below the $600,000 cap, taxed in full as ordinary income in the year it is paid under s. 12(1)(g) — not spread over five years, not sheltered by the LCGE, and not eligible for the s. 40 reserve, because it was never a fixed price to begin with.
STEP 10 OF 10
Name who prepares the metric calculation each period (usually the buyer, since it controls the ledger), the deadline for delivering it, the seller’s right to audit the underlying records, and the response window before the number is deemed accepted.
A seller with no contractual right to see the working papers behind “adjusted EBITDA” has no practical way to catch an error before the response window closes — by the time the next reporting period arrives, last year’s number is often treated as settled.
If the amount owed is fixed on the day of closing and only the timing of payment is uncertain, it is a vendor take-back note, taxed as a capital gain with access to the s. 40 reserve in Step 4. If the amount owed depends on how the business performs after closing — revenue, EBITDA, unit volume, retention of a named customer — it is an earn-out under s. 12(1)(g), taxed as ordinary income when received.
A schedule can mix both: a fixed instalment note for part of the price and a genuine performance-contingent earn-out for the rest, each taxed on its own terms. What it should not do is blend the two into a single ambiguous clause and hope the more favourable treatment applies to the whole payment — the CRA reads the substance of what was actually promised, not the label on the schedule.
Vendor take-back financing in the Canadian lower middle market commonly runs in the 10–20% of price, over three to five years band deavo describes — a market-practice figure, not a statutory one, and worth checking against the five-year reserve arithmetic in Step 4 before assuming a longer VTB term automatically defers more tax.
Many agreements also carry an escrow holdback alongside the earn-out — a separate pool set aside against warranty claims, not against the metric. Keep the two mechanisms distinct in the drafting: treadstonelaw’s escrow-holdback guidance covers the release conditions for that pool, which should not depend on the same trigger events as the earn-out payment.
An earn-out is only as good as the buyer’s ability to trust that the seller is not quietly building a competing shop next door during the measurement period. A restrictive covenant tied to the sale is not, on its own, a competition-law problem: Competition Act s. 45(4) preserves an “ancillary restraints” defence where the restraint “is ancillary to a broader or separate agreement… that includes the same parties” and “is directly related to and reasonably necessary” for it — the textbook example being a non-compete given by a seller as part of a genuine sale of a business.
Two things to check before relying on that defence: keep the restraint reasonably scoped to the business actually sold (geography, line of business, duration tied to the earn-out term rather than open-ended), and keep the sale agreement itself genuine and arm’s length rather than a vehicle for two competitors to agree not to compete. A restraint that outlives any plausible protective purpose stops looking ancillary and starts looking like the thing s. 45(1.1) was written to catch.
No. Tax treatment follows the legal substance of the payment, not the label the agreement gives it. If a payment genuinely depends on post-closing performance, s. 12(1)(g) applies regardless of what the parties call it.
Only if the underlying price is fixed — the two five-year periods are otherwise unrelated. A genuine performance earn-out has no reserve at all, however long its term runs.
The Step 8 mechanism should run in either direction. Name the CBV standard and the referral process once, in the agreement, so it applies regardless of which side raises the dispute.
No — keep them separate. An earn-out payment depends on the business's performance after closing; an escrow holdback secures the seller's warranty and indemnity promises. Tying both to the same release trigger makes a warranty dispute hostage to a performance dispute, and vice versa.
No filing is required — it lives in the purchase agreement itself. What matters is that it stays reasonably scoped to the business sold, so it can rely on the ancillary-restraints defence rather than standing on its own as a restraint on competition.
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