An earnout exists because buyer and seller could not agree what the business is worth, so they agreed to find out. That is a sensible answer to a price gap. It is also where the Income Tax Act stops treating the money as sale proceeds and starts asking whether it is income — which changes both how much tax is due and the year it falls in.
Key takeaways
SECTION 01 OF 09
Section 12, marginal note Income inclusions, opens: “There shall be included in computing the income of a taxpayer for a taxation year as income from a business or property such of the following amounts as are applicable”. Everything listed under it is ordinary income, not a capital receipt.
Paragraph (g), marginal note Payments based on production or use, reads: “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, except that an instalment of the sale price of agricultural land is not included by virtue of this paragraph”. That middle clause is the problem: it anticipates the argument that the money is really part of the purchase price, and forecloses it.
SECTION 02 OF 09
An earnout is by construction an amount dependent on what the business produces after closing. Calculated off revenue, EBITDA or gross profit, its quantum is a function of the use of, or production from, the assets sold — the statutory test almost word for word.
IT-426R ¶ 1 concedes it: where proceeds are “determined by reference to future earnings generated by the underlying assets of the corporation”, then “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”. Either every dollar is taxable as it arrives, or the seller is taxed at closing on a right that may pay nothing — outcomes the CRA calls unsatisfactory.
SECTION 03 OF 09
An amount caught by 12(1)(g) is included in income in full; a capital gain is taxed on the year’s inclusion rate. That arithmetic is worked through in how earn-out proceeds are taxed in Canada. The prior question is which of the two it is.
The larger cost is the exemption. The deduction in section 110.6 — marginal note Capital gains deduction — qualified small business corporation shares at 110.6(2.1) — operates on a capital gain, which an amount under 12(1)(g) is not. For an owner who spent two years arranging affairs around the 24-month tests that decide the exemption, that is the difference between shielding a large slice of the sale and shielding none of the earnout. Treadstone Law makes the adjacent structural point — the exemption is available only on a share sale, so structure decides access before characterisation ever arises.
SECTION 04 OF 09
IT-426R, Shares Sold Subject to an Earnout Agreement (28 September 2004) offers the cost recovery method: no 12(1)(g) income, no valuation of the earnout right at closing, gain reported as amounts become determinable. The page is ARCHIVED and says on its face that “Bulletins do not have the force of law” — an administrative position, not a right.
Paragraph 2 requires all six: arm’s-length parties; a gain “clearly of a capital nature”; an earnout relating to “underlying goodwill the value of which cannot reasonably be expected to be agreed upon… at the date of the sale”; an end within five years of the target’s year end in which the shares are sold; the agreement, a request letter and an undertaking filed with the return; and a vendor resident in Canada. That five-year test runs to “the time the last contingent amount may become payable” — the contract’s outer edge, not the expected date. And it covers shares: an asset sale with an earnout is outside IT-426R entirely.
SECTION 05 OF 09
Under ¶ 3 the vendor reduces the shares’ adjusted cost base as amounts become determinable; once the running total exceeds that base, “the excess is considered to be a capital gain that is realized at the time that that amount became determinable, and the adjusted cost base becomes nil”.
The trigger word is determinable, defined in ¶ 5 as “capable of being calculated with certainty” where the taxpayer “has an absolute but not necessarily immediate right to be paid”. The tax point is when the right crystallises, not when the cash lands. Losses run slower: under ¶ 6 a capital loss arrives only once the maximum receivable is “irrevocably established to be less than the vendor’s adjusted cost base”.
SECTION 06 OF 09
Where the gain is capital and paid over time, subparagraph 40(1)(a)(iii) matches tax to cash. It permits the lesser of clause (C), “a reasonable amount as a reserve in respect of… the proceeds of disposition… payable to the taxpayer after the end of the year”, and clause (D), 1/5 of the gain times “the amount, if any, by which 4 exceeds the number of preceding taxation years… ending after the disposition”.
Clause (D) is the wall, and IT-426R ¶ 7 states the consequence: “no part of the capital gain may be deferred beyond 5 years… regardless of the fact that proceeds may not all be payable within a 5-year period”. A seven-year earnout buys five years of deferral, then the reserve runs out while payments continue — as Treadstone Law notes from the instalment side.
SECTION 07 OF 09
IT-462, Payments based on production or use (27 October 1980, also archived) is the CRA’s general reading of 12(1)(g), and ¶ 5 sets out how one agreement is split between income and proceeds. Where a fixed sum carries an extra amount payable only if production exceeds a stipulated figure, “the fixed sum is treated as proceeds of disposition and the additional amount, if any, is brought into income under paragraph 12(1)(g)”. That is the classic earnout, and the classic split: closing payment capital, earnout income. Paragraph 7 shuts the obvious escape: the rule applies whether the price depends on gross income, net income, “or… some other element based on production or use”, so changing the metric changes the bargain but not the analysis.
Two structures escape. Paragraph 8 excludes agreements where only the timing moves — a fixed price “which cannot be varied in any event” is untouched even on a production-linked schedule; IT-426R ¶ 8 agrees that an agreement fixing only when amounts are paid, “as opposed to determining the quantum of proceeds”, is not an earnout. Paragraph 9 matters more: where the price “is originally set at a maximum which is equivalent to the fair market value of the property at the time of the sale and which can be subsequently decreased if certain conditions related to production or use are not met”, the proceeds are capital, any shortfall being adjusted in the year the reduction is known with certainty. The market calls this a reverse earnout; the bulletin describes the mechanism without using the term.
That escape is narrow. Paragraph 10: “If a maximum sale price is not stipulated or if it is stipulated but is not reasonable, paragraph 12(1)(g) applies to all payments in respect of the sale.” A ceiling everyone knows will never be reached is not a maximum — the tax counterpart of capping an earn-out.
SECTION 08 OF 09
Character first: the closing payment may be capital and exemption-eligible while the earnout is neither. Then timing — tax attaches when the amount becomes determinable, which can precede the cash by a year, and on a reverse earnout attaches to the maximum at closing, before any of it is earned.
And the money may never arrive. A reverse earnout taxes the seller on a maximum a later downturn reduces, the correction coming only when the reduction is certain; an uncapped classic earnout runs the opposite risk under ¶ 6. That makes a suppressed-earnings dispute a tax problem too — and protection there, Treadstone Law notes, “comes almost entirely from what is negotiated and written into the earn-out provisions before closing” (suppressed earnings).
SECTION 09 OF 09
Decide first whether you are building a classic or a reverse earnout: different tax instruments in similar commercial clothes, and the choice has to be made in the agreement rather than reconstructed later. If reverse, the stated maximum must be a genuine fair-market-value figure at closing, or ¶ 10 removes the benefit entirely.
Then read the IT-426R conditions as drafting instructions. Is it a share sale? Does the last contingent payment fall inside five years of the target’s year end? Are the parties at arm’s length? Is the vendor resident in Canada — live where an owner has moved, and a point Treadstone Law flags on cross-border earn-outs. And define the metric to a standard an auditor could apply, since the analysis assumes an amount “capable of being calculated with certainty”: independent verification is worth building in.
And weigh the alternative. Fixed deferred consideration — a vendor take-back at a fixed face amount, or a working capital adjustment — stays outside 12(1)(g), because nothing about its quantum depends on production or use. It keeps the whole price as proceeds of disposition, trading performance risk for credit risk. Both are defensible; only one is defensible by accident.
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