In the second installment of our occasional series on earnouts, John O’Connor and Lindsay Gwyer discuss some of the reasons that, in an asset sale or in a share sale that doesn’t meet the Canada Revenue Agency’s conditions for cost recovery, vendors should consider using a reverse earnout, rather than a classic earnout, as a means of reducing their tax burden
One of the most difficult questions to come up at the negotiating table is also one of the most fundamental: “What is it worth?” To bridge the almost inevitable vendor-purchaser valuation gap, parties to an M&A transaction will often agree to tie part of the purchase price to some measure of post-closing business success. This is often accomplished by means of a “classic earnout”, in which the purchaser pays a base amount on closing while agreeing to make additional payments over a post-closing period that typically runs for three to five years (the quantum of the earnout payment depends on how the business performs against certain pre-established targets).
But there is an alternative to the classic earnout – the “reverse earnout”. In a reverse earnout, instead of starting with a “base” purchase price on closing (with additional payments added as targets are met), the vendor receives the “full” purchase price (whether in the form of a promissory note, cash, a combination of cash and a form of a debt obligation, etc) on closing but must subsequently make payments to, and/or forgive or set-off debt obligations of, the purchaser if targets are not met.
Unsurprisingly, tax considerations are among the most significant factors that typically influence decisions between classic earnouts and reverse earnouts. As we discuss below, it is important to remember that uncertainty about the tax treatment of earnouts – of both kinds – still exists in many situations and that parties to an M&A transaction should carefully consider the tax implications of including an earnout in their deal and whether any other tax planning opportunities exist. In general, however, it is safe to say that in some situations a reverse earnout will benefit the vendor more than a classic earnout.
The basic rule: paragraph 12(1)(g)
It will help to begin with paragraph 12(1)(g) of the Income Tax Act (Canada).This provision requires taxpayers to include in their income any amount that they receive that was dependent on the use of or production from property, whether or not that amount was an installment of the sale price of the property. In many situations, it is at least arguable that payments under an earnout could be caught by paragraph 12(1)(g), and the Canada Revenue Agency (CRA) generally takes this position unless one of the administrative exceptions discussed below applies. For a vendor, the consequence of applying paragraph 12(1)(g) to earnout payments is that those payments would be treated as regular income instead of as a capital gain (in a share sale) or as proceeds from the disposition of goodwill (in an asset sale), each of which receives more favourable tax treatment than regular income.
When the cost recovery method applies
Fortunately, the CRA has provided administrative guidance that should give vendors relative certainty about the tax treatment of earnouts in certain situations. For share sales, the CRA’s administrative position is that when certain conditions are met the vendor may use what the CRA refers to as the “cost recovery method” to account for additional payments received under a classic earnout. Under the “cost recovery method”, amounts received by a vendor are effectively treated as capital gains to the vendor in the year that the amounts become determinable (or, if the shares were sold at a loss, amounts received under the earnout reduce the vendor’s capital loss). In order to benefit from the cost recovery method, certain conditions need to be met, including that it is “reasonable to assume that the earnout agreement arises due to the difficulty of valuing the underlying goodwill at the time of sale.” Accordingly, the cost recovery method won’t be available in all share deals: parties that agree to earnouts for strategic reasons, for example, may be ineligible. Moreover, it is not available in asset deals, according to the CRA.
Reverse earnouts an option when cost recovery does not apply
If the cost recovery method is not available – including in an asset sale or in a share sale that doesn’t meet the CRA’s conditions for cost recovery – a vendor may find a reverse earnout to be an attractive alternative. That’s because the CRA’s position on reverse earnouts is that if the sale price of the property is set at a maximum amount that is equal to the property’s fair market value at the time of the sale and is subsequently decreased based on certain conditions relating to the production or use not being met, then the entire amount received by the vendor will be on account of capital as long as there was a reasonable expectation at the time of the sale that the conditions would be met. It follows from this that, where the targets under a reverse earnout are not achieved, and the vendor is required to repay part of the purchase price, the vendor should be able to adjust the purchase price accordingly or claim a capital loss in respect of these payments.
Tax treatment of reverse earnouts requires careful consideration
However, there is some complexity and uncertainty as to how the adjustments to the purchase price referred to above should be made. This is an issue that a vendor should consider before agreeing to a reverse earnout, as the tax implications will vary depending on factors such as the length of the earnout and the nature of the assets sold. For example, given that capital losses may only be carried back for three years, it may be prudent to limit the maximum length of the earnout to three years, such that any future loss realized may be carried back and off-set against the gain realized in the year of sale.
The timing of the income inclusion is another factor that a vendor contemplating a reverse earnout should consider. With a classic earnout, the vendor generally would not include the earnout payments in its income until the year in which those amounts become determinable. On the other hand, with a reverse earnout, the vendor will have to include the entire amount in calculating its gain or loss in the year of the sale. Accordingly, while a reverse earnout should allow the vendor to benefit from the one-half inclusion to capital gains (or, the similar type treatment applicable to the sale of goodwill), it may also accelerate the payment of tax compared to a regular earnout. If part of the purchase price is not payable until a later year, the vendor may be entitled to claim a reserve in respect of part of the purchase price, depending on the nature of the assets sold.
The purchaser’s perspective
From the purchaser’s perspective, the most important considerations with respect to earnouts will in most cases be commercial. Typically, a purchaser will prefer a classic earnout as it would prefer not to pay the higher purchase price (albeit subject to future reductions) required under a reverse earnout. For tax purposes, payments made by a purchaser under a classic earnout will increase its cost base in the purchased assets, and payments received by the purchaser under a reverse earnout will typically reduce its cost base in the purchased assets (although this depends on how the payment of the earnout is structured). Normally this should be relatively straightforward, although there are some nuances (particularly, if all or a portion of the original purchase price was paid in the form of a promissory note or some other type of debt obligation) and undesirable tax consequences may arise where the purchaser resells assets before the earnout period expires. In some cases a purchaser may also be precluded from claiming deductions on the full value of the property acquired until the expiry of the earnout period.
The foregoing summary generally deals with the tax consequences of earnouts where the vendor and purchaser are resident in Canada for tax purposes. Where the vendor is a non-resident of Canada, different considerations will apply. A payment made to a non-resident of Canada is subject to Canadian withholding tax where the payment is dependent on the use of or production from property in Canada. Accordingly, in the same way that an earnout may be caught by paragraph 12(1)(g), certain earnouts may be subject to Canadian withholding tax. Where the vendor is a non-resident, the vendor and purchaser should both consider whether any withholding tax obligations apply.