Earnouts in Canadian Business Sales: How to Structure and Protect Yourself
An earnout is a deferred purchase price component tied to the business’s post-closing performance. Buyers use earnouts to bridge valuation gaps when they are uncertain about future results. Sellers accept them sometimes by choice, sometimes by necessity, in exchange for upside if the business performs as projected. The risk for sellers is real: you no longer control the business, yet your payout depends on how the buyer runs it. Worse, if the earnout is structured incorrectly, the payments you receive may be taxed as ordinary income rather than capital gains, costing you significantly more tax and potentially eliminating any LCGE benefit. Getting the structure right before you sign is not optional.
What Is an Earnout?
An earnout is a clause in a Share Purchase Agreement (SPA) or Asset Purchase Agreement (APA) that provides for additional purchase price payments after closing, contingent on the acquired business meeting defined performance targets.
Example (illustrative): A buyer offers $4,000,000 for your business at closing, plus an additional payment of up to $1,000,000 if the business achieves $2,000,000 in EBITDA in the 12 months following closing. If EBITDA hits the target, you receive the full $5,000,000. If EBITDA comes in at $1,500,000, 75% of target you might receive $750,000. If EBITDA falls short of a threshold entirely, the earnout pays nothing.
Earnout periods most commonly run 12 to 36 months post-closing. The metrics, thresholds, and payment formula vary by deal.
Why Buyers Propose Earnouts and Why Sellers Accept Them
From the buyer’s perspective, the earnout solves the valuation uncertainty problem. When a business’s value depends heavily on the seller’s relationships, a key contract that may or may not renew, or projected growth that has not yet materialized, the buyer cannot rationally pay full price at closing. The earnout lets the buyer pay for actual performance rather than a projection.
From the seller’s perspective, the earnout is (in theory) an opportunity to receive full value for the business by proving out the projections the buyer doubted. In practice, sellers accept earnouts because
- The buyer’s base offer without an earnout is lower than the seller’s minimum acceptable price
- The seller genuinely believes the business will perform and wants to capture that upside
- Market conditions or deal timing give the buyer more negotiating leverage
Once closing occurs, the seller no longer controls the business. The buyer makes operating decisions on pricing, staffing, capital expenditure, and accounting policy that directly affect the metrics the earnout is tied to. A seller who signs an earnout without robust protective provisions is betting on the buyer’s goodwill.
The Tax Treatment of Earnouts in Canada: The Most Important Thing Sellers Get Wrong
The tax treatment of earnout payments in Canada is governed primarily by ITA s. 12(1)(g) and ITA s. 40(1)(a)(iii). Getting it wrong can cost a seller hundreds of thousands of dollars.
The ITA s. 12(1)(g) trap
Under ITA s. 12(1)(g), an amount receivable that is contingent on the use of or production from property is treated as income, not as proceeds of disposition of that property. This matters enormously for earnouts structured as business sales.
If an earnout payment is tied to the revenue, profits, or production of the business after closing, which describes the majority of earnout formulas, CRA’s position, supported by the courts,, including in Wages v. MNR, is that those payments are income to the seller under s. 12(1)(g). They are included in income at the seller’s marginal rate, with no 50% capital gains inclusion reduction and no LCGE offset.
On a $1,000,000 earnout payment, the difference between capital gains treatment and income treatment can be $260,000 or more in additional tax before considering the LCGE shelter lost.
CRA’s interpretation of when s. 12(1)(g) applies to earnouts is set out in Interpretation Bulletin IT-462 (Payments Based on Production or Use). The key principle: if the earnout is a payment for the ongoing use of the business’s capacity to generate revenue, it is income. If it is a true price adjustment, an amount that was always part of the consideration for the shares but could not be fixed at closing may be treated as capital proceeds.
The capital gains reserve ITA s. 40(1)(a)(iii)
When a seller disposes of shares but all or part of the proceeds are not due until after the end of the year of disposition, the seller may claim a capital gains reserve under ITA s. 40(1)(a)(iii). The reserve defers the recognition of the capital gain proportionally until the proceeds are received up to a maximum of five years (or ten years for certain sales to children).
The reserve only works if the earnout payments are treated as capital proceeds which requires avoiding the s. 12(1)(g) income trap. If the earnout is income, no reserve is available; the income is recognized when the right to receive it arises or becomes determinable.
How to structure an earnout for capital gains treatment
The critical structural principle is that the earnout must be tied to a genuine price adjustment mechanism, not to a royalty or ongoing production payment.
Practically, this means the earnout should be linked to a balance sheet or value metric at a point in time, such as a confirmed customer retention rate as at a date 12 months post-closing or the achievement of a contracted revenue backlog, rather than to an ongoing stream of revenue or profit. The earnout should also be capped at a fixed maximum tied to the originally contemplated purchase price range so that it resembles a price adjustment rather than a royalty. A defined measurement period with a single payment at the end is preferable to periodic royalty-style installments. Where EBITDA or net income metrics are used, care is required, as these are the most common earnout metrics but also the most vulnerable to s. 12(1)(g) characterization. In those cases, the drafting of the metric definition and the payment structure determines whether the earnout survives as capital or falls into income.
Many Canadian business sale earnouts do not survive scrutiny under s. 12(1)(g) because sellers and sometimes their lawyers focus on the commercial terms without modeling the tax outcome. A Kalfa Law Firm review of an earnout structure before signing includes an explicit analysis of the income-vs-capital characterization risk.
Key Earnout Provisions Sellers Must Negotiate
Beyond the tax structure, the commercial terms of the earnout define how much you will actually receive. These are the provisions that most commonly lead to disputes.
1. The metric definition
The most litigated earnout provision in private M&A is the definition of the metric used to calculate the payment. Common metrics, EBITDA, revenue, and gross profit, sound simple but generate enormous ambiguity when the buyer makes post-closing decisions that affect them. Every one of these moves is commercially defensible. Every one can destroy an EBITDA-based earnout.
Seller protections on metric definition should include several key elements. EBITDA, or the chosen metric, should be defined with a specific formula that references pre-closing accounting policies. Corporate overhead allocations from the parent that were not in place pre-closing should be excluded. The buyer should be required to use accounting policies consistent with those used pre-closing when calculating the metric during the earnout period, and to operate the acquired business as a standalone reporting unit throughout that period.
2. The buyer’s obligation to operate the business
Without express contractual protection, the buyer has no general obligation to maximize the earnout payment. A buyer who wants to conserve cash or integrate the acquired business can make decisions that reduce EBITDA or revenue without breaching any implied duty.
Seller protections on operating obligations should address this directly. A covenant to operate in the ordinary course during the earnout period should prevent the buyer from making major operational changes, large capital expenditures, or changes to key personnel without the seller’s consent. The agreement should include a good faith obligation in calculating and paying the earnout. Ontario courts have found implied duties of good faith in commercial contracts under Bhasin v. Hrynew [2014 SCC 71], but express language is more reliable than implied obligations. The agreement should also contain specific prohibitions on actions that would disproportionately affect the earnout metric, including no new inter-company charges, no changes to sales compensation, and no deferral of customer renewals.
3. Accounting and calculation procedures
Who calculates the earnout, how, and what happens when the parties disagree are questions a well-drafted earnout clause must answer clearly. The clause should specify who prepares the earnout statement, typically the buyer, within a defined timeline after the measurement period ends. It should set out the accounting principles to apply, usually consistent with the pre-closing financial statements or IFRS/GAAP consistently applied. The seller should have the right to review the earnout calculation and the supporting working papers. Finally, the clause should include a dispute resolution mechanism in which an independent accountant, often named or drawn from a pre-agreed list of firms, is given binding authority to resolve disagreements about the calculation.
Without a clear dispute resolution mechanism, earnout disputes go to litigation. Litigation over earnout calculations is expensive, slow, and unpredictable.
4. Acceleration on buyer breach or change of control
What happens to the earnout if the buyer breaches the operating covenants, or if the buyer sells the business to a third party during the earnout period to a buyer with no interest in preserving the earnout metric, are questions sellers must address at the negotiating table. Sellers should negotiate for automatic acceleration of the full maximum earnout amount if the buyer materially breaches its operating covenants. Automatic acceleration should also apply if the buyer sells, transfers, or merges the acquired business during the earnout period without the seller’s consent. Assumption obligations should require any subsequent buyer to take on the earnout obligations on the same terms.
5. Payment mechanics and security
When the earnout is paid and what security the seller has that the buyer will actually pay require careful drafting. Payment should be due within a defined period after the end of the measurement period, with 30 to 60 days being typical after the earnout statement is finalized. Sellers should consider whether the earnout obligation should be secured by a promissory note, a guarantee from the parent entity, or a letter of credit, since unsecured earnout obligations are only as good as the buyer’s creditworthiness at the payment date. If the buyer has outstanding indemnification claims at the time the earnout is payable, the SPA must specify whether the buyer can set off those claims against the earnout, a provision sellers should resist strongly.
Common Mistakes Sellers Make with Earnouts
Agreeing to an earnout without modeling the tax: The difference between income and capital gains treatment on an earnout is often larger than the earnout itself. Model the after-tax outcome of the earnout structure, including the LCGE implications, before agreeing to terms.
Accepting a metric the buyer can control: EBITDA-based earnouts without robust operating covenants are the riskiest structure for sellers. If you must accept EBITDA, insist on tight definitions, accounting consistency provisions, and express restrictions on the buyer’s ability to inflate costs during the earnout period.
Skipping the dispute resolution clause: Without a clear, binding mechanism for resolving earnout calculation disputes, you are one disagreement away from litigation. Insist on an independent accountant provision with binding authority.
Failing to negotiate operating covenants: A buyer’s promise to “run the business well” is not enforceable. Operating covenants must be express, specific, and tied to consequences (acceleration of the full earnout) if breached.
Not addressing a subsequent sale of the business: If the buyer can sell the business during the earnout period and the earnout obligation simply evaporates or is assumed by an unknown third party without recourse, the seller has lost a material protection. Address this explicitly.
Treating the earnout as free money: Earnouts are not a risk-free addition to the base price. They represent real uncertainty performance risk, management risk, measurement risk, and counterparty credit risk. A larger base price with no earnout is often worth more than a lower base price plus an optimistic earnout, particularly where the seller loses operational control.
How Kalfa Law Firm Helps
Kalfa Law Firm advises sellers on earnout structuring and negotiation as part of every sell-side mandate where deferred consideration is involved.
Structure your earnout the right way. Speak with us
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Shira Kalfa, BA, JD, Partner and Founder
Shira Kalfa is the founding partner of Kalfa Law Firm. Shira’s practice is focused in corporate-commercial and private M&A law including corporate reorganizations, corporate restructuring, mergers and acquisitions, commercial financing, secured lending and transactional law.
© Kalfa Law Firm | August 4, 2026
The above provides information of a general nature only. This does not constitute legal or accounting advice. All transactions or circumstances vary, and specified legal advice is required to meet your particular needs. If you have a legal question you should consult with a lawyer.
