Earnouts and payments to nonresidents of Canada
A common issue that arises on the purchase and sale of a business is having the parties agree on the purchase price to be paid for property being acquired/sold (whether assets or shares or some combination of both). While the purchase price might be a fixed amount paid on closing, more often than not a contingent element is involved. This is largely due to both parties trying to bridge a perceived valuation gap in respect of the underlying business. There are many different types of contingent consideration, but one of the more common forms is an “earnout”. The following will briefly summarize some of the considerations associated with an earnout arrangement, including the tax treatment of earnouts, and in particular, earnouts in the context of vendors who are nonresidents of Canada.
An earnout arrangement is generally structured in two different ways: a “traditional earnout” or a “reverse earnout”. In a traditional earnout, a purchaser funds a defined portion of the purchase price on closing and agrees to pay the balance on condition that certain financial metrics are satisfied within an agreed upon timeframe. This serves as a way for the parties to agree on a purchase price in a case where the value of the business is unknown or difficult to ascertain at the time of the transaction. It also benefits a purchaser as it ensures that the vendors remain motivated to ensure the success of the business post-closing so that they can “earn-out” the rest of their purchase consideration.
In a reverse earnout, the purchaser chooses to pay the full purchase price to the vendors on closing, with the vendors agreeing to return a portion of the purchase price if certain financial metrics are not satisfied within a given period of time post-closing .
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Source: RSM Canada LLP
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