CRA illustrates the counting of the 5-year limitation under the cost recovery method for earnouts

One of the conditions set out in IT-426R for application of the cost recovery method (contained in subpara. 2(d)) in relation to an earnout is that:

The earnout feature in the sale agreement must end no later than 5 years after the end of the first taxation year of the corporation (whose shares are sold) in which the shares are sold. For the purposes of this condition, the CRA considers that an earnout feature in a sale agreement ends at the time the last contingent amount may become payable pursuant to the sale agreement.

Suppose that the shares of the target corporation were sold on October 1, 2022 and that the purchaser chose December 31 as the end of the short year commencing immediately before the acquisition of control. CRA indicated that since the shares of the target thus were acquired in the short taxation year ending on December 31, 2022, under the 5-year rule, the earnout feature was required to end no later than December 31, 2027.

Regarding when the last contingent amount is considered to have become payable, CRA indicated that this referred to the time when there arose a clear legal, but not necessarily immediate, obligation to pay that contingent amount. There was no requirement under subpara. 2(d) that the contingent amount in fact be paid within the 5-year period.

Neal Armstrong. Summary of 29 November 2022 CTF Roundtable, Q.11 under s. 12(1)(g).