Capital Gains Reserve

A seller who accepts part of the price over time can face tax on the whole gain before the cash arrives. The capital gains reserve answers that problem. Under subparagraph 40(1)(a)(iii) of the Income Tax Act, a taxpayer may deduct a reasonable reserve for the part of the gain that relates to proceeds payable after the end of the year, then bring it back into income as the years pass.

The reserve is most common in business sales that use vendor financing, where the buyer pays a deposit and the rest under a promissory note to the seller. It also applies to a vendor take-back mortgage on commercial real estate, and to any other capital property sold for deferred payments. Whether a holdback or escrow amount counts as payable later depends on its terms.

It is a deferral, not an exemption. The full gain is still taxed, at the one-half inclusion rate, but later. Interest on the note is separate: it is taxed as ordinary income under the usual rules and is not covered by the reserve. Individuals report the reserve on Form T2017, Summary of Reserves on Dispositions of Capital Property, every year a reserve is claimed or brought back in; a corporation claims it in its own corporate return.

Each year, the reserve is the lesser of two amounts:

1. A reasonable amount for the proceeds not yet payable. Form T2017 calculates it as the gain multiplied by the amount payable after the end of the year, divided by the total proceeds of disposition.
2. A statutory cap: one-fifth of the gain, multiplied by four minus the number of earlier taxation years that ended after the sale.

The cap is what makes it a five-year reserve:

The mechanics repeat annually. Last year's reserve comes back into income as a capital gain, and a new reserve is deducted if payments are still outstanding. The reserve is optional: a seller can claim less than the maximum, but cannot later claim more for that property than was claimed the year before. When a note runs longer than four years after the year of sale, the cap overtakes the cash, and the seller pays tax on the gain before the last instalments arrive. Lamba Law's free seller financing calculator helps model the payment side of that schedule.

Subsection 40(2) of the Income Tax Act denies the reserve in a given year when:

• The seller was not resident in Canada, or was exempt from tax, at the end of the year or at any time in the following year.
• The buyer is a corporation that, immediately after the sale, is controlled directly or indirectly by the seller or by the person or group that controls the seller, or, where the seller is a corporation, that controls the seller.
• The buyer is a partnership in which the seller is, immediately after the sale, a majority-interest partner.

The second rule matters in reorganizations: a sale to your own holding company for a note does not qualify.

The period stretches to 10 years, with at least one-tenth of the gain reported each year, for certain transfers that keep a business going. These include transfers to a child resident in Canada of qualified small business corporation shares or family farm or fishing property, some intergenerational business transfers, qualifying business transfers to an employee ownership trust, and qualifying conversions to a worker cooperative. Each has its own conditions.

The two can work together. According to the CRA's capital gains guide, a gain brought back into income from a reserve qualifies for the lifetime capital gains exemption only if the original gain came from property eligible for the deduction, so the shares must have qualified when they were sold. The CRA also bases the deduction limit on the year the property was disposed of, not the year the reserve is brought back in.

The exemption can only shelter gains actually reported, so sequencing matters. Because the reserve is optional, a seller of qualifying shares can claim a smaller reserve in the year of sale, report enough gain to use the available exemption, and defer only the remainder. The calculation also has to account for alternative minimum tax and any cumulative net investment loss, which is why the reserve and the exemption are usually modelled together before the vendor note terms are fixed.

The reserve is built for a fixed price paid over time, where the amount still owed is known each year-end. An earn-out is different: part of the price depends on future results, so the amount is unknown at closing and there is no fixed unpaid balance to measure a reserve against. Left to the general rules, contingent payments could be taxed as income under paragraph 12(1)(g), or the seller could be taxed at closing on the estimated value of the right to receive them.

For share sales, the CRA's archived bulletin IT-426R offers an administrative alternative in place of a reserve: the cost recovery method. Earn-out payments first reduce the seller's cost base in the shares and become capital gains only once that cost is recovered, as each amount becomes determinable. The CRA accepts the method only under strict conditions, including arm's-length dealing and an earn-out that ends within five years after the end of the corporation's taxation year in which the shares were sold. The earn-out entry sets out the full list.

Many deals combine a fixed vendor note with an earn-out. The note can support a reserve and the earn-out generally cannot, so the two are modelled separately. Bulletins are not law, and an earn-out on an asset sale needs separate analysis, so earn-out wording should be settled with tax advice before signing.

Meera Kapoor sells all the shares of her Mississauga commercial signage company to Liam Doucette in June 2026 for $1,500,000. Her adjusted cost base is $300,000, so her capital gain is $1,200,000. The company holds a large investment portfolio, so the shares are not QSBC shares and the exemption is not available. Liam pays $500,000 at closing and signs a $1,000,000 vendor note, repayable $100,000 a year from June 2027 with interest.

At the end of 2026, $1,000,000 of the $1,500,000 price is unpaid, so the reasonable reserve is $800,000; the cap is four-fifths of the gain, $960,000. Meera claims $800,000 on Form T2017 and reports a $400,000 gain, $200,000 of it taxable.

In 2027, the reasonable reserve and the cap are both $720,000, so she reports $80,000. From 2028 the cap controls: the reserve falls to $480,000, then $240,000, then nil, and she reports $240,000 of gain in each of 2028, 2029 and 2030. By the end of 2030 her whole gain has been taxed, although $600,000 of the note is still owed. She planned for that at closing: she set aside part of each payment for tax and protected the balance with a pledge of the shares she sold and a guarantee from the company, backed by a general security agreement over its assets.