The Restrictive Covenant Taxation Scheme: Killing a Fly with a Sledgehammer

November 28, 2013

This posting was authored by Stephen Rukavina
an Associate in the Vancouver Office of Miller Thomson LLP

The Federal Court of Appeal’s decisions in Canada v. Fortino and Manrell v. Canada held that payments for a non-competition agreement were not taxable.  After those decisions, one could expect that taxpayers would allocate greater and greater amounts of the purchase price from sales to related non-competition and similar agreements in the hopes of avoiding any taxation on such amounts.  For obvious reasons, the federal government wanted to close this loophole.

Unfortunately, the federal government has decided to kill a fly with a sledgehammer.  The Fortino and Manrell decisions created a problem that could have been solved with some simple legislative amendments.  Instead, the federal government has enacted an entire restrictive covenant taxation scheme.  The new scheme is complex, confusing, and overly broad.  From now on, taxpayers and their legal counsel will need to carefully consider the tax implications of non-competition and similar agreements that relate to the acquisition or provision of property or services.

Restrictive Covenants

The new scheme applies to a “restrictive covenant” which is defined, in part, as follows:

… an agreement entered into, an undertaking made, or a waiver of an advantage or right by the taxpayer, whether legally enforceable or not, that affects, or is intended to affect, in any way whatever, the acquisition or provision of property or services by the taxpayer or by another taxpayer that does not deal at arm’s length with the taxpayer … .

This definition is very broad.  It could apply to a non-competition agreement, non-solicitation agreement, confidentiality agreement, services agreement, and many other types of agreements.  The restrictive covenant does not even have to be given by the person acquiring or providing the property or services, as long as it is given by a non-arm’s length taxpayer:  e.g., an owner-manager giving a non-competition agreement that relates to his or her corporation’s sale of assets.

Excluded from the definition of restrictive covenant is an agreement or undertaking “that disposes of the taxpayer’s property”.  The most reasonable interpretation of this exclusion is that it applies to a specific provision to dispose of property rather than an entire share purchase agreement or asset purchase agreement.

Default Rule:  Income Inclusion

The following applies to a taxpayer who grants a restrictive covenant (“Grantor”).  The Grantor must include in the Grantor’s income for a taxation year all amounts in respect of the restrictive covenant that are received or receivable in the taxation year by the Grantor or by another non-arm’s length taxpayer (“Default Rule”).

There is potential for double taxation of the same amount since the Grantor may be deemed to receive amounts that are actually received by non-arm’s length taxpayers.  Fortunately, there is a relieving provision that deems the non-arm’s length taxpayers to have not received the amounts included in the Grantor’s income.

Exceptions to the Default Rule

The Grantor will not have an income inclusion under the Default Rule if one of the following three exceptions apply.

  Employment Income Exception

In order for the Employment Income Exception to apply, the Grantor must grant the restrictive covenant to an arm’s length taxpayer, and the amounts paid must be included in the Grantor’s income as employment income.  The Grantor will have to pay tax on the amounts as employment income and will be able claim any available employment deductions.  The person paying the amounts must withhold and remit payroll taxes.

  Eligible Capital Exception

The Eligible Capital Exception may apply when amounts received for a restrictive covenant are on account of eligible capital (e.g., goodwill).  For example, the restrictive covenant may be necessary to ensure long-term customers continue to contract with the business purchased or that the business purchased maintains its positive reputation.  The amounts received are taxed as eligible capital when this exception applies.

The following three requirements must be satisfied in order for the Eligible Capital Exception to apply.  First, the Grantor must grant the restrictive covenant to an arm’s length person.  Second, the amounts paid must be on account of eligible capital in respect of the business carried on or formerly carried on by the Grantor and to which the restrictive covenant relates.  Third, an election in prescribed form and a copy of the restrictive covenant must be filed.

This exception is targeted at a sole proprietor or corporation making an asset sale, and the sole proprietor or corporation gives a restrictive covenant.  The exception will not apply when an owner-manager shareholder gives a restrictive covenant that relates to his or her corporation’s asset sale because, in those circumstances, the second requirement noted above is not satisfied.

  Share / Partnership Interest Exception

The Share / Partnership Interest Exception may apply in the context of a sale of shares or a partnership interest.  However, the requirements that must be satisfied in order for the exception to apply severely narrow its scope.  When the exception applies, amounts received are taxed as proceeds of disposition, i.e., on capital account.

The following requirements must be satisfied in order for the Share / Partnership Interest Exception to apply:

  • The Grantor must grant the restrictive covenant to an arm’s length person;
  • The amount paid must directly relate  to the Grantor’s disposition of a capital property that is
    • a share of a corporation that carries on business to which the restrictive covenant relates,
    • a share of a corporation 90% or more of the fair market value of which is attributable to one other corporation which carries on business to which the restrictive covenant relates, or
    • a partnership interest in a partnership that carriers on business to which the restrictive covenant relates;
  • The disposition is to the person to whom the restrictive covenant is granted (“Grantee”) or to a person related to that person;
  • The amount paid is consideration for an undertaking by the Grantor not to provide, directly or indirectly, property or services in competition with the property or services provided or to be provided by the Grantee or by a person related to the Grantee (i.e., a non-competition agreement);
  • The restrictive covenant may reasonably be considered to have been granted to maintain or preserve the value of the interest disposed of by the Grantor;
  • Subsection 84(3) of the Income Tax Act does not apply to the disposition (i.e., a corporation does not redeem, acquire, or cancel its shares);
  • The amount is taxed as a non-eligible capital receipt of the Grantor; and
  • An election in prescribed form and a copy of the restrictive covenant must be filed.

Note, there is an anti-avoidance rule that prevents this section from applying if the amount would otherwise be included in the Grantor’s income as business or property income or office or employment income.

Reallocation Rule

A taxpayer might wish to allocate no value to a restrictive covenant or only a nominal value in hopes of not having to deal with the Default Rule and the complex exceptions.  Unfortunately, the restrictive covenant taxation scheme does not allow for such a simple solution.

Under the scheme, the following rule applies if an amount received or receivable from a person can reasonably be regarded as being in part the consideration for a restrictive covenant granted by a taxpayer.  The part of the amount that can reasonably be regarded as being consideration for the restrictive covenant is deemed to be an amount received or receivable by the taxpayer in respect of the restrictive covenant, and that part is deemed to be an amount paid or payable to the taxpayer by the person to whom the restrictive covenant was granted (“Reallocation Rule”).  In other words, the portion of a purchase price that can reasonably be regarded as paid for a restrictive covenant is deemed to be received by the Grantor of the restrictive covenant regardless of who actually received the amount or paid the amount.

The portion deemed to be paid to the Grantor is subject to the Default Rule and will be treated as income of the Grantor unless one of the above noted exceptions applies.

Exceptions to the Reallocation Rule

There are several exceptions to the Reallocation Rule.  If an exception applies, the Canada Revenue Agency cannot use the Reallocation Rule to reallocate a portion of the purchase price to the restrictive covenant.

  Employee Exception

The Employee Exception basically applies to arm’s length employees who receive no compensation for a non-competition agreement.  In order for the Employee Exception to apply, the following requirements must be satisfied:

  • An individual grants a restrictive covenant to an arm’s length person (for the purposes of this exception the “Purchaser”);
  • The restrictive covenant directly relates to the acquisition from one or more other persons (“Vendors”) by the Purchaser of an interest in the individual’s employer, in a corporation related to that employer, or in a business carried on by that employer;
  • The individual deals at arm’s length with the employer and the Vendors;
  • The restrictive covenant is an undertaking by the individual not to provide, directly or indirectly, property or services in competition with the property or services provided by the Purchaser or by a person related to the Purchaser in the course of carrying on the business to which the restrictive covenant relates (i.e., a non-competition agreement);
  • No proceeds are received or receivable by the individual for granting the restrictive covenant; and
  • The amount that can reasonably be regarded to be consideration for the restrictive covenant is received or receivable only by the Vendors.

The amount mentioned directly above is to be added in computing the amount received or receivable by the Vendors as consideration for the disposition of the interest in the individual’s employer.

  Goodwill Exception

The Goodwill Exception basically applies to asset sales that include goodwill and where no proceeds are allocated to a non-competition agreement granted by a sole proprietor selling his or her assets, a corporation selling its assets, or a shareholder of a corporation that is selling its assets.  In order for the Goodwill Exception to apply, the following requirements must be satisfied:

  • The restrictive covenant is granted by a taxpayer (for the purposes of this exception the “Vendor”) to a person with whom the Vendor deals with at arm’s length at the time the restrictive covenant is granted (for the purposes of this exception the “Purchaser”);
  • The restrictive covenant is an undertaking of the Vendor not to provide, directly or indirectly, property or services in competition with the property or services provided by the Purchaser or by a person related to the Purchaser in the course of carrying out the business to which the restrictive covenant relates (i.e., a non-competition agreement);
  • The amount that can reasonably be regarded as being consideration for the restrictive covenant is
    • included by the Vendor in computing a goodwill amount of the Vendor (e.g., where the Vendor is a sole proprietor selling his or her business), or
    • received or receivable by a corporation that was an “Eligible Corporation” (defined below) of the Vendor when the restrictive covenant was granted and included by the corporation in computing a goodwill amount of the corporation in respect of the business to which the restrictive covenant relates (e.g., where the Vendor is the owner-manager of a corporation that is selling its assets);
  • No proceeds are received or receivable by the Vendor for granting the restrictive covenant;
  • The restrictive covenant can reasonably be regarded to have been granted to maintain or preserve the fair market value of the benefit of the expenditure derived from the goodwill amount; and
  • An election in prescribed form and a copy of the restrictive covenant are filed.

An “Eligible Corporation” of a taxpayer is a taxable Canadian corporation of which the taxpayer holds, directly or indirectly, shares of the capital stock.

The Goodwill Exception may also apply if the Vendor grants the restrictive covenant to an individual related to the Vendor and who is at least 18 years old (“Eligible Individual”).  In other words, the exception can still apply in some instances when the arm’s length requirement is not met.  However, two additional requirements must be satisfied.  First, the Vendor must be a resident of Canada at the time of the grant of the restrictive covenant.  Second, the Vendor cannot, at any time after the grant of the restrictive covenant, have an interest in the Eligible Corporation of the Eligible Individual.

Note, there is an anti-avoidance rule that prevents this exception from applying if one of the results of not applying the Reallocation Rule would be that the Employment Income Exception would not apply to consideration that would, if the restrictive covenant regime did not apply, be included in computing a taxpayer’s income from a source that is an office or employment or a business or property.  This anti-avoidance rule also applies to the two other exceptions discussed below.

  Share Sale Exception

The Share Sale Exception basically applies to a share sale where the vendor of the shares receives no compensation for a non-competition agreement.  In order for the Share Sale Exception to apply, the following requirements must be satisfied:

  • The restrictive covenant is granted by a taxpayer (for the purposes of this exception the “Vendor”) to a person with whom the Vendor deals with at arm’s length at the time the restrictive covenant is granted (for the purposes of this exception the “Purchaser”);
  • The restrictive covenant is an undertaking of the Vendor not to provide, directly or indirectly, property or services in competition with the property or services provided by the Purchaser or by a person related to the Purchaser in the course of carrying out the business to which the restrictive covenant relates (i.e., a non-competition agreement);
  • It is reasonable to conclude that the restrictive covenant is integral to an agreement in writing under which shares of the capital stock of a corporation (“Target Corporation”) are disposed of to the Purchaser  or to another person that is related to the Purchaser and with whom the Vendor deals at arm’s length;
  • No proceeds are received or receivable by the Vendor for granting the restrictive covenant;
  • Subsection 84(3) of the Income Tax Act does not apply to the disposition (i.e., the Target Corporation does not redeem, acquire, or cancel its shares); and
  • The restrictive covenant can reasonably be regarded to have been granted to maintain or preserve the fair market value of the shares disposed of.

The Share Sale Exception can apply even if the Vendor grants the restrictive covenant to an Eligible Individual, i.e., certain non-arm’s length individuals.  However, two additional requirements must be satisfied.  First, the Vendor must be a resident of Canada at the time of the grant of the restrictive covenant and the disposition of the shares.  Second, the Vendor cannot, at any time after the grant of the restrictive covenant, have any interest in the Target Corporation or the Eligible Corporation of the Eligible Individual.

The amount that can reasonably be regarded as being in part consideration received or receivable for a restrictive covenant is to be added in computing the consideration that is received or receivable by each taxpayer who disposes of shares of the Target Corporation to the extent of the portion of the consideration that is received or receivable by that taxpayer.

  Property Other Than Goodwill or Shares Exception

This exception basically applies to asset sales that do not include goodwill and where no proceeds are allocated to a non-competition agreement granted by a sole proprietor selling his or her assets, a corporation selling its assets, or a shareholder of a corporation that is selling its assets.  In order for the Property Other Than Goodwill or Shares Exception to apply, the following requirements must be satisfied:

  • The restrictive covenant is granted by a taxpayer (for the purposes of this exception the “Vendor”) to a person with whom the Vendor deals with at arm’s length at the time the restrictive covenant is granted (for the purposes of this exception the “Purchaser”);
  • The restrictive covenant is an undertaking of the Vendor not to provide, directly or indirectly, property or services in competition with the property or services provided by the Purchaser or by a person related to the Purchaser in the course of carrying out the business to which the restrictive covenant relates (i.e., a non-competition agreement);
  • It is reasonable to conclude that the restrictive covenant is integral to an agreement in writing under which the Vendor or the Vendor’s Eligible Corporation disposes of property other than shares to the Purchaser, or the Purchaser’s Eligible Corporation, for consideration that is received or receivable by the Vendor, or the Vendor’s Eligible Corporation;
  • No proceeds are received or receivable by the Vendor for granting the restrictive covenant;
  • The restrictive covenant can reasonably be regarded to have been granted to maintain or preserve the fair market value of the property disposed of;
  • The consideration that can reasonably be regarded as being in part the consideration for the restrictive covenant is received or receivable by the Vendor or the Vendor’s Eligible Corporation  as consideration for the disposition of the property; and
  • The consideration cannot reasonably be regarded as being for a goodwill amount.

This exception can apply even if the Vendor grants the restrictive covenant to an Eligible Individual, i.e., certain non-arm’s length individuals.  However, two additional requirements must be satisfied.  First, the Vendor must be a resident of Canada at the time of the grant of the restrictive covenant and the disposition of the property.  Second, the Vendor cannot, at any time after the grant of the restrictive covenant, have an interest in the Eligible Corporation of the Eligible Individual.

Non-Residents

Amounts that would, if a non-resident Grantor had been resident in Canada throughout the taxation year in which the amount was received or receivable, be required to be included in computing the non-resident Grantor’s income under the Default Rule are subject to a 25% withholding tax.  Withholding tax also applies to amounts received on a restrictive covenant related debt that has been written off as bad debt.  Canada’s tax treaties may provide a reduction in the amount of withholding tax.

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