There are many issues to address in a merger and acquisition transaction. In most purchase and sale transactions the purchaser, after paying the seller consideration to acquire the business, wants to ensure it is protected from the seller competing with the sold business. A common mechanism to provide this protection is a restrictive covenant.
Restrictive covenants are varied and often heavily negotiated. While it is important to ensure the commercial terms and conditions of the restrictive covenant are acceptable to the parties, the tax implications of granting a restrictive covenant should not be overlooked.
What is a restrictive covenant?
For starters, it is important to understand that the Income Tax Act (Canada) (the “Act”) contains an extremely broad definition of a restrictive covenant. Section 56.4 of the Act defines a restrictive covenant as 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.
While a non-compete covenant clearly falls within the scope of the above definition, the definition is broad enough to also include non-solicitation, non-disclosure and numerous other things.
What are the tax implications of granting a restrictive covenant?
The framework of the restrictive covenant rules in the Act are designed to cause one of two results (unless an exception is available). The first result is to include in income all amounts in respect of the restrictive covenant received or receivable in the taxation year by the grantor (or by another non-arm’s length taxpayer). Normally a seller wants to ensure its proceeds received in a purchase and sale transaction are on account of capital.
The second result is to deem part of the amount receivable that can be reasonably regarded as being consideration for the restrictive covenant to be an amount received by the taxpayer in respect of the restrictive covenant.
What are the exceptions?
In order to receive capital treatment on an amount allocated in respect of a restrictive covenant, or to avoid a deeming provision to reallocate proceeds in respect of a restrictive covenant (where no amounts were allocated in the first place) an exception must be met. There are a number of exceptions to either of the above two results that can generally be described as an employee exception, an asset sale exception or a share sale exception. The exceptions are nuanced and should be reviewed carefully to ensure compliance. As well, the exception may only apply to a non-compete covenant.
If there is an election, when is it due?
Finally, even if there is an exception available, there may be a requirement to file a joint election for the exception to apply. The requirement to file the joint election is required for some, but not all of the exceptions. Failure to file the joint election results in the exception not being available.
Note that the election is a joint election, meaning that the seller typically needs the purchaser to cooperate and sign the election. As such, it is important to include a covenant in the definitive agreement to ensure that the purchaser will sign the joint election. The joint election is normally due on or before the filing deadline of the grantor of the restrictive covenant (where the grantor is a resident of Canada) and in all other instances, is due within 6 months from the date the restrictive covenant was granted. While the Act provides that the joint election is to be prepared using a prescribed form, no such prescribed form exists. That said, the Canada Revenue Agency includes on its website the information it suggests taxpayers include when making the election.
If you have any questions regarding restrictive covenants in a merger and acquisition transaction (or otherwise), please contact a member of the Miller Thomson LLP Corporate Tax Group.
