Section 56.4 of the Income Tax Act (Canada) dealing with the taxation of payments for restrictive covenants was finally enacted last month. Changes were first proposed in 2003 after the Courts held that non-compete payments were non-taxable. The proposed rules have been amended several times over the last decade, with the final version becoming law (retroactive to various announcement and amendment dates) on June 26, 2013.
The rules are complex and encompass a very broad spectrum of covenants such as non-competition, non-solicitation and non-disclosure covenants. Generally, payments made as consideration for such covenants are fully taxable, unless an exception applies. Where such payments are made to non-residents of Canada, Canadian withholding taxes may be applicable. Moreover, the Canada Revenue Agency (the “CRA”) has authority to re-allocate a portion of the proceeds of a share or asset sale to the grant of the restrictive covenant to the extent any portion thereof can reasonably be regarded as being consideration for such grant, unless an exception to the re-allocation rule applies. The re-allocated proceeds would then be fully taxable.
In most cases, taxpayers who grant a restrictive covenant will expect payments received to be taxed in the same manner as the proceeds of a sale of shares, goodwill or other property, as the case may be. Therefore, it is important for taxpayers to obtain tax advice regarding the impact of these new rules and the planning required to fit within the desired exceptions. Earlier tax advice obtained by taxpayers may not apply to new transactions, due to amendments to the rules.
In some cases a joint tax election must be filed. Appropriate language should be included in the relevant agreements to require the purchaser to sign the joint tax election. In certain circumstances, a joint tax election will be required to be filed on or before December 23, 2013 for a grant of restrictive covenant in respect of completed transactions if such an election has not already been filed. Where the restrictive covenant was granted on or before October 24, 2012, a joint tax election may not be required in certain circumstances.
Members of the MT National Tax Group are experienced in providing tax advice on the application of these rules in the context of various transactions.