The Basic Restrictive Covenant Rule (s.56.4(2)) a “vendor” taxpayer (or another taxpayer with whom the taxpayer does not deal at arm’s length) must include in income the full amount of all amounts received or receivable in a taxation year in respect of a restrictive covenant (“RC”) granted by him or her provided that if certain conditions apply, the amount received or receivable can be characterized as a capital gain or a gain arising from cumulative eligible capital, only half of which is included in income. The legislation defines the “vendor” as the person granting the RC and the “purchaser” as the person receiving the RC.
The definition of an RC is extremely broad and will apply to most, if not all, forms of agreement not to compete. An RC is partially defined in s. 56.4(1) as:
“…an agreement entered into, an undertaking made, or a waiver of an advantage or right by the taxpayer…that affects, or is intended to affect, in any way whatever, the acquisition or provision of property or services by the taxpayer…”
Note the following observations by the author:
- An RC may apply to lending agreements or non-solicitation agreements
- An RC does not have to be enforceable
- S. 56.4(3) provides three exception to the income inclusion
- S. 56.4(4) provides rules applicable to amounts paid or payable by a purchaser in respect of an RC
The S. 56.4(3) Exceptions
S. 56.4(3) provides three exceptions to the income inclusion rules in ss. 56.4(2) for amounts received or receivable in respect of an RC granted by a taxpayer to a person with whom the taxpayer deals at arm’s length as follows:
(1) s. 56.4(3)(a)—the amount is required to be included in the taxpayer’s income (or would have been required to be included in income if it had been received in the taxation year) as income from employment (that is, the full amount of the payment is included in income under s. 5 or 6);
(2) s. 56.4(3)(b)—the amount is an eligible capital amount in respect of the business to which the RC relates; or
(3) s. 56.4(3)(c)—the amount directly relates to the disposition of property that is an “eligible interest” in the partnership or corporation that carries on the business to which the RC relates. i.e. – if the payment relates to a sale of shares or a partnership unit that gives rise to a capital gain, then the payment is more in the nature of a capital amount than an income amount and is treated as such.
An election in prescribed form is required by the taxpayer (or jointly between the taxpayer and the purchaser if the purchaser carries on business in Canada) for the exception in ss. 56.4(3)(b) and (c) to apply.
For a Purchaser:
1. Where the amount is treated as employment income of an employee of the purchaser, the purchaser will treat the amount paid or payable as wages paid to the employee.
2. If an election has been made pursuant to s. 56.4(3)(b), the amount subject to the election is considered to be an outlay incurred by the purchaser on account of capital for the purpose of applying the definition “eligible capital expenditure” in ss. 14(5). In these circumstances, the purchaser should be able to amortize a portion of the outlay incurred as a deduction in computing income from a business.
3. If an election has been made pursuant to s. 56.4(3)(c), the amount subject to the election is included in computing the cost to the purchaser of an eligible interest acquired by the purchaser. While no immediate deduction is available in these circumstances, the purchaser will be able to deduct the outlay if there is a disposition of the eligible interest in the future.
Other than above, the proposed provisions are silent as to the income tax treatment to the purchaser of amounts paid or payable in respect of an RC. As such, where the above provisions are not applicable, the purchaser will need to apply general income tax principles in determining the appropriate income tax treatment.
Proposed s. 212(1)(i) imposes a 25% withholding tax obligation in respect of amounts paid or payable to a non-resident person that are subject to subsection 56.4(2), subject to Treaty reduction.
Where a joint election pursuant to s. 56.4(3)(b) or (c) is made, the vendor is deemed to have disposed of cumulative eligible capital or an eligible interest in a partnership or shares of a corporation. Where the vendor is a non-resident person, the purchaser should ensure that the compliance requirements contained in s. 116(3) in respect of “taxable Canadian property” are addressed to avoid the 25% withholding tax requirement.
The Big Out – S. 56.4(3)(c):
The election available under paragraph 56.4(3)(c) will likely be the most important exception from the full income inclusion requirement of s. 56.4(2). Paragraph 56.4(3)(c) applies only if all of the following conditions are met:
(1) the disposition of the eligible interest is to a purchaser or to a person related to the purchaser;
(2) the amount in issue is consideration for an undertaking by the taxpayer not to compete (note that not all RCs will be an undertaking not to compete, and therefore, not all RC payments can qualify for this election, even if they are paid in connection with the sale of an eligible interest);
(3) the RC can reasonably be considered to have been granted to preserve the value of the eligible interest disposed of to the purchaser;
(4) if the covenant not to compete is granted after July 17, 2005, ss. 84(3) does not apply to the transaction;
(5) the amount received or receivable is added to the particular taxpayer’s proceeds of disposition in respect of the eligible interest; and
(6) the taxpayer and the purchaser make a joint election in prescribed form.
An “eligible interest” is a capital property of a taxpayer that is an interest in a partnership that carries on a business, shares in the capital stock of a corporation that carries on a business, or shares of a corporation 90% or more of the fair market value of which is attributable to eligible interests in one other corporation.
For a whole lot more on these complex rules, please see the excellent articles by mark Woltersdorf. In his recent two-part series (published in CCH Tax Topics) entitled “Restrictive Covenants – The Final Chapter (For Now), Mark Woltersdorf of Fraser Milner Casgrain LLP sets out his analysis of what would appear to be the final chapter in what can only be described as a completely botched tax policy first introduced by the Department of Finance some 10 years ago. This overreaching response was offered in response to the 2000 Fortino and 2003 Manrell FCA decisions and the underlying aggressive tax planning. Yes, the taxpayers and their advisors were somewhat greedy in attempting to divert taxable proceeds of disposition into tax-free windfalls. However the response by the Department of Finance can at best be described as over-the-top and unnecessarily complex. What should have been a simple fix has now turned into a myriad of incomprehensible, complex rules that puts ordinary taxpayers at risk of non-compliance.
Indeed it took this tax lawyer 10 pages of detailed commentary to try to describe the effect of these rules. For all the gory details see both articles which are published on the FMC-Law website at the following links – RCs Part I and RCs Part II. For those keeners looking for the actual legislation please refer to the Technical Tax Amendments Act (2012) now contained in Bill C – 48. The 2012 version of the rules was first released in the October 24, 2012 Notice of Ways and Means motion.
Tags: Article; Individual Tax Planning; William (Bill) H. Cooper