Non-competition agreements and other forms of restrictive covenants are common features of employment contracts, as well as a wide variety of other types of commercial transactions. In exchange for monetary consideration, restrictive covenants are used to ensure that a former employee or vendor of a business does not improperly solicit or compete in the same business and territory for a certain period of time with his former employer or purchaser of the business.
With the enactment of Bill C-48 on June 26, 2013, section 56.4 of the Income Tax Act (Canada) (the "Act") is now in force. The recent (albeit long-awaited) enactment of section 56.4 of the Act will have a considerable impact on the manner in which payments for restrictive covenants are treated for taxation purposes. It is also significant for a number of other reasons, including the retroactive effect of the provisions.
The first draft of section 56.4 of the Act was released by the Department of Finance in February of 2004. The new provision was largely introduced in response to two decisions of the Federal Court of Appeal, which had held that certain amounts paid to shareholders in connection with the sale of their companies' shares, as consideration for non-competition agreements, were not subject to income tax (which inevitably led to an increase in share sale transactions containing a non-compete component). Over the course of the next nine years, a number of revisions were made to the proposed draft legislation in response to concerns raised by taxpayers and their advisors. However, the scope of the version of section 56.4 of the Act that was finally enacted by Parliament continues to extend well beyond non-competition payments made to a vendor of corporate shares. Rather, the newly enacted provision applies to a wide range of restrictive covenants, whether granted in the course of carrying on a business, or employment, or in the context of a sale of assets or shares of a company. Furthermore, new section 56.4 generally applies retroactively to amounts received or receivable after October 7, 2003, subject to certain limited exceptions.
The new rules encapsulated in section 56.4 are lengthy and complex. Below is a summary of certain key features of new section 56.4:
- by default, most payments received by a taxpayer in consideration for the taxpayer making a "restrictive covenant" must now be fully included in the income of the taxpayer for the purposes of the Act, subject to certain limited exceptions;
- a "restrictive covenant" is broadly defined to include more than just conventional non-compete agreements; non-solicitation and non-disclosure covenants are also captured by the applicable definition of a "restrictive covenant";
- certain payments made in respect of a "restrictive covenant" to a non-resident may now be subject to non-resident withholding taxes;
- in certain circumstances, the Canada Revenue Agency may seek to reassess a taxpayer on the basis that the portion of the purchase price of shares or business assets that may reasonably be regarded as being paid for the granting of a restrictive covenant represents consideration for the restrictive covenant. As such, any such proceeds would potentially be fully taxable; and
- certain elective relief from the newly enacted restrictive covenant provisions may be available in respect of certain restrictive covenants granted before November 9, 2006. To secure such relief, affected taxpayers must file a qualifying election by December 23, 2013.
Taxpayers that have previously granted restrictive covenants should carefully examine the transitional rules that apply to new section 56.4 of the Act without delay to assess the impact of the new rules, and the availability of transitional relief, in light of their own circumstances.
Without proper advice and good tax planning, employers, purchasers and vendors could find themselves on the wrong side of these new rules. As a consequence, caution should be exercised when assessing the tax treatment of, and quantifying the payment to be made for, restrictive covenants.
Co-authored by Amanda Vanderlee, student at law.