On July 16, 2010, the Canadian federal government released further amendments to the draft legislation dealing with payments for non-competition and other restrictive covenants. These proposals continue to be significant for taxpayers who acquire or dispose of businesses.
A Colourful History
In 2004, after the The Queen v. Fortino et al.1 and Manrell v. The Queen2 decisions rendered non-compete payments a tax-free windfall, the Department of Finance released draft legislation under which consideration for a wide range of restrictive covenants would be taxed on a full income basis. Capital gains treatment for certain payments was permitted through a few rather cumbersome exceptions, each with its own set of qualifications.
The draft legislation was amended several times; however, concerns about the scope and complexity of the proposals remained. In 2008, the legislation was included in Bill C-10, which passed the House of Commons but stalled at the Senate Committee on Banking, Trade and Commerce. Bill C-10 died on the order paper when a federal election was called. The legislation has yet to be re-introduced in Parliament.
The Restrictive Covenant Rules, Simplified?
Very broadly, proposed section 56.4 of the Act provides that if a taxpayer, or a person with whom the taxpayer does not deal at arm’s length, grants a restrictive covenant, all amounts receivable in respect of the covenant will be treated as ordinary income of the taxpayer, unless the amounts: (1) would otherwise be taxed as employment income; (2) would otherwise be eligible capital amounts (resulting in taxation similar to capital gains); or (3) are in respect of a non-competition covenant and would be treated as additional proceeds of disposition of certain shares or interests in a partnership which qualify as an “eligible interest”.
The definition of “restrictive covenant” is expansive, including any arrangement, undertaking or waiver of an advantage or right by a taxpayer that affects the acquisition or provision of property or services. Covenants that actually dispose of property (not those merely related to the disposition of property), are excluded.
Proposed amendments to section 68 of the Act will re-allocate amounts that can reasonably be regarded as consideration for a restrictive covenant (i.e., where the parties have not allocated sufficient consideration to the covenant). If an available exception applies, only the actual amount of consideration for the restrictive covenant will be taxable.
Exceptions to the Re-Allocation Rule
Since 2004, exceptions have been added which narrow the application of section 68. These apply only to non-competition covenants, not to other types of restrictive covenants.
Each exception has its own set of requirements. The latest technical amendments contain more changes. The result is far from satisfactory. The complexity of these rules obscures any policy justification behind them and creates traps for the unwary.
Covenant Granted by an Employee
Where an employee agrees not to compete with an arm’s length purchaser, subsection 56.4(6) may relieve the employee from being deemed to receive consideration for his or her covenant. The employee must also deal at arm’s length with the employer and the vendors of the interest in the employer, and the employee cannot receive any proceeds for granting the covenant. Only the vendors can receive any amount which can reasonably be regarded as consideration for the covenant.
This exception will be limited to situations where the employee is prepared to grant the covenant without consideration, perhaps in anticipation of continued employment. The purchaser must take care to ensure that the covenant is legally enforceable. It may be necessary to have the employee execute the non-competition agreement under seal.
Disposition of Goodwill
Subsection 56.4(7) may preclude the re-allocation of amounts to a covenant which is granted to preserve the value of goodwill sold to an arm’s length purchaser. The amount that can reasonably be regarded as being consideration for the covenant must be included in the vendor’s “goodwill amount”, or if the amount is received or receivable by an “eligible corporation” of the vendor, it must be included as a “goodwill amount” in respect of the business to which the covenant relates. No consideration for the covenant can be receivable directly or indirectly by an individual not dealing at arm’s length with the vendor.
The parties must file a joint election to qualify for this exception.
An “eligible corporation” is a taxable Canadian corporation in which the vendor holds, directly o indirectly shares. The requirement in this definition that persons not at arm’s length with the vendor hold less than 10% of the outstanding shares was deleted in the July 16, 2010 amendments. A “goodwill amount” is one which the vendor must include in calculating cumulative eligible capital under subsection 14(5). The result is similar to capital gains treatment for the vendor of goodwill.
No proceeds can be paid to the person granting the covenant. Again, the purchaser will need to satisfy itself as to the enforceability of the covenant.
Disposition of Property
Where a non-competition covenant is integral to a written agreement for the disposition of property to an arm’s length purchaser, the exception in subsection 56.4(8) may apply. The requirements are consistent with those for the sale of goodwill, but no election is required under subsection 56.4(8).
For non-share dispositions, the consideration must be received by the covenant grantor. As a result, subsection 56.4(8) has limited application to asset sales because the covenant will usually be granted by a taxpayer other than the vendor of assets. This exception may be more useful for arm’s-length share sales, because the covenant grantor need not be the same as the taxpayer who disposes of shares.
The July 16, 2010 amendments contained a significant change to subsection 56.4(8) on a sale of shares. Amended subsection 56.4(8) provides that no proceeds can be receivable by the person for granting the covenant. This was previously a requirement for asset sales; however, it was less troublesome because proceeds are typically paid to a corporation but the covenant is granted by the owner.
The new condition gives rise to a valuation predicament where the parties to the transaction decide to allocate any amount to the covenant. In these circumstances, subsection 56.4(8) will not apply. If the parties’ assessment is wrong and a different amount is subsequently determined to be reasonable consideration for the covenant, the vendor will be deemed to have received that amount pursuant to section 68. It may be preferable, then, for the parties not to allocate any amount to the covenant if they are confident that subsection 56.4(8) would otherwise apply.
Share Sale to a Related Party
Subsection 56.4(8.1) offers some relief in the family business succession context, by permitting the sale of shares to a non-arm’s length purchaser. Specifically, shares can be sold to an individual who is over 18 and related to the grantor of the covenant (an “eligible person”) or to a corporation owned by an eligible person.
In addition to the requirements under subsection 56.4(8), the grantor must be resident in Canada at the time the covenant is granted, and the grantor must not retain any interest whatsoever in the target corporation or the purchasing corporation after the sale. This would preclude a succession plan involving preferred shares with the intention that the retiring family member will redeem the shares over time.
Subsection 56.4(8.1) requires that the covenant be granted to an individual, not a corporation. One hopes that this is a drafting oversight as there would not appear to be a policy reason to require that the covenant be granted to the individual owner, rather than the ultimate purchaser of shares.
Further Relief - Capital Gain Election
Each of subsections 56.4(7), (8) and (8.1) requires that no portion of the consideration that can reasonably be regarded as being consideration for the covenant, be received or receivable by a non-arm’s length individual in respect of the vendor.
Where all of the other requirements of the relevant exception are met, but a non-arm’s length individual receives consideration for the covenant, subsection 56.4(9) provides that only the consideration received by the non-arm’s length person (the “allocable portion”) will be subject to re-allocation. A joint election to tax the allocable portion in the vendor’s hands as a goodwill amount, or as additional proceeds of disposition, as the case may be, is required.
Consideration received by certain corporations, partnerships or trusts will be deemed to be received as agent of the vendor, if it is actually paid to the vendor within 180 days. The agency characterization offers relief where consideration for a non-competition covenant would otherwise be “trapped” within a non-arm’s length entity, triggering additional tax upon distribution to the vendor.
Although they do not yet have the force of law, these proposals have a significant impact on how we structure business transactions. Continued efforts to fine-tune the rules have increased their complexity without narrowing the scope of the proposed legislation, or reducing the compliance burden on taxpayers in a meaningful way.
Taxpayers and their advisors must continue to negotiate and document business transactions with the expectation that the draft legislation will someday be enacted, retroactive to the relevant announcement dates.