This story begins in 2003, when Canada’s Federal Court of Appeal held in Manrell that payments under non-competition agreements are not taxable to the recipient. Evidently not pleased by that result, the Department of Finance promptly drafted legislation to address the tax treatment of payments under restrictive covenants. As sometimes happens in Ottawa, the amendments made their way through the legislative process at a snail’s pace, going through several iterations over what ended up being an entire decade. But now – as of June 26, 2013, to be precise – the amendments, which take the form of the new Section 56.4 of the Income Tax Act (Canada) (the Act), have finally become law, retroactively to October 7, 2003.
In this post, we consider (i) what constitutes a “restrictive covenant” under s. 56.4, (ii) the “default” inclusion in income rule for payments received for such covenants, (iii) certain exceptions to the inclusion in income rule and (iv) the issues that these new rules are creating, or might in future create, in the context of M&A transactions.
Definition of “restrictive covenant”
The definition of “restrictive covenant” in s. 56.4 as enacted is very broad. Generally, the definition includes any agreement, undertaking or waiver of an advantage or right, whether enforceable or not, that might in any way affect the acquisition or provision of property or services by a taxpayer. While the most common restrictive covenants of this type are found in non-competition or non-solicitation agreements, the definition is broad enough to extend to other types of agreements or covenants, some of which may be outside the scope of what the Department of Finance intended to catch.
Inclusion in income: the default position
The default position under s. 56.4(2), sometimes referred to as the “income inclusion” rule, is that a payment to a taxpayer as consideration for a restrictive covenant must be included in its entirety in the income of that taxpayer, subject to certain exceptions (see below). As well, where certain elections or exceptions are not available, the Canada Revenue Agency (CRA) may have the authority to reassess the taxpayer so as to reallocate amounts to the restrictive covenant, which amounts would consequently (by operation of the income inclusion rule) be included in that taxpayer’s income. For example, the reallocation rule could apply where a transaction includes a restrictive covenant, but the parties to the transaction choose not to allocate any amount to the restrictive covenant (or choose to allocate an amount that the CRA considers unreasonably low).
Inclusion in income: exceptions
There are several exceptions to the “income inclusion” rule, some which necessitate the filing of an election with the CRA and some of which are non-elective but prevent the CRA from reallocating amounts to a restrictive covenant. The most common elections (albeit narrow ones) seen in an M&A context include:
- The asset sale exception – The exception in paragraph 56.4(3)(b) of the Act requires the grantor of the restrictive covenant to have agreed to the covenant in the course of selling a business and its underlying assets. Where a joint election between the buyer and the grantor is made, the amount will be considered an eligible capital amount to the taxpayer and taxed as a disposition of eligible capital property. The buyer should be able to amortize a portion of the outlay incurred as a deduction in computing income from a business. This election assumes that the person granting the restrictive covenant (typically the shareholder) is carrying on the business, which is often not the case.
- Shares and partnership interests – The exception in paragraph 56.4(3)(c) requires that the amount of the restrictive covenant directly relate to the disposition of property that is an “eligible interest” in a partnership or corporation that carries on the business to which the restrictive covenant relates. 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. This definition would not include shares held as part of certain complex corporate structures as the definition only applies where the value of the shares of the upstream corporation is attributable to only one subsidiary corporation, although in certain circumstances it may be possible to implement a pre-closing reorganization of the target in order to fit within the definition. A joint election is required between the buyer and grantor, and certain other factual conditions must be satisfied. If the conditions for this election are met, the grantor must add the amount received on account of the restrictive covenant to its proceeds of disposition from the sale of the shares or partnership interests, such that the amount will be taxed as a capital gain (or loss) to the grantor. Although there is no immediate deduction available for the buyer, the buyer will be entitled to add the amount it pays for the restrictive covenant to its cost basis in the shares or partnership interests, which will reduce the amount of any gain (or increase the loss) on a disposition of the shares or partnership interests in the future.
- Subsection 56.4(7) exception – As discussed above, the CRA has the authority to reallocate a greater portion of the purchase price to the restrictive covenant if it believes that the amount that has been allocated is unreasonable in the circumstances, including where no amount has been allocated to a restrictive covenant. Subsection 56.4(5) generally prohibits the CRA from making a reallocation if certain conditions are met, including where the conditions in s. 56.4(7) are satisfied. The conditions of this rule are quite specific and complex, but generally can be met in most M&A deals, provided that no allocation of the purchase price has been made to the restrictive covenant and the restrictive covenant can be reasonably regarded as having been granted to maintain or preserve the fair market value of the shares, partnership interests or assets disposed of. In most cases, there is no requirement to file a joint election with the CRA. In transactions involving certain related individuals, this exception may not be available where the grantor is not resident in Canada.
Implications for M&A transactions
Although these rules were enacted only in 2013, they are retroactive to the fall of 2003. Knowing that the rules were to be retroactive, Canada’s tax community had been operating, even prior to the enactment, as though the rules – in some form or another –would apply. Because of this, practitioners have already had the opportunity to observe some of the ways in which the rules can affect M&A deals:
- Negotiation between buyer and seller – as mentioned above, a common exception that is relied on in the M&A context is the s. 56.4(7) exception, which is popular partly due to the fact that generally no election has to be filed with the CRA. One of the conditions, however, is that no amount of the purchase price is allocated to the restrictive covenant. In this regard, tension can exist between buyer’s employment counsel (who may want to have an amount allocated to a non-competition covenant in order to support arguments as to enforceability in court) and seller’s tax counsel (who want to ensure that the s. 56.4(7) exception is met so that no election is required to be filed with the CRA). This point is usually heavily negotiated in settling the purchase agreement.
- Non-resident withholding tax – amounts paid or payable to a non-resident person that are subject to s. 56.4 are subject to non-resident withholding tax at the rate of 25% (subject to any applicable tax treaty). Any liability for a failure to properly withhold will fall on the buyer. Accordingly, if a grantor of a restrictive covenant is a non-resident, the buyer will want to be very careful to determine whether any of the exceptions under s. 56.4 apply and to ensure that an election, if required, is filed in the proper form and within the required time.
- Breadth of the definition of “restrictive covenant” - as noted above, the definition of “restrictive covenant” in the Act is extremely broad and not limited to non-competition or non-solicitation agreements. It can include agreements that are neither restrictive nor covenants. There is concern in the legal community about the unpredictability of the types of arrangements to which the CRA will attempt to apply s. 56.4. We have already seen “break fees” or other termination fees attract s. 56.4 treatment, as well as other inducement type fees.
- Valuing the non-compete - Difficult issues remain as to how to value a restrictive covenant, particularly in the context of complex M&A transactions where the restrictive covenant is just one of the many representations and covenants made by a vendor, or in a situation where the enforceability of the restrictive covenant may be dubious. As discussed above, the new rules give the CRA broad authority to reallocate purchase price to a restrictive covenant. It remains to be seen how aggressive the CRA will be in challenging the allocations made by taxpayers.
The final restrictive covenant rules (for now, anyway) are the result of ten years of back-and-forth between the Department of Finance and the tax community, but nonetheless, the rules remain extremely complex and, despite the experience already developed in working with them, a number questions about their application remain to be resolved. A failure to pay close attention to the restrictive covenant rules could have significant consequences for the parties to an M&A transaction, particularly for a vendor who risks transforming what might otherwise be a capital gain (only half of which must be included in income) into ordinary income, or for a purchaser dealing with a non-resident vendor who could be liable for a failure to withhold. Given the complexity and uncertainty surrounding the rules, it is important to get corporate and tax counsel involved at an early stage in the negotiation of an M&A deal involving any sort of agreement that could be characterized as a restrictive covenant as defined in the Act.