Restrictive Covenants 

Tax Strategy

Restrictive Covenants

FROM: SEP-OCT 2005 ISSUE | BY MANU KAKKAR

Restrictive covenants, such as non-competition agreements ("non-competes"), are very common in various commercial transactions and arrangements. For example, in purchase and sale transactions involving either assets, shares, or a combination of the above, non-competes are frequently used to ensure that the vendor (or the key shareholder/employee of the corporate vendor) does not compete with the purchaser in the same line of business in a certain territory for a prescribed period of time, in exchange for monetary consideration.

The Federal Court of Appeal's 1999 decision in Fortino v. the Queen [97 D.T.C. 55 (TCC) affirmed by 2000 D.T.C. 6060 (FCA)] stated that non-compete receipts were not income from a productive source pursuant to section 3 of the Income Tax Act (the Act) and thus escaped the taxation net. However, there was uncertainty in the tax community about the Fortino decision because the Crown had not pleaded that the receipts were capital gains and was precluded from introducing the argument at trial.

The FCA's 2003 decision in Manrell v. the Queen [2002 D.T.C. 1222 (TCC) reversed by 2003 D.T.C. 5225 (FCA)] answered a question left unresolved by the Fortino decision by stating that non-compete receipts are non-taxable capital receipts and not capital gains. The FCA in Manrell analyzed the meaning of property and concluded that property does not include a right not to compete and therefore a capital gain could not occur on the receipt of a non-compete by a taxpayer because there was no disposition of property.

Three Alternate Scenarios

In response to the Crown's losses in Fortino and Manrell, the department of Finance drafted new legislation included in its February 27, 2004, Technical Amendments that elaborated on provisions originally announced in an October 7, 2003, press release. These new rules ensure that the receipt of non-competes are always taxable.

The provisions set out in section 56.4 of the Act describe the taxation of restrictive covenants both from the payer's and the recipient's perspective. Subsection 56.4(4) of the Act describes the taxation of the non-compete from the purchaser's perspective in three alternate scenarios. Similarly, there are three alternate ways in which amounts received or receivable by a taxpayer (or by a person with whom the taxpayer does not deal at arm's length) out of a restrictive covenant granted to an arm's length purchaser may be treated pursuant to subsection 56.4(3) of the Act:

• As employment income if in respect of an office or employment. These amounts are taxed in the year of receipt pursuant to sections 5 and 6 of the Act. Furthermore, any amounts that are receivable will be included in income in the year that they have become outstanding more than 36 months pursuant to subsection 6(3.1) of the Act. These types of non-competes are deductible to the purchaser as wages and, as a result, the purchaser must withhold and remit in a timely manner the appropriate source deductions as it would other salaries to employees pursuant to paragraph 153(1)(a) of the Act.
• As a reduction in the formula for cumulative eligible capital (CEC), if in respect of the disposition of eligible capital property of a business, and if the taxpayer and the purchaser file a joint election. The tax impact of this alternative to the recipient of the non-compete can be varied. There could be simply a reduction in the taxpayer's CEC pool with no immediate taxation. Alternatively, there could be recaptured CEC (similar in concept to recaptured capital cost allowances) that will result in full income inclusion and taxation for the taxpayer. In addition to or separate from the recaptured CEC, there could be a negative CEC balance which would effectively be taxed at the same rates as capital gains. It should be noted that the quantitative tax implications on the sale of eligible capital property is complicated and that accountants should proceed with caution in this area. These amounts are treated as eligible capital property for the purchaser.
• As proceeds of disposition of a capital property, if it relates to a disposition of an eligible interest of the taxpayer and if the taxpayer and the purchaser file a joint election. An eligible interest is defined as being an interest in a partnership or a share of a corporation that carries on a business. The amount of the non-compete that can effectively be considered to be a capital gain is limited by the formula: A minus B. The formula effectively permits the excess of the fair market value (FMV) of a taxpayer's eligible interest with all restrictive covenants granted by the taxpayer included therein (A) over the FMV of an eligible interest with no restrictive covenants granted by the taxpayer included therein (B) to be considered as a capital gain for income tax purposes. These amounts are added to the cost of the property acquired by the purchaser.

The Default Rule

If none of the three aforementioned scenarios apply then the amounts received or receivable by the taxpayer in respect of the non-compete is fully taxable as "other income" pursuant to subsection 56.4(2) of the Act. Interestingly, the new restrictive covenant rules found in subsection 56.4(2) of the Act do not address the tax implications for the payer of paying such a non-compete. Therefore, the deductibility of these types of non-compete payments for the purchaser will be dependent on the facts and the applicable tax legislation, case law, and basic principles. The lack of legislative certainty for the purchaser of such non-competes may increase the risk of a Canada Revenue Agency (CRA) reassessment on this issue.

Pitfalls and Opportunities

Clearly, the more favourable tax treatment applies in the granting of a non-compete by the taxpayer to an arm's length purchaser for consideration. In situations involving the granting of a restrictive covenant to a non-arm's length purchaser for consideration, the default rule and full taxation shall apply.

Let us consider the following example: assume a medical doctor operating as a sole proprietor decides to incorporate his practice according to the provincial medical legislation. The primary asset of FMV that the doctor will transfer on a tax-deferred basis to the new incorporation (Newco) pursuant to section 85 of the Act is goodwill. In order for the goodwill to retain its FMV and withstand valuation scrutiny from the CRA, it is often advised in such a transaction that the medical doctor enter into a non-compete agreement with Newco.

Proposed subsection 56.4(2) of the Act could possibly override the tax deferral mechanism of section 85 of the Act and fully tax the medical practitioner on the accrued gain of the shares received as consideration by Newco in exchange for his goodwill. This is because the Newco shares could be viewed as consideration received by the medical practitioner for the non-compete. There is a technical argument that section 85 of the Act should override subsection 56.4(2) of the Act; however, further legislative clarification would be welcomed in this regard.

Bias Towards Sale of Shares

If a taxpayer sold his shares of a corporation to an arm's length purchaser, provided that certain conditions are met, the taxpayer's restrictive covenant receipts would be taxed as a capital gain. Alternatively, if a corporation sold assets to an arm's length purchaser and the shareholder received an amount for a restrictive covenant from the same purchaser, then the non-compete would be fully taxable in the shareholder's hands.

The policy reason for the bias of the new restrictive covenant rules towards the sale of shares versus the sale of corporate assets is unclear given the central concept of integration in Canadian taxation. If the amount of money offered to the shareholder for a restrictive covenant on an arm's length corporate sale of assets is significant, consideration should be given to structuring the sale as a sale of shares. As compensation to the purchaser for the foregone increased tax basis on the direct acquisition of assets, the vendor can consider sharing the tax savings with the purchaser on the more favourable treatment of the restrictive covenant on a sale of shares.

Conclusion

The new rules on restrictive covenants are fraught with uncertainty. Unforeseen pitfalls exist and planning opportunities may be missed by taxpayers and accountants who do not carefully read the proposed rules found in section 56.4 of the Act. But perhaps the department of Finance will heed the comments of tax advisors and the public on the limitations of the new rules and provide legislative remedy in the near future.

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Manu Kakkar, MTax, CA, CGA, is an independent tax consultant specializing in personal, corporate, estate and trust tax planning, corporate reorganizations, divestitures and acquisitions, scientific research and experimental development tax credits. E-mail manu@kakkar.com.

"Tax Strategy" is co-ordinated by J. Thomas McCallum, CBV, FCGA, a business valuation and income tax consultant based in Whitby, Ontario, and author of several CGA-Canada professional development courses. E-mail jtmc@jthomasmccallum.com.

The information appearing in "Tax Strategy" is provided for the interest of the readers. Neither CGA Magazine nor the column authors and co-ordinator assumes any responsibility or liability to any persons relying on the information in the article to perform tax planning and/or compliance of any kind.