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Restrictions with Restricted Covenants

20/09/2012


​When selling a company or a business, it is common for the purchaser to require a non-competition clause (“non-comp”) in the sale agreement. This clause generally prohibits the vendor from engaging in the same kind of business for a specified period of time. The non-competition clause helps the vendor attain full value for the business and helps the purchaser protect the purchased value. Without a non-comp, the vendor could set up shop next door or join a major competitor which could damage the existing business and destroy the value of any goodwill paid for.

For tax purposes, a non-comp clause falls under the definition of a restrictive covenant as defined in proposed section 56.4. Note that there are many other types of covenants which could fall under into this definition and the definition is not exclusive to non-comp clauses.

Naturally the provisions governing the treatment of restrictive covenants are very complex, have undergone a substantial amount of revisions since they were first proposed in 2003 and are still in draft form. There are differences depending on whether the vendor is selling shares or assets. There are differences if a value is specifically allocated to the non-comp versus no amount allocated. There are situations where an election is required to meet the exceptions and situations where no election is required. At the end of the day, the deal must be structured correctly and take into account these provisions to avoid a nasty tax surprise.

Below, and in very broad strokes, I will outline the general rules and the exceptions available. As stated, these rules are complex and this is in no way meant to be an exhaustive analysis of the provisions.

The General Rule

The general rule is that the taxpayer who grants the non-comp will have an income inclusion for all amounts received in respect of the non-comp. By its very nature the general rule is punitive as the vendor has a 100% income inclusion rather than capital gains treatment (and potential the ability to claim the capital gains deduction) or a payment in respect of goodwill. Further, the payment is taxed in the hands of the person who grants the non-comp, not necessarily the taxpayer who is receiving the payment.

Exceptions to the Rule

The tax act does provide three exceptions to the general rule, but they are extremely difficult to fall into. The exceptions only apply (1) in arm’s length transactions (2) when a value is specifically allocated to the non-comp and (3) when the taxpayer who granted the covenant is entitled to receive the payment. What does this mean? It means that sales to family members will not qualify. It means that an amount has to be specifically allocated to the non-comp in the sales agreement. It means in a share sale, complex structures often make it difficult to meet these criteria.

Given the narrow criteria required to meet the exceptions, practically speaking they are often irrelevant in most sale transactions. However, assuming you can meet the criteria, the exceptions will enable the amount to be taxed as employment income, as eligible capital or as a capital gain.

What if the purchase agreement did not specifically allocate an amount to the non-comp? Would the entire sale price then get capital or goodwill treatment? Unfortunately the answer is no. Proposed paragraph 68(c) allows the Minister to deem a reasonable amount in respect of the restrictive covenant. Section 68 carves out an amount from the purchase price and converts it from sale proceeds (i.e. capital) to an income receipt.

What is a Reasonable Amount?

If you would prefer not to find out how the Minister determines this, you need to hit one of four possible exceptions. If an exception is met, Section 68 will not apply to deem consideration to be received by the taxpayer for the non-comp. These exceptions may apply where:

• an arm’s length employee provides the covenant;
• a corporation provides the covenant as part of the sale of goodwill to an arm’s length purchaser;
• there is an arm’s length sale of property, including shares of a corporation; or
• there is a non-arm’s length sale of a corporation.

However, each of these exceptions comes with a very detailed list of conditions that must be met for them to apply. Again, in a complex structure, these detailed conditions are difficult to meet.

The restrictive covenant rules are complex, potentially punitive and cover a broad range of situations. Taxpayers who are entering into sales transactions should be addressing this issue early on in the process to ensure that excessive tax is not paid as a result of granting a non-comp to the purchaser.

Please consult your MNP Tax advisor well before entering into a purchase and sale transaction.​