This is the fifth of a series of articles dedicated to tax considerations of shareholders' agreements for private corporations. The focus is on the tax implications of non-competition covenants in a shareholders' agreement that could be triggered upon the departure of a shareholder.
Tax implications of a restrictive covenant
A shareholder might end his or her involvement with the business for various reasons, such as a dispute with fellow shareholders, a marriage breakdown, insolvency or simply a desire to pursue other activities. Whatever the reason, it is common for a shareholders' agreement to stipulate that a shareholder's departure will trigger the sale of his or her shares to the company or the remaining shareholders. Provisions dealing with the sale may restrict the departing shareholder's right to compete with the business for a period. Normally, these "non-compete" provisions are intended to support the value of the shares by preserving the business' goodwill, which might otherwise be impaired through subsequent competition by the selling shareholder.
In this context, proposed changes to the Income Tax Act (Canada) are important. They provide that any amounts received or receivable by the departing shareholder, or another non-arm's length person, in respect of a "restrictive covenant" are fully taxable as income of the departing shareholder, rather than being included in calculating a capital gain or loss on the sale of the shares. The rules are augmented by provisions that can allow the Canada Revenue Agency (CRA) to treat an amount as being in respect of a restrictive covenant even if it is actually received for something else, such as sale proceeds for the shares. Certain exceptions are available, but only if many conditions are met.
The proposed changes have a long history - originally announced in 2003, released in draft in 2005, further revised in 2007 and again in 2010 - and although not yet enacted, will apply after October 7, 2003.
In these rules, a restrictive covenant includes a non-compete agreement or a non-compete provision in an agreement dealing with other matters, such as the sale of shares. Changes to the rules could still be made, but this aspect is unlikely to be modified, so it is important to take the rules into account when preparing or updating a shareholders' agreement, and to take appropriate steps to qualify for one of the exceptions or otherwise mitigate the impact of the rules.
Value determination - deemed amounts received
The simplest, and most common, approach to avoiding the potential full income inclusion under these rules might be to not allocate any proceeds to the departing shareholder on account of the non-compete covenant. This avoids the difficult prospect of having to determine how much the covenant is worth.
However, if no allocation is made but it is clear that the covenant has value to the parties, the CRA could potentially perform its own valuation and deem the resulting amount to be received by the departing shareholder in respect of the non-compete.
To avoid the uncertainty this creates, the rules can prevent the CRA from reallocating consideration in certain situations. Unfortunately, the rather demanding conditions are difficult to meet and can often conflict with the desired approach to structuring the buyout tax-efficiently. For example:
- The shares must not be redeemed or purchased for cancellation by the corporation itself, nor can a tax-deferred "rollover" transaction be used.
- If the departing shareholder deals at arm's length with the purchasing shareholder(s), the latter must be related to the company that carries on the business to which the covenant relates (or must acquire the shares through an entity that is related).
- If the departing shareholder does not deal at arm's length, the covenant must be given to a related adult shareholder and the departing shareholder must not retain any ownership interests in the company or a holding company owned by the related shareholder (so "staged" buyouts or payments of contingent consideration, for example, could be problematic).
- The relief may be only partial at best (and certain elections might be required for the year of sale) if the departing shareholder has a holding company that receives the share sale proceeds and a non-arm's length person has a direct or indirect interest in that company, or if other non-arm's length shareholders (spouses, children, or their holding companies) are required to sell their shares because of the "principal's" departure and the noncompete relates only to the principal.
Allocation to the noncompete - arm's length Situations
If the "non-allocation" exception conditions above cannot be met, and the shareholders deal at arm's length, another approach involves providing for a reasonable allocation of the total buyout consideration to the non-compete covenant. This can be done only if the business is carried on through a single corporation and the departing shareholder's interest to be sold under the buyout transaction is shares of the corporation or a holding corporation that derives at least 90% of its value from shares of the corporation. Although it will often be difficult to determine an appropriate amount (especially if a sale would simply not proceed without the non-compete arrangement), the rules do not require a "fair market value" allocation - merely one that is reasonable - and case law would suggest that generally an allocation made by arm's length parties should not be supplanted by the CRA.
If a reasonable allocation is made and the buyout is not structured as a redemption or using a tax-deferred rollover arrangement, the parties can file a joint election for the year of sale to have the allocated amount treated as share sale proceeds rather than the fully taxable income that would otherwise arise. In this somewhat roundabout manner, the desired capital gain treatment can be obtained. The shareholders' agreement should clearly require the parties to make the required election by the filing deadline.
If a non-compete covenant is expected to be a critical feature of a buyout arrangement under a shareholders' agreement, the parties should consider the potential impact of the covenant and develop a strategy for managing the potential income tax consequences. The application of the restrictive covenant rules can be broad, and the conditions for avoiding the negative results are challenging to meet, so the approach to dealing with these rules must be carefully tailored to the particular circumstances. In many cases, to be sure of avoiding an adverse tax result, the business aspects of the buyout structure will have to be modified.
Once the final version of the restrictive covenant rules is released and enacted, shareholders' agreements should be reviewed again, to determine whether further modifications might be required. As always, professional advice is highly recommended.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.