The restrictive covenant rules were first introduced in 2003 as a response to the Fortino and Manrell cases. Since this time the restrictive covenant rules have gone through a number of amendments which has substantially complicated the initial rules. The authors examine the rules as they were proposed in Bill C-10, dated October 29, 2007, including amendments made to other sections of the Act as a consequence of these rules. Furthermore, tax implications for non-residents and potential GST implications are examined. Illustrative examples are provided to demonstrate problems that may arise due to the complexity of these rules. The authors examine potential valuation matters that may arise in the context of restrictive covenants. The authors conclude that while the purpose of these rules may be laudable, they add great complication and administrative burden to otherwise routine commercial transactions.
"The hardest thing in the world to understand is the income tax." -Albert Einstein The Department of Finance's attempt to establish a legislative framework to deal with the Manrell4decision makes for an excellent study in the complexities of balancing two essential principles of taxation: fairness and predictability of fiscal legislation versus the prevention of abusive tax planning. While the Manrell decision left an understandably unacceptable gap in the Act5 that may have been abused by taxpayers, the resulting response by the Department of Finance far exceeded anything tax practitioners could have expected. The complexity of the proposed restrictive covenant legislation reflects the Department of Finance's desire to capture any potential and conceivable covenant, even those that have not as of yet been contemplated. The application of these new rules to specific transactions requires an excellent understanding of the rules and exceptions, otherwise undesirable tax consequences may result. This paper aims to clarify the proposed rules pertaining to restrictive covenants and will also examine certain difficulties that arise from the complexity of these rules. Be prepared for brain overload.
While many papers have already been written on the new restrictive covenant proposals6 (and certainly this paper will overlap on some of the analysis already completed by the eminent authors), it is hoped that this paper will further expand on some of the practical difficulties that these proposals contain for taxpayers and their advisors.
TRADITIONAL TAX TREATMENT OF RESTRICTIVE COVENANTS PRIOR TO FORTINO AND MANRELL
Given the prevalence of restrictive covenants in business and share sale transactions, it is somewhat surprising that Canadian case law has not addressed the tax treatment of restrictive covenants prior to Fortino7. Indeed, restrictive covenants are a standard element to most sales of business assets or shares, and most transactions of this nature would not be consummated without the seller agreeing to a restrictive covenant of some sort.
While Canadian case law prior to Fortino is mute8 on the tax treatment of restrictive covenants, the Canada Revenue Agency ("CRA") has issued a number of Interpretation Bulletins and opinions to aid taxpayers and tax practitioners seeking guidance as to the tax treatment of restrictive covenants, and more specifically non-competition agreements. Indeed, prior to Fortino and Manrell, very few commercial agreements specifically allocated consideration to non-competition agreements, and allocating amounts to covenants other than non-competition covenants was largely unheard of. The CRA's traditional approach to the taxability of restrictive covenants depends on the nature of the underlying transaction to which the restrictive covenant relates. Starting with IT-330R,9 the CRA has consistently10 taken the position that an amount received as consideration for entering into a non-competition agreement relating to the disposition of business property should be treated as a disposition of eligible capital property. On the other hand, an amount received for entering into a restrictive covenant that relates to the disposition of shares will fall within the ambit of section 42 of the Act.11
In subsequent years, the CRA further refined its position on non-competition agreements by stating that the right to compete in business fell within the definition of property in subsection 248(1) of the Act:
Property is broadly defined in subsection 248(1) of the Act to include, "...a right of any kind whatever..." It is our view that where a taxpayer gives up his right to compete in a business under a contract that right would be a property for the purpose of the Act and any consideration received by the taxpayer for giving up such right would generally be on account of capital."12
In addition, as late as 2002, in a revised Interpretation Bulletin, the CRA continued to pronounce that noncompetition payments may be eligible capital expenditures (although it is interesting to note the use of the word "may").13
The CRA's position prior to Fortino and Manrell seemed tenable, which may explain the lack of challenge from taxpayers. Indeed, given the very broad definition of "property" in the Act, it was conceivable and seemed probable that the CRA's position represented the state of the law at the time. As such, practitioners gave little thought to allocating amounts to a non-competition agreement entered into during a sale of business assets or shares, thereby resulting in a favourable capital gains tax treatment for the vendor.
FORTINO AND MANRELL
As alluded to earlier, the impetus to reform the taxation of non-competition agreements in Canada was provided by two significant court decisions: Fortino and Manrell. In Fortino, the Crown was not allowed to present its most promising arguments due to procedural constraints. Following the Crown's loss in Fortino, taxpayers began more aggressively entering into tax-free non-competition agreements. The CRA's test case with respect to non-competition agreements was Manrell. It is now well known that the CRA lost this case as well, resulting in the current proposed restrictive covenant rules.
In Fortino, shareholders of Fortino's Supermarket Ltd. ("Fortino's") sold their shares to a competing grocery store chain, ("Loblaws") for consideration of approximately $7 million. In addition to the share sale, the shareholders entered into non-competition agreements, which provided that the shareholders would not compete (in specific areas of Ontario) with the purchaser for a 10-year period (5 years in the case of the shareholders' immediate family members). Consideration for the non-competition agreement was approximately $1.35 million. It was noted that absent the non-competition agreement, the share sale would not have gone through.
The shareholders did not report the non-competition agreement amounts in their personal tax returns. On assessment, the Minister included the taxable portion of the non-competition agreements under subsection 14(1) of the Act. The Minister subsequently reassessed and removed the subsection 14(1) income inclusion, and recomputed the capital gain of the share sale by adding the non-competition payments to the proceeds of disposition of the shares.
The taxpayers appealed; their position being that the non-competition agreements represented consideration for personal goodwill, not income from a source, and constituted a windfall. The taxpayers argued that there was no provision in the Act which would subject the non-competition payments to income tax.
The Minister conceded that the non-competition payments should not have been included as proceeds of disposition of the shares, but as taxable income from a source under section 3. Alternatively, the Minister argued if the non-competition payments were not found to be income from a source under section 3 they should be taxed under section 14.
The non-competition payments were found by the Tax Court to be in the nature of a non-taxable capital receipt, and therefore, not income from a source under section 3. Section 14 was found not to apply, as it does not apply to shareholders who are not operating any business themselves. The grocery business was operated by the corporation, Fortino's, and not the shareholders.
The decision of the Tax Court was affirmed by the Federal Court of Appeal ("FCA").
The Capital Property Argument
One of the positions taken by the Minister to establish a basis for the reassessments under issue was that the non-competition payments constituted disguised proceeds of disposition of the shares. However, this argument was dropped before the trial. The intended alternative position that the non-competition payments be treated as a disposition of property ("a right of any kind whatever"),14 and therefore, taxable under sections 38 and 39 was not specifically raised in the pleadings when the trial started. Therefore, for procedural reasons, the Minister was precluded from arguing that the non-competition payments should be treated as proceeds of disposition of capital property. The FCA confirmed the decision of the Tax Court with respect to the amounts not being income from a source under section 3, and confirmed that the Minister was not allowed to raise the argument with respect to proceeds of disposition of a right of some sort.
The issue with respect to whether the granting of the non-competition agreement constituted a disposition of property giving rise to a capital gain was subsequently addressed in the Manrell decision.
The Section 3 Argument
Paragraph 3(a) of the Act includes in a taxpayer's income all amounts which are income from a source, including but not restricted to income from an office, employment, business, or property. Therefore, in order to determine if an amount is taxable under section 3, one must first determine if the amount is income, and also, whether the amount is income from a source.
The Tax Court, after reviewing the extensive case law on this point, concluded that the non-competition payments were "more in the nature of a capital receipt and were not income from a productive source under section 3."15 Accordingly, it was found that the non-competition payments were not taxable as income from a source under section 3 of the Act.
The Section 14 Argument
The non-competition payments were made to the shareholders of the corporation. In an effort to apply section 14 to the shareholders, the Minister attempted to lift the corporate veil as if the corporation was acting as agent for the shareholders. The Tax Court concluded that the grocery business was conducted by the corporate entity (Fortino's), and not by the shareholders. Therefore, the non-competition payments could not be characterized as eligible capital amounts.
The Section 42 Argument
Section 42 of the Act deems the proceeds of disposition of property to include amounts received as consideration for warranties, covenants, or other contingent or conditional obligations given by a taxpayer in respect of the disposition of the property.
Notwithstanding the Minister did not argue that section 42 was applicable, the Tax Court also considered this issue. Warranties or covenants contemplated by section 42 must have an element of conditional or contingent obligation. The non-competition payments were not contingent obligations given with respect to the sale of the shares. There was no uncertainty as to when the non-competition payments were made or the amount payable. Therefore, the Tax Court concluded that section 42 was not applicable.
Following Fortino, the CRA was seeking a test case with respect to non-competition agreements. The CRA's strongest arguments with respect to non-competition agreements were to be tested in Manrell both at the Tax Court level and the FCA.
While the Fortino case stood for the proposition that non-competition agreement receipts were not taxable, the CRA was not provided with the opportunity to fully argue its case in Fortino. The CRA's principal argument that a non-competition agreement was property, and thus subject to capital gains treatment, was to be tested in Manrell.
In Manrell, the taxpayer entered into a non-competition agreement on the arm's length share sale of his manufacturing business. The payment for the non-competition agreement was included in the purchase price of the shares. The non-competition agreement was a condition to the share sale and pertained to a specific duration or term and geographic territory. The taxpayer initially included the non-competition payments in the proceeds of disposition of his shares on his 1995, 1996 and 1997 tax returns. The tax returns were assessed as filed. As the payments under the non-competition agreement were receivable in four annual installments, the taxpayer claimed the benefit of statutory reserves16 to spread the taxable capital gain over the years in which the payments were received.
Subsequent to the decision in Fortino, the taxpayer filed notices of objection in an attempt to recharacterize the non-competition payments as non-taxable on the basis that a non-competition agreement was not property for purposes of the Act. The Minister confirmed the original assessments, failing to recharacterize the non-competition payments as tax–free. The taxpayer appealed to the Tax Court.
The taxpayer's appeal was dismissed. The Tax Court found that the right to compete under the noncompetition agreement fell within the definition of property found in subsection 248(1) in the context of the phrase "right of any kind whatever." The taxpayer disposed of a right to compete, which was found to be property for purposes of the Act.
The Tax Court decision was reversed on appeal. The FCA found that property must have or entail an exclusive right to make a claim against someone else.17 Through the execution of the non-competition agreement, the taxpayer only gave up the non-exclusive commonly held right to carry on business, and did not give up property within its ordinary meaning. The shared right to carry on business was found not to be a "right of any kind whatever," and therefore, was not "property" within the statutory definition found in subsection 248(1). As a capital gain can only be realized on the disposition of "property," the taxpayer did not realize a capital gain in respect of the non-competition payments received.
Tax Court of Canada – Definition of Property
The taxpayer's position at the Tax Court level was that the agreement to not exercise the right to compete did not constitute property for purposes of the Act. The non-competition payments were therefore, not taxable on the basis that the payments did not constitute a gain from the disposition of property.
The taxpayer argued that subsection 248(1) restricts the definition of property to the common law concept of property. Quoting jurisprudence from England and Australia, the taxpayer asserted that, at common law, the ability to compete is not considered property. The Crown responded that the taxpayer disposed of a bundle of rights, and made a promise not to do something in connection with these rights. The Crown also added that the definition of property found in subsection 248(1) is broader than that of England and Australia, and would include non-competition payments, including the right to enter into a business and the promise to do or not to do certain things.
The taxpayer argued that in the context of the Act, the phrase "a right of any kind whatever" must be understood to mean a right in the nature of property. The right to compete is simply the freedom everyone shares to carry on a business. It is a personal liberty, not a right that is exclusive or that entails any claim against anyone else. Therefore, it is not within the statutory definition of property.
The taxpayer also submitted that if the Tax Court finds that the right to compete constitutes property, he has not done anything to sell or dispose of his right to compete, but simply covenanted not to exercise his right. A disposition requires that the taxpayer actually alienate, or part with, the property in question. When an individual agrees not to compete, they do not part with that right to compete. Therefore, a disposition has not been triggered. Notwithstanding the covenant to not exercise the right to compete, it is still possible to engage in a competing business; all that has changed is that the recipient of the covenant or promise has a right to seek recourse if the covenant or promise is broken. The ability to engage in the competing business does not cease to exist by virtue of the granting of the covenant.
The Crown argued that the use of the word "includes" in the statutory definition of property in subsection 248(1) indicates that it must be given a meaning that is broader than its ordinary meaning. In particular, the phrase "a right of any kind whatever" is sufficiently broad that it includes rights that do not necessarily have the usual characteristics of property.18
The Tax Court agreed that notwithstanding that the right to compete may not be property at common law, this fact is not relevant; the language in subsection 248(1) cannot be ignored. Property is defined in subsection 248(1) as "property of any kind whatever, whether real or personal or corporeal or incorporeal and without restricting the generality of the foregoing, includes a right of any kind whatever." There is no restriction in subsection 248(1) to the common law concept of property.19
Federal Court of Appeal – Definition of Property
For purposes of deciding whether a right to compete is a "right of any kind whatever," and therefore, "property" as defined by subsection 248(1), the FCA considered the ordinary meaning of the word "property," the statutory context, and the relevant jurisprudence.
When considering the ordinary meaning of the word "property," the FCA quoted the following from Principles of Property Law: 20
Property is sometimes referred to as a bundle of rights. This simple metaphor provides one helpful way to explore the core concept. It reveals that property is not a thing, but a right, or better, a collection of rights (over things) enforceable against others. Explained another way, the term property signifies a set of relationships among people that concern claims to tangible and intangible items.21
Subsequent to citing that passage, the FCA stated:22
It is implicit in this notion of "property" that "property" must have or entail some exclusive right to make a claim against someone else. A general right to do something that anyone can do, or a right that belongs to everyone, is not the "property" of anyone. In this case, the only thing that Mr. Manrell had before he signed the non-competition agreement that he did not have afterward was the right he shares with everyone to carry on a business. Whatever it was that Mr. Manrell gave up when he signed that agreement, it was not "property" within the ordinary meaning of that word.
The Crown argued that, although a right to compete was not "property" within the ordinary meaning of that word, the definition of "property" found in subsection 248(1) was broad enough to include it because the definition referred to "a right of any kind whatever."
The taxpayer argued that, in the context of the Act, the phrase "a right of any kind whatever" must be understood to mean a right in the nature of property. At the very least, it must be a right entitling its holder to "compel someone else to pay money or do something, or the right to exclude all competing claimants to the same right." What the Crown tried to characterize as a "right to compete" was, according to the taxpayer, simply the freedom everyone shares to carry on a business.23
The FCA concluded that "property" must have or entail an exclusive right to make a claim against someone else. The phrase "right of any kind whatever" was not included in the Income Tax Act enacted in 1948 to expand the ordinary meaning of property to include a non-exclusive commonly held right to carry on business.24
The FCA noted that in the history of Canadian tax jurisprudence considering the statutory definition of the word "property," there is not a single case in which the word property was held to include a right that is not or does not entail an exclusive and legally enforceable claim.25
At paragraph 54 of the decision, the FCA states:
Before signing the non-competition agreement, Mr. Manrell could carry on or invest in a plastic mould manufacturing business competing with the three operating companies that were sold. However, that gave him no claim against anyone else, and no right to stop anyone else from starting exactly the same business. By signing the non-competition agreement, Mr. Manrell became obliged not to undertake activities that he could have undertaken before. If what he gave up was a right of some kind, it was a right shared by everyone to carry on a business. I see nothing in the context of the Income Tax Act that justifies the conclusion that this was a "right of any kind whatever" that makes it "property" within the statutory definition.
The FCA did not find anything in the statutory context or the relevant jurisprudence to indicate that the meaning to be given to the word "property" should derogate from its ordinary meaning. Thus the term "property" as defined in subsection 248(1) was not intended to include non-exclusive, commonly held rights, including the right to compete.
The Impact of Manrell
There is no doubt that the Manrell case was a surprising win for taxpayers. There is even less doubt that the Manrell case shocked the CRA and the Department of Finance, as their position seemed to be strongly founded both in fiscal policy and in law. Judge Sharlow, writing for the FCA acknowledged that the court's conclusions in Manrell may not have reflected the fiscal policy with respect to non-competition agreements:
This case presents a strong temptation to legislate in the guise of statutory interpretation. No doubt many will consider the result of this case to be unsatisfactory in terms of fiscal policy. I am sympathetic to the view that it seems unfair that the shareholder of a corporation who bargains for a non-competition payment in the context of a sale of the shares is not taxed on the payment, even though in economic terms it may represent the realization of a substantial part of the commercial value of the business of the corporation.
However, it is one thing to recognize an unsatisfactory state of affairs, and quite another to repair it. Perhaps non-competition payments should be within the tax net in some way, but in what way? The history of this case and Fortino illustrate several theoretical possibilities. I have no doubt that other theories could be devised.26
The Department of Finance clearly took Justice Sharlow's advice to heart and repaired the lacuna in the Act. While Manrell dealt specifically with non-competition agreements, the principles enunciated by the court could easily be transposed to other forms of contractual covenants, not only in the course of the sale of business assets and shares, but also in the ordinary course of business. Thus, taxpayers could conceivably allocate amounts to other clauses in an agreement and argue that these amounts were tax-free based on the principles set forth by the Federal Court of Appeal. In effect, the Manrell decision created a complete class of rights that arguably have value to taxpayers, but that are non-taxable. This could allow a taxpayer to carve out clauses in a contract and assign them value, free of tax. For each tax-free clause carved out of the agreement, the aggregate amount of taxable consideration received would be reduced. In other words, taxpayers had the potential to greatly reduce taxes, not only during the sale of business assets and shares, but also for many other commercial agreements conceivable. The Department of Finance expressed these concerns before the Standing Senate Committee on Banking, Trade and Commerce as follows:
[...] A couple of tax cases gave us some pause, Fortino v. Canada and Manrell v. Canada. Those two cases read together stood for the proposition that an amount received by a shareholder for a covenant not to compete was tax free. We all would have liked to go to the status quo ante where one saw those covenants but did not see an amount broken out of the deal to be specifically in consideration of the covenant. These court decisions gave rise to the startling proposition of a tax-free receipt in the context of the disposition of a business. We began to see many taxpayers assigning a value to a non-compete covenant with their own corporations. That became unsustainable as part of the tax system, and as a result we had to move to implement these rules.
However, we were faced with a problem. The court decision established the principle that a personal covenant gave rise to a tax-free receipt and brought to the limit, which means that you can have any personal covenant and achieve a tax-free amount. These rules had to be fairly comprehensive and to deal across the board with all kinds of covenants but we dealt more particularly with the covenants not to compete because they were the more common ones in place. Other covenants would have come forth in order to take advantage of the decisions.27[Emphasis added]
Additionally, certain high-profile cases may have put further strain on the Department of Finance's tolerance regarding non-competition schemes. Needless to say, this threat could not go unanswered by the Department of Finance. The preceding comments explain why a simple amendment of the definition of "property," to include non-competition and similar agreements may have been quick and efficient, but would not have effectively countered the Manrell decision. For this reason, the Department of Finance has opted for a complete new set of rules to cover not only non-competition agreements but also any covenant that falls within the tax gap created by Manrell. As the Manrell decision had such potentially large tax implications, the corresponding rules resulting from this decision are both complex and far-reaching.
* The authors wish to thank Adam Hoffman, LL.B., Dennis Nerland, LL.B., Faizal Valli, CA and Roberto Domagas, CA (all of whom practice with either Moodys LLP Tax Advisors or Shea Nerland Calnan LLP Barristers & Solicitors) for their very significant contributions to the writing and research of this paper. All errors remain those of the authors. The valuation section of the paper was written by Doug Welsh, CA, CBV of Clark Valuation Services Ltd. and the authors thank him for his tremendous work.
1 Kim G C Moody is a partner at Moodys LLP Tax Advisors in Calgary, Alberta.
2 Matt Clark is an associate at Shea Nerland Calnan LLP Barristers and Solicitors in Calgary, Alberta.
3 Nicolas Baass is an associate at Moodys LLP Tax Advisors in Calgary, Alberta.
4 Tod T. Manrell v. Her Majesty The Queen, 2003 DTC 5225.
5 The Income Tax Act, RSC 1985, c.1 (5th Supp.), as amended and proposed to be amended, and including the regulations promulgated thereunder (the "Act"). Unless otherwise stated, statutory references in this paper are to the Act. No assurance can be given that proposed amendments to the Act will be enacted in the form proposed or at all.
6 See, for example:
a) David G. Weekes, "Restrictive Covenants – Proposed Section 56.4," 2005 Prairie Provinces Tax Conference, (Toronto: Canadian Tax Foundation, 2005), 2:1-7.
b) Hugh Woolley, CA, TEP, "Valuation & Allocation Issues in Canadian Income Tax," 2006 British Columbia Tax Conference, (Vancouver: Canadian Tax Foundation, 2006), 13:1-42.
c) Glen London and Dennis Amirault, "The Sale of a Business - Some Practical Tips and Avoidable Traps", 2007 British Columbia Tax Conference, (Vancouver: Canadian Tax Foundation, 2007), 6:1-31.
d) Crystal Taylor and Clint Gifford, "Bill C-33: Part 2 Technical Amendments," 2007 Prairie Provinces Tax Conference, (Toronto: Canadian Tax Foundation, 2007), 15:1-31.
e) Clifford M. Goldlist, "Implications of Recent Tax Changes on Business Purchases and Sales," 2007 Ontario Tax Conference, (Toronto: Canadian Tax Foundation, 2007), 11:1-24.
f) Manon Thivierge, "Planning for the Purchase or Sale of a Business," Report of Proceedings of Ffifty- Seventh Tax Conference, 2005 Tax Conference (Toronto: Canadian Tax Foundation, 2006), 10:1-30.
7 Fortino v. Her Majesty The Queen, 97 DTC 55 (TCC) and Her Majesty The Queen v. Fortino, 2000 DTC 6060 (FCA).
8 The word 'mute' is used here given that the jurisprudence prior to Fortino and Manrell is almost non-existent. There are many cases that deal with the deductibility of client lists and the related restrictive covenant acquired. One case, Richstone v. MNR 74 DTC 6129, dealt with payments ascribed to a restrictive covenant following the departure of a former employee that was found to be employment income.
9 Interpretation Bulletin IT-330R, "Dispositions of Capital Property Subject to Warranty, Covenant or other Conditional or Contingent Obligations," September 7, 1990. IT-330R was archived by the CRA in 2004. Paragraph 5 of IT-330R states "Where capital properties of a business are sold, a non-competition covenant, given by the vendor not to carry on a competitive business, is considered to be in respect of the disposition of the goodwill of the business and is therefore not subject to section 42."
10 See, for example:
a) CRA Document No. 1991-201, February 1991, "Non-Competition Payments";
b) CRA Document No. 9313690, May 6, 1993, "Non-Competition Payment";
c) CRA Document No. 9525077, November 8, 1995, "Non-Competition Payment".
11 See paragraph 6 of IT-330R that states: "In this regard, any amount received for a non-competition covenant referred to in paragraph 5 that is in respect of the disposition of shares comes within the provisions of section 42 as part of proceeds of disposition of the shares."
12 Supra, note 11(c).
13 See Interpretation Bulletin IT-143R3, "Meaning of Eligible Capital Expenditure," August 29, 2002. Paragraph 32 of IT-143R3 states: "An amount paid by a taxpayer to another person with whom the taxpayer deals at arm's length, to obtain that other person's covenant not to engage in any business within a designated geographical area during a specified period of time, that is the same as or is similar to the business carried on by the taxpayer, may qualify as an eligible capital expenditure." [emphasis added].
14 See the definition of property found in subsection 248(1).
15Tax Court of Canada decision in Fortino, supra, note 8, at paragraph 54.
16 See subparagraph 40(1)(a)(iii).
17 Supra, note 5, at paragraph 25.
18 Ibid. at paragraphs 14 and 23.
19 Manrell v. Her Majesty The Queen, 2002 DTC 1222 at paragraph 15.
20 Ziff, Bruce H., Principles of Property Law, 3rd ed. (Scarborough: Carswell, 2000).
21 Supra, note 5, at paragraph 14.
22 Ibid., at paragraph 25.
23 Ibid., at paragraph 20.
24 Ibid., at paragraph 41.
25 Ibid., at paragraph 53.
26 Ibid., at paragraphs 60-61.
27 Transcripts to the Proceedings of the Standing Senate Committee on Banking, Trade and Commerce, Issue 22 Evidence – Meeting of June 12, 2008.
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.