Our firm has written on the Canadian taxation treatment of
restrictive covenants many times. Our blogs of
April 11, 2008 and
July 20, 2010 are two small examples. In addition, I wrote an
extensive paper for the Canadian Tax Foundation on this topic in
2008. However, some of the content of my 2008 paper is out of date given some extensive
amendments to proposed section 56.4 subsequent to the release of
that paper but much of it is still relevant.
As many Canadian practitioners know, section 56.4 of the
Canadian Income Tax Act (the section that deals with
restrictive convents) is now law given the enactment of Bill C-60
on June 26, 2013. Given such, it is very important for accountants
and lawyers who advise on many types of "vanilla"
commercial transactions to be aware of the implications of section
56.4. Section 56.4 is mind-bogglingly complex and will require an
extensive review in every case to ensure that any possible negative
implications are identified and mitigated to the extent
As a simple example, consider the situation where Mr. Apple owns
certain shares of a Canadian "Opco". Mr. Apple enters
into a letter of intent to dispose of all of his shares of Opco to
an arm's length purchaser. As part of the agreement, Mr. Apple
agrees to a non-compete agreement which will restrict his ability
to compete in a certain geographical area for a specified period of
time. Such a non-compete agreement will be considered a restrictive
covenant1 for purposes of new section 56.4.
Accordingly, what are the implications? Such implications are
beyond the scope of this short blog but suffice it to say that even
in this simple example the new rules will need to be carefully
considered before finalizing the terms of the purchase and sale
agreement. In a worst case scenario, the fair market value of the
restrictive covenant granted by Mr. Apple could be included in his
income and fully taxed. This compares unfavorably to what Mr. Apple
may expect since he would likely view the sale of his Opco shares
and the granting of a non-compete agreement to be treated as
proceeds of disposition resulting in capital gains treatment.
Capital gains are only half taxable in Canada therefore the fully
taxable treatment on restrictive covenant grants is comparatively
punitive. In addition, the $750,000 capital gains deduction
("CGD") (to be increased to $800,000 in 2014 and indexed
thereafter) would not be available for any amounts taxed as a
restrictive covenant. Ouch!
Also, the situation would be even more complex if Mr. Apple was
a US citizen and a Canadian resident since Mr. Apple would also
have to consider the US tax implications of the restrictive
covenant grant (in addition to any CGD claimed).
It has been my experience that many advisors, especially
accountants and commercial lawyers, have ignored the restrictive
covenant rules likely due to such advisors not being aware of the
implications. Such advisors will no longer have a choice but to pay
attention to the newly enacted restrictive covenants rules. In
addition, old transactions should be reviewed since much of section
56.4 has retroactive effect back to 2003.
1. A restrictive covenant is very broadly defined in
section 56.4 and encompasses much more than non-compete
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.
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