Recent legislative changes contained in Bill C-48, which received Royal Assent on June 26, 2013, provide that any amount received or receivable by a taxpayer in respect of a restrictive covenant will be treated as ordinary income for income tax purposes unless specific exceptions apply. These legislative changes are retroactive to October 7, 2003.
What is a Restrictive Covenant?
Section 56.4 of the Income Tax Act contains the definition of a restrictive covenant. The definition is quite broad and effectively captures any type of agreement, whether legally enforceable or not, that requires the grantor (the individual agreeing to be bound by the restrictive covenant) to continue to do or to abstain from doing a certain specified action.
Restrictive covenants are most commonly found in the form of non-competition and non-solicitation agreements and are frequently granted by shareholders and/or key employees in transactions involving the purchase and sale of assets, shares, or partnership interests. However, the Canada Revenue Agency (CRA) has noted that the definition can extend to include such things as confidentiality agreements and exclusivity clauses.
Exceptions
Income from office or employment
The general income inclusion rule outlined above will not apply if the amount received or receivable by the grantor as consideration for the restrictive covenant is required to be included in the calculation of the grantor's income from office or employment.
Eligible capital property
This exception requires the grantor to have agreed to a restrictive covenant in the course of selling a business and its underlying assets (asset sale). Where the grantor and buyer jointly elect, in prescribed form with their return of income for the tax year that includes the date of the covenant, the amount received or receivable by the grantor as consideration for the restrictive covenant will be considered an eligible capital amount and taxed as a disposition of eligible capital property.
Shares and partnership interests
This exception requires the grantor to have agreed to a restrictive covenant in the course of disposing of an eligible interest in shares or partnership interests (share sale). There are five additional requirements that can significantly limit the accessibility of this exception. However, where the grantor is eligible for the exception and the grantor and buyer elect in prescribed form, a portion of the amount received or receivable by the grantor as consideration for the restrictive covenant will be treated as additional proceeds of disposition of the eligible interest and taxed as a disposition of capital property.
Reallocation rule
Pursuant to paragraph 68(c), the CRA has the legislative authority to reallocate a greater portion of the purchase price to the restrictive covenant where it is believed that an unreasonable allocation has been made. Since the amount received or receivable by a taxpayer for a restrictive covenant is treated as ordinary income for income tax purposes, this reallocation rule can convert a capital gain (of which only 50% would be included in income for tax purposes) into ordinary income (of which 100% would be included in income for tax purposes) if the appropriate considerations are not addressed properly.
Subsection 56.4(5) states that the reallocation rule contained in paragraph 68(c) will not apply where the conditions of subsection 56.4(6) or subsection 56.4(7) are met. While the necessary conditions are quite specific, in general the exceptions will apply to non-competition agreements where no allocation of the purchase price has been made to the restrictive covenant.
In short, these recent legislative changes have added another element of complexity for taxpayers when entering into transactions that include restrictive covenants. Contact your Collins Barrow advisor if you have granted a restrictive covenant, or for more information on the impact of the changes.
Tom Hunt, CPA, CA, is a Tax Manager in the Ottawa office of Collins Barrow.
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