TAXING RESTRICTIVE COVENANTS PURSUANT TO THE PROPOSED SECTION 56.4 OF THE INCOME TAX ACT1
1. The Loophole
Darren Sukonick, a partner in the Corporate/Technology department of Torys LLP in Toronto, represented CanWest Global Communications Corp. in its purchase of Hollinger International Inc. ("HII") in 2000. He testified before a US. District Court in 2007 that the $80-million non-competition payments made to Conrad Black and other HII senior executives personally and which ultimately resulted in their fraud convictions, were intentionally structured as non-compete payments because "non-compete payments were not taxable in Canada at the time."2
That loophole is closing: on October 7, 2003, the Department of Finance proposed amendments to the Income Tax Act3whereby all payments received or receivable in respect of restrictive covenants (including non-competition agreements) from the sale of a business are taxable as income, subject only to limited exceptions4. The current draft of the proposed legislation is the Income Tax Amendments Act, 20105that was published by the Minister of Finance on July 16, 2010 (the "Income Tax Amendments Act", the "proposed section 56.4 amendments" or the "proposed amendments").
The proposed amendments are the legislative fall-out from the Federal Court of Appeal's decisions in Fortino6 and Manrell7 which, by 2003, had fully invalidated the Canada Revenue Agency's8 traditional approach of treating non-competition payments as proceeds from the disposition of capital property. The proposed amendments have not yet been implemented but if they do receive Royal Assent, the legislation will have retroactive effect to amounts received or receivable from October 7, 20039. The amending provisions apply to all restrictive covenants granted upon the sale of a business, not merely to non-competition covenants. "Restrictive covenant" is defined in the draft subsection 56.4(1) as follows:
"[R]estrictive covenant", of a taxpayer, means an agreement entered into, an undertaking made, or a waiver of an advantage or right by the taxpayer (other than an agreement or undertaking for the disposition of the taxpayer's property or — except where the obligation being satisfied is in respect of a right to property or services that the taxpayer acquired for less than its fair market value — for the satisfaction of an obligation described in section 49.1 that is not a disposition), whether legally enforceable or not, that affects, or is intended to affect, in any way whatever, the acquisition or provision of property or services by the taxpayer or by another taxpayer that does not deal at arm's length with the taxpayer.10
This paper is a commentary on the draft legislation as published on July 16, 2010. The author traces the evolution of the jurisprudence and the statutory lacunae that was the impetus behind the amendments, and then summarizes the draft legislation, underscoring its complexity. In the final analysis, the author challenges the kind of 'judicial innovation'11 ironically engaged in by the Federal Court of Appeal in Manrell12 that led to the proposed section 56.4. The Manrell decision, as this paper seeks to show, is so characterized by the author because of its fundamental departure from the "object and spirit" of the Act and the general intent of Parliament "to reach conduct of the taxpayer" that the legislation was designed to apply to13. The author further intends to underscore the point that in Justice Sharlow's enthusiasm to avoid judicial activism, her decision manifests an almost surreal degree of strict constructionism that was itself a radical departure from the history of the law and practice conventions in this area.14
2. Untethering the Income Tax Act
The immediate and overriding concern among practitioners is the complexity of the proposed amendments - they are expected to have stifling effects on papering otherwise commonplace commercial transactions. Though also noteworthy is the fact the proposed amendments suggest a continued trending by Canadian tax legislators towards the U.S. tax regime (which generally treats proceeds of non-competition agreements as ordinary income)15, it is more their complexity coupled with further uncertainty created by their delayed implementation that is causing alarm. Blair Dwyer asserts this situation raises questions about the effect on "the rule of law [in this country]... because practitioners are being forced to comply with an unenacted piece of draft legislation that changes form more frequently than the shapeshifter Odo (of Star Trek Deep Space Nine fame)".16 Indeed, the most strident of criticisms point to the delays and complexity of the proposed amendments as defeating the principal policy objectives behind statutory reforms: those of "certainty, consistency, predictability and fairness" under the Income Tax Act.17
It is the opinion of the author that the difficulties with the proposed s. 56.4 amendments are their lack of any pragmatic underpinnings: the tax treatment of non-compete payments are to be de-coupled from the very core of their raison d'être, the purchase and sale of a business; a capital transaction. Full income inclusion for non-competition payments under the proposed amendments - in order to attribute fair value to the restrictive covenant - results in a very "metaphysical exercise"18 of differentiating between such proximate intangibles as a person's goodwill in the marketplace and his right to carry on a competitive business.
Before the Fortino and Manrell decisions, the CRA had customarily treated the proceeds from non-competition covenants in the sale of a business as a capital gain, which fit in easily with the tax treatment of the larger transaction: both had been treated as a disposition of "property" thereby facilitating the purchase price allocations that are often heavily negotiated in large business acquisitions. With these proposed amendments, however, the legislature rejected the CRA's approach19, ignored the pragmatic realities of the business transaction itself and created (particularly with the many exceptions that need be superimposed on the income inclusion provisions to avoid undesired tax consequences) a labyrinthine structure which some tax commentators have described as "horrifically complex"20 causing "brain overload"21; ... a black hole.
1. Tax practitioners in Canada have extensively criticized the draft legislation for lacking transparency (see Blair Dwyer, "Proposed Section 56.4 Still Draft After All these Years" 2011 British Columbia Tax Conference, Vancouver, Canada, online at: http://www.dwyertaxlaw.com/publication_restrictive_covenants_2011.pdf). Manon Thivierge, a partner at Heenan Blaikie Montréal, entitled her presentation on the proposed s. 56.4 amendments to the Income Tax Act at the Canadian Tax Foundation conference in November 2011 as "Restrictive Covenants and s. 56.4: Traps for the Wary" intending to convey the unintended risks to practitioners resulting from the complexity of the proposed legislation. I chose an analogy to a black hole in respect of the proposed s. 56.4 amendments because, in the words of Dr. G.H. George, "[t]he concepts associated with a black hole provide perhaps the most extreme departure which present day physics can provide from the "common sense" of our every day experience here on Earth." Presentation to a meeting of the St. John's (Newfoundland) centre of the Royal Astronomical Society of Canada, 1989 March 15, internet: http://www.engr.mun.ca/~ggeorge/astron/blackholes.html.
2. Heritage Institute, "Conrad Black Trial: Non-Compete Payments & the Role of Torys LLP Lawyers", April 16, 2007, online at http://heritageinstitute.com/governance/black/9torys.htm.
3. Income Tax Act, R.S.C., 1985, c. 1 (5th Supp.), as amended, (the "ITA", the "Income Tax Act" or the "Act").
4. Exceptions include covenants given by employees; covenants given in the context of an asset sale which requires that the taxpayer granting the restrictive covenant be carrying on the business being conveyed; and covenants given upon the sale of shares provided there is no multi-tiered corporate structure but which is subject to various additional requirements. A critical analysis of these exceptions is provided by David Louis in "Restrictive Covenant Rules, Restrictive Covenants: Last of the Unholy Trinity" CCH Tax Notes Issue No. 571, August 2010. A more detailed discussion of the exceptions is provided below in section 8 (The Exceptions).
5. Proposals to Amend the Income Tax Act and Related Legislation to Effect Technical Changes and to Provide for Bijural Expression in that Act.
6. Fortino v. The Queen (2000) DTC 6060 (F.C.A.), aff'g 97 DTC 55 (TCC) ("Fortino").
7. Manrell v. The Queen (2003) DTC 5225 (F.C.A.), rev'g 2002 DTC 1222 (TCC) ("Manrell").
8. Hereafter referred to as the "CRA".
9. Amounts paid by arm's-length parties under an agreement made prior to October 7, 2003 are excepted, provided that the amounts are received before 2005. See D. Jeffrey Harder "Valuation and Tax Issues" 2004 BCC p. 20:1 at p. 22.
11. See Justice Iacobucci's decision in Ludmer v. Minister of Revenue,  2 S.C.R. 1082 (S.C.C.), at paragraph 38.
12. Justice Sharlow, who wrote the court's decision in Manrell, was concerned about judicial "innovation" when he determined that non-competition payments were not to be treated as 'property' under section 248(1) and thereby radically changed the judicial landscape in this area.
13. See Justice Estey comments in Stubart Investments Ltd. v R.,  1 S.C.R. 536,  C.T.C. 294 , 84 D.T.C 6305, at paragraph 56.
14. The consequences of the Manrell decision include the difficulty in legislating amendments to the ITA that will close the loophole Justice Sharlow created; amendments which have been more than eight years in the making, and still counting.
15. See Muskat v. United States, 2009 WL 211067 (1st Circ. 2009).
16. Blair Dwyer, "Proposed Section 56.4 Still Draft After All these Years" 2011 British Columbia Tax Conference, Vancouver, Canada, online at: http://www.dwyertaxlaw.com/publication_restrictive_covenants_2011.pdf
17. The stated policy objectives set forth by the Supreme Court in respect of interpreting the ITA are to seek certainty, consistency, predictability and fairness under the Act for taxpayers in the organization of their affairs. See The Queen v. Canada Trustco Mortgage Co.,  5 C.T.C. 215 (S.C.C.), at paragraphs 1, 12, 31, 42, 50 and 61.
18. Justice Lamarre describing section 14 of the ITA in Fortino v. R., 1996 CarswellNat 2269, 97 D.T.C. 55,  2 C.T.C. 2184, at paragraph 67.
19. The CRA, depending on the specific facts, had treated the proceeds of a restrictive covenant as either a disposition of eligible capital property or amounts received as consideration for contingent or conditional obligations in respect of such disposition of property.
20. Moody, Clark and Baass "The Restrictive Covenant Proposals: Brain Overload," Report of Proceedings of Sixtieth Tax Conference, 2008 Tax Conference (Toronto: Canadian Tax Foundation, 2009), 36:1-54, p. 51.
21. Moody, Clark and Baass "The Restrictive Covenant Proposals: Brain Overload," Report of Proceedings of Sixtieth Tax Conference, 2008 Tax Conference (Toronto: Canadian Tax Foundation, 2009), 36:1-54, p. 1.
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