Canada: Taxation Of Restrictive Covenants – Caution When Trying To Qualify For Exceptions To Full Income Inclusions!

Last Updated: July 29 2014
Article by Kim G.C. Moody

Our firm has written about the taxation of restrictive covenants many times before. You will find a link to a blog written late last year that explained the basic mechanics of the "new" restrictive covenant rules under section 56.4 of the Canadian Income Tax Act (the "Act") here.

Section 56.4 of the Act is mind-numbingly complex. However, to oversimplify, if a person grants a restrictive covenant, such as a non-compete agreement (which is often part of a purchase and sale agreement for the sale of business), then the person granting the covenant needs to concern themselves with the new section 56.4. If section 56.4 applies, then any amount received or receivable by the grantor (or deemed to be received or receivable pursuant to section 68 of the Act – I call this the "deemed receipt" rule) in respect of that restrictive covenant grant will be taxed as a full income inclusion. This surprises many taxpayers. There are usually two responses when tax geeks like me give restrictive covenant grantors the bad news:

1. "I didn't receive any amount for the restrictive covenant grant... it was just part of the purchase and sale agreement for the disposition of my shares [or assets]."

My response to the above comment is that it doesn't matter if you didn't receive anything explicit for the restrictive covenant grant. Paragraph 68(c) will deem you to have an amount that is received or receivable and is reasonable in the circumstances irrespective of the form or legal effect of the contract or agreement. Ouch!

2. "No one told me about these rules! Are you sure you're right?!"

Yes... we understand that you likely have not been counselled on these challenging new rules. As mentioned in our previous blog, it is our firm's experience that many non-tax advisors are simply ignoring the new rules or are not aware of them. Frankly, to ignore the new rules is dangerous and something we do not recommend. And yes, we are right.

Thankfully, new section 56.4 contains some exceptions which broadly fit into two categories:

1. Exceptions to the full income inclusion rule – Subsection 56.4(3)

These exceptions are very narrow and not the subject of this blog. Suffice it to say, however, that many persons who enter into vanilla commercial transactions involving a restrictive covenant grant will not be able to avail themselves of the exceptions under subsection 56.4(3).

2. Exceptions to the "deemed receipt" rule – Subsections 56.4(6) and (7)

As mentioned above, paragraph 68(c) of the Act will deem a person to have an amount received or receivable in respect of a restrictive covenant on what is reasonable in the circumstances. There are exceptions to the deemed receipt rule in subsections 56.4(6) and (7). If applicable, these rules can be very helpful if no amounts are directly received by the grantor since section 68 will not be applicable to deem amounts to have been received or receivable.

One of the conditions to be eligible for the exception to the deemed receipt rule is that "no proceeds are received or receivable by the vendor for the granting of the restrictive covenant" (see paragraphs 56.4(6)(e) and 56.4(7)(d)). Accordingly, many tax geeks (including me), became concerned about what the above phrase means. Pursuant to general principles of the common law of contracts, a contract must be entered into for consideration... even if such consideration is nominal. Thus, prima facie is impossible to respect this condition in a common law jurisdiction. If so, then the exception to the deemed receipt rule would not be available. Yikes! While it is possible to enter into a contract under seal (a very old concept of how to enter into a valid contract... Wikipedia has an interesting overview of this concept and can be viewed here), it is debatable whether this constitutes consideration although the better view, after debating this issue with many of my lawyer friends, is that a contract under seal does not require consideration.1

Given the above, some of my tax nerd friends and I, who are responsible for the Society of Trust and Estate Practitioners ("STEP") Canada Revenue Agency ("CRA") Roundtable decided to ask the CRA about their views on the above subject at the recent STEP National Conference. Below you will find the original question and the CRA's response. For those of you interested, you'll find all of the questions and answers for the 2014 Roundtable here.

QUESTION 15. Restrictive Covenants

In very general terms, the rules concerning restrictive covenants are divided into two categories, the first being where there is no consideration for the restrictive covenant, and the second being where there is consideration. The rules applicable to situations where there is no consideration are generally more widely applicable. However, a restrictive covenant is normally structured as a contract, and a contract requires that consideration be given by the parties. Accordingly, it would be common in drafting a restrictive covenant to state that the consideration is the sum of $1 and other valuable consideration etc. In these circumstances, does the fact that a contract of a restrictive covenant stipulates the amount of $1 mean that there is consideration, such that the elections, provided under subsection 56.4(7) are inapplicable? Is CRA prepared to accept that a nominal sum, merely to constitute a contract which is legally binding, does not constitute proceeds allocated to the restrictive covenant for this purpose?

CRA Response

While we understand that a nominal amount of consideration may be given by the parties in a contract relating to a restrictive covenant to ensure that the contract is legally binding, it is the CRA's view that this would still constitute an amount of proceeds received or receivable by the particular party for granting the RC. As such, the exceptions set out in subsections 56.4(6) and (7) could not apply because the respective conditions in paragraph 56.4(6)(e) and paragraph 56.4(7)(d) would not technically be met. In such cases, the amount of proceeds (or any additional amount deemed by paragraph 68(c)) received or receivable by the taxpayer for the RC would be taxable as ordinary income under subsection 56.4(2) unless one of the three exceptions in subsection 56.4(3) otherwise applies.

As such, taxpayers seeking relief in these circumstances may want to contact the Department of Finance Canada to outline their concerns on this issue.

The above answer was certainly not what practitioners were hoping to hear from the CRA. We were hoping that the CRA would say that administratively they would ignore the nominal consideration for purposes of ensuring that the exception to the deemed receipt rule would apply. Nope.

This is not a new issue and I have had many discussions with the Department of Finance on this issue over the years. However, we were hoping for administrative relief to be exercised by the CRA when administering the law. We will continue to have discussions with the Department of Finance on this important issue.

In the meantime, practitioners who advise on matters involving restrictive covenant grants should:

  1. Seek specialized tax advice on section 56.4 early on in the planning;
  2. Ensure that restrictive covenant contracts are done under seal2 (assuming one subscribes to the camp that such a grant would not be for consideration); and
  3. Keep their ears to the ground to see if the CRA changes their administrative position at some point in the future.

Like Einstein said, "the hardest thing to understand in the world is the income tax". The restrictive covenant rules are certainly illustrative of this.

 Footnotes

1 See Friedmann Equity Developments Inc. v. Final Note Ltd. 2000 SCC 34 ("Friedmann") at paragraphs 20 and 48.

2 The Supreme Court of Canada has stated that a corporate seal, by itself, may not be sufficient to constitute a contact under seal. See Friedmann at paragraphs 36 and 37 for an overview of the requirements to create a contract under seal.

Moodys Gartner Tax Law is only about tax. It is not an add-on service, it is our singular focus. Our Canadian and US lawyers and Chartered Accountants work together to develop effective tax strategies that get results, for individuals and corporate clients with interests in Canada, the US or both. Our strengths lie in Canadian and US cross-border tax advisory services, estateplanning, and tax litigation/dispute resolution. We identify areas of risk and opportunity, and create plans that yield the right balance of protection, optimization and compliance for each of our clients' special circumstances.

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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Kim G.C. Moody
Events from this Firm
16 Nov 2018, Webinar, Riyadh, Saudi Arabia

On Dec. 22, 2017, President Trump signed into law the biggest US tax reform bill in 31 years, changing the lives of Americans at home and abroad.

1 Dec 2018, Seminar, Toronto, Canada

On Dec. 22, 2017, President Trump signed into law the biggest US tax reform bill in 31 years, changing the lives of Americans at home and abroad.

5 Dec 2018, Webinar, Calgary, Canada

This technical session will be of interest to advisors to private businesses (accountants, lawyers, investment and insurance advisors, bankers, trust officers and others) and business owners

Similar Articles
Relevancy Powered by MondaqAI
Moodys Gartner Tax Law LLP
Collins Barrow National Incorporated
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Moodys Gartner Tax Law LLP
Collins Barrow National Incorporated
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions