Non-competition agreements can be a valuable tool for purchasers
who want to protect their investments in new businesses. However,
non-competition agreements can have unintended and unexpected tax
consequences, particularly to sellers who grant non-competition
agreements to purchasers.
The Income Tax Act (Canada) (the Act)
contains specific provisions regarding the taxation of
"restrictive covenants", a broadly defined term that
includes, among other things, non-competition agreements,
regardless of whether such agreements are legally enforceable.
Under section 56.4 of the Act, the portion of the purchase price
allocated to the granting of a restrictive covenant (whether by the
parties or as a result of a deemed allocation, as discussed below)
will generally be taxable to the seller as regular income, as
opposed to a capital gain. This treatment is significantly less
favourable for the seller because regular income is subject to tax
at the seller's normal tax rate, whereas only half of a capital
gain is subject to tax.
However, the Act allows a seller that deals at arm's length
with the purchaser to avoid this unfavourable tax treatment with
respect to the amount allocated (or deemed to be allocated) to
non-competition agreements in certain circumstances, including:
if the amount would, absent the
restrictive covenant rules, be included in the calculation of
"cumulative eligible capital" under the Act and the
parties file a joint election; or
if the amount is proceeds of
disposition from the disposition of an "eligible
interest" (as defined in the Act), the parties file a joint
election, and a number of other specific conditions are met.
It is important to note that, subject to certain rules discussed
below, the portion of the purchase price that can be reasonably
regarded as payment for the restrictive covenant will be deemed to
have been payment for the restrictive covenant. This will be the
case even when the parties have allocated a portion of the purchase
price to the restrictive covenant if the allocation chosen by the
parties is not reasonable. This rule would result in any amount so
deemed generally being treated as regular income to the seller.
The deeming rule will not apply with respect to non-competition
agreements in certain circumstances, most notably where the parties
deal at arm's length and, among other things:
the amount that can reasonably be
considered consideration for the non-competition agreement is
allocated to a "goodwill amount" (as defined in the Act)
and the parties file a joint election in respect of the
non-competition agreement; or
no amount is allocated to the
non-competition agreement and it is reasonable to conclude that the
non-competition agreement is integral to an agreement in writing
whereby the seller sells either property or shares to the
If the deeming rule does not apply, no amount will be treated as
regular income to the seller in respect of the non-competition
The rules regarding the taxation of restrictive covenants are
complex. Parties wishing to use non-competition agreements in their
transactions should ensure that they consider whether their
non-competition agreements will result in additional tax being
payable and whether any elections are necessary to prevent such
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general guide to the subject matter. Specialist advice should be
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