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Restrictive Cov...

Restrictive Covenants


On June 26, 2013 Bill C-48 received Royal Assent entacting the proposed legislation related to the taxation of Restrictive Covenants (RCs). This legislation is retroactive to years as far back as 2003, although it is uncertain whether CRA could reopen a return past the normal reassessment period for legislation passed long after the return was filed.


Subsection 56.4(2) provides that any amount received or receivable for a RC will be treated as ordinary income for tax purposes. Obviously when dealing with the sale of a business by means of shares sale the difference is declaring the income as a capital gains and ordinary income (or 50% inclusion and 100% inclusion). A RC is an agreement between parties, or an undertaking or waiver of an advantageous right that affects, or is intended to affect, in any way, the acquisition of property or services. This agreement need not be legally enforceable.


Some Exceptions to the General Inclusion

There are three narrow exceptions (56.4(3)) to the general income inclusion rule provided that the vendor and purchaser deal at arm’s length, as follows:


1)      Employment income – if the amount is required to included in employment income or would be so if the amount had been received in the year.

2)      Eligible capital property – if the amount would be included in in the tax payer’s cumulative eligible capital in respect of the business carried on in Canada by the taxpayer.

3)      Shares and partnership interests – if the amount is the disposition of an eligible interest


Reallocation of Proceeds

Due to the preferential tax treatment of capital gains, as compared to the full income inclusion for the proceeds related to the RC, CRA retains the rights to challenge and reallocate the proceeds under Section 68 which generally allows CRA to challenge unreasonable allocations of proceeds. There are some very specific cases, certain employee relationships (subsection 56.4(6) and arm’s length and non-arm’s length transfer of goodwill and certain property subsection 56.4(7)) where CRA cannot reallocate the proceeds.


Election Required

To fall within the exception 2 or 3 above, the vendor and thebuyer must jointly elect in a prescribed form. As the prescribed form is not yet available, the seller and buyer must file a jointly-signed letter to make the election. SEE BELOW FOR CRA RULES FOR THE ELECTION


            Election for restrictive covenants

Since we have not published a prescribed form for the elections contained in section 56.4 of the Income Tax Act, the seller (grantor) and buyer (payor) have to file a jointly-signed letter to make the election.

This letter must include the following information concerning the grantor:

  • Full name
  • Social insurance number or business number
  • Address, and mailing address if applicable
  • The taxation year of the grantor in which they sold the restrictive covenant

This letter must include the following information concerning the payor:

  • Full name
  • Social insurance number or business number
  • Address, and mailing address if applicable
  • The taxation year of the payor in which they bought the restrictive covenant

This letter must include the following information concerning the covenant:

  • A description of the covenant
  • The full name of the taxpayer granting the covenant
  • The full name of the taxpayer receiving the consideration for the covenant
  • An indication that these parties deal at arm's length
  • Under which provision of section 56.4 is the election being made by the parties

The election is deemed to be filed on time if it is filed on or before the day that is 180 days after Royal Assent, That is December 23, 2013. Otherwise, the prescribed form (or letter) must be filed on or before the person’s filing due date for the taxation year that includes the date the RC was granted for persons resident in Canada. For non-residents, the deadline is 6 months after the day the RC was granted.

Note that the basic requirements for exception 3 to the general rule include that the RC must be a non compete. As such various other RC’s such as non-solicitation and non-disclosure (or confidentiality agreements) may not qualify for the exception.
Restrictive Cov...
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Saturday, 19 June 2021