Michael Coburn, "Practical Strategies for Dealing with the Restrictive Covenant Provisions", 2014 Conference Report (Canadian Tax Foundation), 8:1-29

Examples of scope (p. 7)

Examples of agreements, undertakings or waivers that appear to be caught by the definition of restrictive covenant include: non-competition covenants non-solicitation covenants break fees confidentiality provisions non-disparagement covenants rights of first refusal territorial restrictions non-disturbance covenants

Overlap with s. 12(1)(x) (p. 7)

[I] t would be expected that payments for many of the covenants caught within the definition of "restrictive covenant" would otherwise be taxable as income pursuant to paragraph 12(l)(x) due to both the inclusive language in paragraph 12(l)(x) and the general position that an mount received "as part of the ordinary business" operations of a taxpayer is taxable as income. [fn 16: See Ikea Ld. v. The Queen 98 DTC 6092 (SCC), 96 DTC 6256 (FCA), 94 DTC 1112 (TCC) and Morguard Carpentier v. The Queen 2013 DTC 5009 (FCA).]

Low value of unenforceable restrictive covenants (p.8)

One of the more unusual aspects of the definition of restrictive covenant is the statement that a restrictive covenant includes a covenant that is not enforceable.

…[T]o the extent that the anti-avoidance aspect of the restrictive covenant provisions rely on the ability to reallocate value to a restrictive covenant through the application of subsection 68(c), one would assume that a determination of the appropriate amount of value to reallocate would have to consider whether the covenant was actually enforceable.

Indeed, the CRA itself has acknowledged the connection between enforceability and value, albeit in a context outside of the restrictive covenant provision. [fn 17: In IC 89-3…the CRA states that determining the fair market value of an option requires an analysis of whether the option is enforceable.]

Enforceability of restrictive covenant if no allocation of consideration (pp. 4-5)

[T]here may be a perception that to ensure the legal enforceability of a restrictive covenant it is necessary to allocate significant proceeds to the grant of the restrictive covenant.

…[I]n Elsley v. J.G. Collin Inx. Agencies, [fn 12: [1978] 2 S.C.R.] the Supreme Court of Canada seems to downplay the significance of a direct allocation of proceeds….Indeed, in Elsley, the Court enforced a non-competition restrictive covenant even though no proceeds were directly allocated to it.

S. 56.4(3) as a counter to s. 68(c) (pp.21-22)

[S]ubsection 56.4(3) contains provisions that effectively allow an amount received as consideration for granting a restrictive covenant to be characterized as either proceeds of disposition (presumably allowing for capital gains treatment in the hands of the recipient) or an eligible capital amount.

[S]ubsection 56.4(3), to the extent it would allow the grantor to achieve the same outcome as a nil allocation, could act as effective counter to section 68.

The following example sets out how this might occur.

  • Assume Mr. X, as part of an asset sale, grants a restrictive covenant that does not qualify as a Non-Competition Covenant and therefore does not qualify for a safe harbour from section 68.
  • In allocating the proceeds from the sale, Mr. X and the Purchaser allocate $100,000 to capital property, $100,000 to depreciable property and $100,000 to goodwill. The parties do not allocate any amounts to the restrictive covenant.
  • After the transaction is completed, the CRA is able to successfully establish that a reasonable business person would not have agreed to the above allocation. The CRA is further able to establish that a reasonable allocation would have been $50,000 to capital property, $100,000 to depreciable property and $50,000 to the restrictive covenant.

What would the tax impact of such reallocation be?

  • In terms of the allocation to the restrictive covenant, the amount might qualify for treatment as cumulative eligible capital amount pursuant to paragraph 56.4(3)(b) in that:
  • X and the Purchaser are arm's length;
  • X would have received any proceeds that were reallocated to the restrictive covenant, X and
  • the amount would, absent subsection 56.4(5), be included in the description of an "E" in the definition of cumulative eligible capital amounts.

Therefore the only condition for the application of subsection 56.4(3)(b) exception (and the resulting treatment of the amount as a cumulative eligible capital amount) would be the filing of an election)….

…[I]t might be argued that one reason why allocating nil or nominal proceeds to restrictive covenant is reasonable is that the parties may have been able to achieve the same tax outcome through an allocation of proceeds and the application of the recharacterization provisions. It would seem to be reasonable proposition that two parties would, when faced with two alternatives that lead to the same result, choose the one that did not require a formal election or a potentially difficult assessment of the value of a standard restrictive covenant.

Narrowness of non-compete description in ss. 56.4(3)(c)(ii, 56.4(6)(d), 56.4(7)(b) and 56.4(7)(c) (p. 7)

[I]f a covenant falls within the definition of restrictive covenant but not the concept of a Non-Competition Covenant it cannot be exempted from the applicable of section 68.

…Generally, a non-solicitation provision would be seen as an extension of non-competition provisions insofar as the purpose of the non-solicitation covenant is typically to prevent the vending party from contacting certain key third parties to encourage these parties to commence a business relationship with a competing party….

…[I]t may be worth reconsidering the common practice of separating non-competition and non-solicitation provisions….

…[F]ormulae, methodology and other intellectual property may have value in the hands of a generic third party. However, in most situations it would be expected that the confidentiality concerns of a purchaser arise from the perceived harm that could arise if the confidential information was obtained by a competitor.

…[B]reak fees, non-disparagement covenants and non-disturbance covenants would seem to clearly fall outside the concept of a non-competition covenant.

Application of the requirement – that the proceeds be received by the grantor of the non-compete covenant or an eligible corporation thereof – to a trust or partnership (pp.12-13)

[Under s. 56.4(7)(b)] generally, consideration must be received by either the "taxpayer" or an "eligible corporation" of the taxpayer. [S]ubsection 56.4(1) deems a partnership to be a taxpayer… .

[I]t would be expected in many, if not most, transactions involving trust or partnerships that persons other than the trust or partnership would be asked to grant a Non-Competition Covenant. In particular, the trustee of a trust in his or her personal capacity, a beneficiary of a trust or a partner of a partnership may be expected to grant a Non-Competition Covenant.

…With respect to a trust, it would seem that a Restrictive Covenant granted by a beneficiary or trustee of a trust would not meet the receipt of consideration requirements as neither the trustee or beneficiary would receive either a goodwill amount or consideration for the disposal of property.

…[I]n a situation where a partnership receives and then allocates a goodwill amount to the partners of the partnership, subparagraph 56.4(7)(b)(i) provides that "the amount that can be reasonably be regarded as being consideration for the restrictive covenant" must be included in the income of the party (or an eligible corporation of j that party) that grants the restrictive covenant.

The reference to "the amount" rather than "an amount" suggests that it may be necessary to allocate to each partner that portion of the goodwill amount that directly represents consideration for the Non-Competition Covenant granted by that party….

So, for example, if Partnership X receives $1,000,000 as a goodwill amount and it allocated one-third of this amount to each of Partners A, B and C (each of whom provided a Non-Competition Covenant), would the Receipt of Consideration Requirement be met if it could be demonstrated that 90% of the goodwill amount was actually attributable to Partner A's Non-Competition Covenant?

Requirement of nil proceeds for covenant: tracing issue (p.14)

[A] grantor of a Non-Competition Covenant could acknowledge that the consideration for granting the covenant is the beneficiary's agreement to acquire property from the grantor…[for example]:

"[T]he Restrictive Covenants are integral to the Purchase Agreement and have been granted to maintain or preserve the fair market value of the Purchased Assets."

…The fairly general language of subsection 56.4(7)(d)…suggests the possibility that if proceeds can be "traced" to the grant of a restrictive^ covenant this would be sufficient to cause a failure to meet the "no proceeds" requirement.

Ultimately, however, such an interpretation would not be consistent with the structure of section 56.4. If the "no proceeds" requirement is not met in any situation where proceeds are attributable but not allocated to a restrictive covenant, it would likely never be met insofar as some consideration is always going to be attributable to a restrictive covenant. To put it differently, the only way no proceeds could be considered attributable to a restrictive covenant would be if the restrictive covenant had no value… .

Exclusion of hybrid sales and safe income strips (p.15)

[A]ll share repurchases or redemptions, including ones that do not result in an actual deemed dividend, would appear to be excluded from the arm's length safe harbour provisions.

…[S]everal forms of hybrid transaction involve the application of subsection 84(3)… . Similarly, many safe income strip transactions involve the extraction of funds through a dividend triggered by a subsection 84(3) redemption….

Burden on CRA of establishing unreasonableness/reasonableness of nil allocation (pp.17-19)

Effectively, the courts have created a test where the CRA will be considered to have failed to meet the reasonable tests in section 68 if the CRA cannot demonstrate that the taxpayer made an unreasonable allocation….

…[T]he threshold for establishing unreasonableness is high. Specifically, the Federal Court of Appeal in Transalta… cited with approval the reasonableness standard set out in Gabco… […68 DTC 5210.]

[Transalta suggests that] the strategy of minimizing the impact of section 56.4 by allocating nil or nominal proceeds to the grant of a restrictive covenant… would succeed even where a safe harbour did not apply if it could be demonstrated that a reasonable business man would agree to a nil or nominal allocation of proceeds.

…[T]here would appear to be significant support for the position that two reasonable business persons would agree to allocate nil or nominal consideration to a restrictive covenant.