Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.
Principal Issues: Will the rules in subsection 56.4 apply in a specific fact situation such that the amount or a portion of the amount that is granted in respect of a restrictive covenant will be included in income by virtue of subsection 56.4(2) or another provision of the Act? Would the exception to income treatment in either subsection 56.4(7) or 56.4(3) apply?
Position: see analysis
Reasons: see analysis
August 22, 2017
Joanne Verkerk HEADQUARTERS
Manager Technical Section Income Tax Rulings
Business Audit Division Directorate
SME Directorate Sandro D’Angelo
CPB Branch - HQ (613) 410-9703
ATTN: XXXXXXXXXX 2017-068830
This is in reply to your memorandum of February 14, 2017, wherein you requested our assistance on the application of the restrictive covenant rules (“RC” rules) in section 56.4 of the Income Tax Act (“Act”) in a particular fact situation.
Our understanding of the facts, as described in your memorandum, and certain other information you submitted to us, is summarized as follows:
- XXXXXXXXXX (“Targetco”) is a private company incorporated under the laws of XXXXXXXXXX. Targetco XXXXXXXXXX. (footnote 1)
- On XXXXXXXXXX (the “Closing Day”), XXXXXXXXXX, a XXXXXXXXXX incorporated under XXXXXXXXXX law (the “Purchaser”) purchased all XXXXXXXXXX common shares (the “Shares”) of Targetco from its shareholders (the “Shareholders”). (footnote 2)
- Section XXXXXXXXXX of the Share Purchase Agreement (“SPA”) dated XXXXXXXXXX, stipulates that the purchase price of the Shares is $XXXXXXXXXX CAD, XXXXXXXXXX.
- The purchase price of the Shares was payable XXXXXXXXXX:
On the Closing Day, the Purchaser paid $XXXXXXXXXX CAD XXXXXXXXXX. (footnote 3) XXXXXXXXXX $XXXXXXXXXX CAD XXXXXXXXXX (footnote 4) XXXXXXXXXX:
o XXXXXXXXXX (footnote 7)
o XXXXXXXXXX (footnote 8)
- In addition, in order to receive their XXXXXXXXXX period described above. (footnote 9) XXXXXXXXXX
- XXXXXXXXXX were also required under the terms of the SPA to agree to a non-competition covenant (“NCC”) and a non-solicitation covenant (“NSC”) XXXXXXXXXX.
HQ Audit’s position:
As set in your memorandum, it is your view that the XXXXXXXXXX NCC and NSC are inextricably linked and should be viewed as a single RC. XXXXXXXXXX:
In your view, the definition of RC is sufficiently broad to include the entire portion of the XXXXXXXXXX as income pursuant to subsection 56.4(2) unless one of the exceptions applies. (footnote 16) XXXXXXXXXX.
The Taxpayer’s position is that the XXXXXXXXXX constitute part of the total purchase price of the Shares and should be treated as proceeds of disposition (“POD”) of the Shares. The Taxpayer rejects the Canada Revenue Agency’s preliminary position that the XXXXXXXXXX payments (all or any portion) must be included in any Shareholder’s income under subsection 56.4(2) XXXXXXXXXX.
In the Taxpayer’s view, the purchase price of the Shares agreed to by the arm’s-length parties reflects the value of the business of Targetco, even though the XXXXXXXXXX Shareholders must comply with the terms of the NCC and NSC (XXXXXXXXXX) in order to receive XXXXXXXXXX.
Based on the above, the Taxpayer maintains that no portion of the XXXXXXXXXX should be included in any Shareholders income under subsection 56.4(2), XXXXXXXXXX:
In our view, there are two key issues for us to consider:
1. Should XXXXXXXXXX, NCC and NSC be viewed as separate RCs or as a single RC for the purposes of the RC rules?
2. Would any of the exceptions in subsections 56.4(3), 56.4(6) and 56.4(7) apply to prevent all or any portion of the XXXXXXXXXX from being included in income under subsection 56.4(2) XXXXXXXXXX?
The term “restrictive covenant” is defined in subsection 56.4(1) of the Act as “… an agreement entered into, an undertaking made, or a waiver of an advantage or right by the taxpayer, 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 ….”.
XXXXXXXXXX, we analysed the scope of the definition of an RC. It is our understanding that the RC rules were broadly drafted to prevent taxpayers from being able to structure transactions that would result in them receiving amounts as non-taxable capital receipts in inappropriate circumstances. Thus, we confirmed that the definition could apply to a host of contractual provisions that may be either positive or restrictive in nature such that, in addition to typical non-competition clauses, an RC could include: exclusivity clauses, signing bonuses, break fees, supplier loyalty agreements, confidentiality agreements, franchise agreements, and referral fees.
Under subsection 56.4(2) of the Act, where an amount is received or receivable for a RC granted by a taxpayer, such amount is generally required to be included in the taxpayer’s income in full unless a specific exception applies. The exceptions are found in paragraphs 56.4(3)(a), (b) and (c) and subsections 56.4(6) (footnote 18) and (7).
Generally speaking, where an amount is received or receivable by a taxpayer as consideration for the disposition of a property and no amount has been specified as being received or receivable for a RC, section 68 can apply to deem a portion of the consideration (as may be reasonable in the circumstances) as being an amount received or receivable by the taxpayer for the RC. In these circumstances, the amount deemed by section 68 as being in respect of the RC will be included in the taxpayer’s income under subsection 56.4(2) of the Act. However, subsection 56.4(5) provides that section 68 will not apply where subsections 56.4(7) applies. Where this exception applies, the amount in respect of the RC can be treated in one of three ways: (i) POD in respect of a disposition of goodwill; (ii) as POD in respect of a disposition of property (other than goodwill or shares or a corporation); or (iii) as POD in respect of a disposition of shares in the capital stock of a corporation.
The provisions in subsection 56.4(7) differ slightly for RCs granted to an arm’s-length person (subparagraph 56.4(7)(a)(i)) and RCs granted to an “eligible individual” (subparagraph 56.4(7)(a)(ii)). Since the current fact situation pertains to the granting of one or more RCs to a person (i.e., the Purchaser), who appears to otherwise be dealing at arm’s-length with Targetco and its Shareholders, we will review the relevant conditions that must be met in this context. (footnote 19)
Issue 1 – A single RC or separate RCs
The first requirement, which is found in subparagraph 56.4(7)(a)(i), states that the RC must be granted by a taxpayer (referred to in subsections 56.4(7) and 56.4(8) as the “vendor”) to another taxpayer (in this subsection referred to as the “purchaser”) with whom the vendor deals at arm’s length. Another key requirement is that the RC must be an undertaking of the vendor not to provide, directly or indirectly, property or services in competition with the property or services provided by the purchaser (or by a person related to the purchaser) in the course of carrying on the business to which the restrictive covenant relates (a non-compete covenant). This condition is found in paragraph 56.4(7)(b) and states:
“(b) where subparagraph (a)(i) applies, the restrictive covenant is an undertaking of the vendor not to provide, directly or indirectly, property or services in competition with the property or services provided or to be provided by the purchaser (or a person related to the purchaser) in the course of carrying on the business to which the restrictive covenant relates, and…”
This restricts the application of paragraph 56.4(7)(b) to what are referred to as non-competition covenants. In the current fact situation, XXXXXXXXXX appear to have granted one or more RCs which include the XXXXXXXXXX, NCC and NSC.
XXXXXXXXXX, the CRA was asked to comment on RCs such as non-solicitation and confidentiality provisions and the exception in paragraph 56.4(3)(c). The response given was as follows:
“For purposes of the exception in paragraph 56.4(3)(c) all six of the required conditions must be met. As indicated above, one of the required conditions set out in subparagraph 56.4(3)(c)(ii) is that the amount in respect of the RC granted by the taxpayer must be consideration for an undertaking by the taxpayer not to compete. If the amount in respect of the RC granted by a taxpayer is not consideration for a RC that is an undertaking not to compete then the required condition set out in subparagraph 56.4(3)(c)(ii) will not be met.
Our understanding of the requirement of subparagraph 56.4(3)(c)(ii) of the Act when applied in the course of the sale of shares is that the subparagraph would allow an election with respect to the undertaking not to solicit the clients of the corporation that is sold, but it would not allow such an election with respect to the value of an undertaking not to solicit the employees to change employment.”
A similar issue was also discussed in XXXXXXXXXX. In particular, we considered whether a confidentiality clause would preclude a taxpayer from making an election under paragraph 56.4(3). After considering the issue, XXXXXXXXXX, we concluded the following:
“… the fact that a non-competition agreement may include both a non-competition and a confidentiality clause would not in and of itself disqualify the entire non-competition agreement for the purposes of the exceptions in subsection 56.4(3) or 56.4(7).”
In the current fact situation, the NSC appears to be an integral part of the NCC. That is, no meaningful distinction can be made between the NCC and the NSC, as both appear to be fundamental elements needed to restrict a Shareholder’s ability to compete with Targetco.
Essentially, the terms of the NCC and NSC, which are in the same section of the SPA, also appear to reflect the conditions that one might normally expect to see in a typical non-competition agreement. Thus, the NSC and NCC could be treated as a single RC that is in respect of a non-compete covenant.
Issue 2 – Subsection 56.4(7)
Given the result of our analysis for Issue 1, we will focus our discussion in this part on whether the exception in subsection 56.4(7) applies to the single RC that is comprised of the NCC and NSC.
In this fact situation, it appears that the conditions in subparagraphs 56.7(a)(i) and (b)(ii) are met. The Shareholders (vendors) have granted an RC to the Purchaser who appears to be arm’s length with the vendors (subparagraph 56.7(a)(i)) and the RC is essentially a true non-compete in respect the sale of Shares by the vendor to the Purchaser (clause 56.4(7)(b)(ii)(B)). In addition to meeting these conditions, each of the following conditions must also be met in order for subsection 56.4(7) to apply:
- As per paragraph 56.4(7)(d), no proceeds are received or receivable by the vendor for granting the RC.
- As per paragraph 56.4(7)(e), the disposition cannot be a redemption, acquisition or cancellation of a share to which subsection 84(3) applies.
- As per paragraph 56.4(7)(f), the RC must reasonably be regarded to have been granted to maintain or preserve the fair market value of the goodwill amount, or the property disposed of, including the shares of the vendor (target) corporation.
- As per paragraph 56.4(7)(g), a joint election in prescribed form is required to be made when the RC pertains to goodwill. Where the RC pertains to shares or other property no joint election is required (XXXXXXXXXX).
Based on our understanding of the facts, it does appear that all the required conditions in subsection 56.4(7) are met such that by virtue of 56.4(5), section 68 would not apply to the RC that is comprised of the NCC and the NSC. Further, where all the required conditions in subsection 56.4(7) have been met, the joint election condition in paragraph 56.4(7)(g) is not required (XXXXXXXXXX).
The RC that is comprised of the NCC and NSC does appear to meet all the conditions in subsection 56.4(7) such that the amount of the XXXXXXXXXX that pertains to this RC, whatever that amount is determined to be, should be treated as POD of the Shares.
We trust our comments will be of assistance.
Michael Cooke, C.P.A., C.A.
Business Income and Capital Transactions Section
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
Note to reader: Because of our system requirements, the footnotes contained in the original document are shown below instead:
3 SPA XXXXXXXXXX.
7 SPA XXXXXXXXXX.
8 SPA XXXXXXXXXX.
9 SPA XXXXXXXXXX.
11 SPA XXXXXXXXXX.
13 SPA XXXXXXXXXX.
15 XXXXXXXXXX. Calculation Valuation prepared by XXXXXXXXXX.
16 Subsections 56.4(3); 56.4(6); and 56.4(7) contain the RC rules exceptions.
17 Also summarized from HQ Audit’s memorandum and from a letter from the Taxpayer’s lawyer XXXXXXXXXX.
19 Whether the Purchaser is considered to be arm’s length with the Shareholders remains a question of fact and this determination is beyond the scope of our review.
20 This is the TSO Auditor’s view.
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