8 November 1995 Internal T.I. 9525077 - NON-COMPETITION PAYMENTS

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.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

Are non-competition payments received by shareholder of a corporation and a non-shareholder taxable under 14(1) where the business assets of the corporation are sold and the shareholder and non-shareholder do not otherwise carry on a business personally (either before or after the sale).

Position:

No. Capital gains treatment applies.

Reasons:

To be ECE the Act requires a business. See also IT-386R, para 4.

                  November 8, 1995

LONDON TAX SERVICES OFFICE HEADQUARTERS
Audit Services Michael Cooke
(613) 957-8953
Attention: Dave MacPherson
952507

Non-Competition Payments

This is in reply to your memorandum dated September 14, 1995, wherein you requested our views as to the taxability of certain non-competition payments received by
XXXXXXXXXX

Facts

The facts of this particular situation, as we understand them, are set out as follows:

XXXXXXXXXX

The Issue

Is there a disposition of property such that section 42 of the Act applies and the taxpayers' treatment of the capital gain with the capital gains reserve is correct or should the non-competition amounts be treated as proceeds of disposition of an eligible capital property (ECP) under subsection 14(1) of the Act with no reserve available.

You View

XXXXXXXXXX

Our Analysis

Property is broadly defined in subsection 248(1) of the Act to include, "...a right of any kind whatever...". It is our view that where a taxpayer gives up his right to compete in a business under a contract that right would be a property for the purposes of the Act and any consideration received by the taxpayer for giving up such right would generally be on account of capital.

Subsection 14(1) of the Act provides that where, at the end of a taxation year the amounts required to be deducted from a taxpayer's cumulative eligible capital (CEC) in respect of a business exceed the amounts required to be added to it, the negative balance, if any, is required to be included in the taxpayer's income for the year from that business. For the purpose of this subsection amounts described in the definition of CEC at clause 14(5)(a)(iv)(E) of the Act are described as an eligible capital amount (ECA) which reduces the CEC (now contained the definition of CEC as subclause 14(5)(E)(a)).

As noted above ECA is defined to include 3/4 of any amount that a taxpayer, "as a result of a disposition ... has or may become entitled to receive, in respect of the business carried on or formerly carried on by him where ... the payment would have been an eligible capital expenditure of the taxpayer in respect of the business...". This is the so called "mirror image test".

An eligible capital expenditure (ECE) is defined in subparagraph 14(5)(b) of the Act as essentially being an outlay or expense made on account of capital for the purpose of gaining or producing income from a business unless that amount was otherwise recognized in computing the taxpayer's income for tax purposes. Paragraph 33 of Interpretation Bulletin IT-143R2 states that, "An amount paid by a taxpayer to another person with whom the taxpayer deals at arm's length, to obtain that other person's covenant not to engage in any business within a designated geographical area during a specified period of time, that is the same as or is similar to the business carried on by the taxpayer (emphasis added), may qualify as an ECE.

Paragraph 5 of Interpretation Bulletin IT-330R states that, "Where capital properties of a business are sold, a non-competition covenant, given by the vendor (emphasis added) not to carry on a competitive business, is considered to be in respect of the disposition of the goodwill of the business and is therefore not subject to section 42. Such a disposition is the disposition of eligible capital property and is subject to the provisions of section 14". Paragraph 6 of this IT then goes on to state that where a shareholder sells the shares of a corporation representing the underlying business assets, "...any amount received for a non-competition covenant referred to in paragraph 5 that is in respect of the disposition of shares comes within the provisions of section 42 as part of proceeds of disposition of the shares".

The Department's view on how to properly apply the mirror image test is expressed in Interpretation Bulletin IT-386 at paragraph 4. The Department considers that the taxpayer receiving the payment must "look in the mirror" to see whether, if the payment were made by him, it would qualify as an ECE. If we apply the mirror image test to the facts as set out in this case then it appears that the non-competition amounts would not qualify as an ECE since both XXXXXXXXXX are not carrying on any business in a personal capacity. It is our view that in order for the amounts to qualify as ECE there must be a business or former business carried on by the taxpayer to which those amounts would relate. It is also our view that since XXXXXXXXXX is neither the vendor of shares which reflect the underlying business assets of the XXXXXXXXXX or the vendor of the business assets themselves, the policies as set out in paragraphs 5 and 6 of IT-330R are not applicable.

Conclusion

It is our view that the characterization of amount using the mirror image test should be determined from the point of view of XXXXXXXXXX. This view is consistent with the Department's view as expressed in IT-386. Accordingly, what XXXXXXXXXX have disposed of is their right to compete in a business under a contract and subject to our comments which follow, the non-competition payments should be treated as proceeds of disposition of that capital property which may give rise to a capital gain and a capital gains reserve under paragraph 40(1)(a)(iii) of the Act.

Unless you have evidence that the consideration paid by the XXXXXXXXXX was less than the fair market value of the purchased assets, including goodwill of the XXXXXXXXXX if any, there would not appear to be any basis upon which subsections 15(1), 56(2), 246(2) or other similar provisions can be considered.

F. Lee Workman
Section Chief
Financial Industries Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch