Section 56.4

Subsection 56.4(1) - Definitions

Eligible Corporation

Administrative Policy

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

Residency requirement (p.8:15)

[I]f a Canadian-resident shareholder of Foreignco provides a non-competition covenant in conjunction with the sale of Foreignco, the arm's-length sale safe harbour is not available.

Eligible Interest

Administrative Policy

11 October 2013 APFF Roundtable, 2013-0495691C6 F - Clause restrictive

must be one, rather than more than one, underlying corp

Mr. X sells all the shares of Holdco, which holds all the shares of Opco 1 and Opco 2, to Buyco, which is at arm's length. He grants a non-compete covenant to Buyco respecting the business of each of Opco 1 and 2.

Before indicating that the exception in s. 56.4(3)(c) was not available, CRA stated (Tax Interpretations translation) that s. (c) of the definition of "eligible interest" did not extend to the situation where 90% or more of the shares of a corporation was "attributable to eligible interests in two other corporations."

Locations of other summaries Wordcount
Tax Topics - Income Tax Act - Section 56.4 - Subsection 56.4(3) - Paragraph 56.4(3)(c) non-solicitation clause/divergence of covenanter and seller 360
Tax Topics - Income Tax Act - Section 56.4 - Subsection 56.4(7) - Paragraph 56.4(7)(b) non-solicitation clause could be treated as part of a non-compete 153
Tax Topics - Income Tax Act - Section 56.4 - Subsection 56.4(7) - Paragraph 56.4(7)(f) maintenance of Holdco fmv/divergence of seller and covenanter 233

Articles

Mark Woltersdorf, "Restrictive Covenants – The Final Chapter (For Now) – Part I", CCH Tax Topics, No. 2132, 17 January 2013, p. 1 at p. 3

It is uncertain why the above definition [of eligible interest] excludes shares of a corporation where, for example, that corporation owns all of the shares in the capital stock of two or more subsidiary corporations. For example, assume the only property of Holdco consists of all of the shares of Subco1 and Subco2. The fair market value of Subco1 is roughly equal to that of Subco2. Subco1 owns the land and building used exclusively by Subco2 to carry on its business. In these circumstances, the Holdco shares would not be an eligible interest. To avoid this, Subco1 and Subco2 could amalgamate as a pre-closing transaction so that shares in the capital stock of Holdco would qualify as an eligible interest.

Restrictive Covenant

See Also

Pangaea One Acquisition Holdings XII S.À.R.L. v. The Queen, 2018 TCC 158

agreement with another shareholder to enter into a share sale with a 3rd party was a restrictive covenant

The appellant (“Pangaea”) was a Luxemburg s.à.r.l. that was one of the shareholders of a Canadian corporation (“Public Mobile”). The unanimous shareholder agreement provided that its shares could not be transferred without the consent of all the “Special Majority Shareholders” including Pangaea , In the context of negotiations that led to the sale of the shares of Public Mobile to Telus, Pangaea and a resident shareholder (“Thomvest”) entered into an agreement on September 23, 2013 (the “Letter Agreement”) that provided that Thomvest would pay $3,000,000 as consideration for Pangaea’s agreement to execute a share purchase agreement. Thomvest withheld and remitted 25% from this payment and the Minister denied Pangaea’s refund claim for this tax on the basis that the payment was a restrictive covenant payment per s. 56.4(1) that did not benefit from any relief under the Canada-Luxembourg Treaty.

In finding that the letter agreement was described by the preamble of the “restrictive covenant” definition, Smith J stated (at para 58):

[T]he preamble of the Letter Agreement provides that the Appellant “proposes to, concurrently with the entering into of this letter agreement (…) enter into a share purchase agreement (…)”. I find that this is sufficient to establish that the Letter Agreement affected or was intended to affect the “provision of property”… .

Locations of other summaries Wordcount
Tax Topics - Income Tax Act - Section 212 - Subsection 212(1) - Paragraph 212(1)(i) lump sum paid for non-resident's concurrence in share sale was for restrictive covenant 179

Administrative Policy

16 August 2017 Internal T.I. 2017-0701291I7 - Exclusive Distributorship Rights

a lump sum paid to a non-resident for granting an exclusive right to distribute its product in Canada was for a restrictive covenant

In consideration for a lump sum, a non-resident in a Treaty country (NRco) granted an arm’s length Canadian company (Canco) the exclusive right to distribute its product in Canada. In particular:

The rights to distribute the Product are granted on an exclusive basis (except for the right reserved by NRco to co-promote the Product in Canada). The right to distribute relates to a specific presentation … and only for the specified purpose… . Rights granted under the Distribution Agreement include rights on new XXXXXXXXXX of the Product in case NRco decides to launch them in Canada.

After finding that the lump sum was not a royalty under s. 212(1)(d), the Directorate stated:

[P]aragraph 212(1)(i) is broad enough to apply to it on the basis that the Upfront Payment is an amount that would, if NRco had been resident in Canada throughout the taxation year in which the amount was received, be required by subsection 56.4(2) to be included in computing NRco’s income for the taxation year. Subsection 56.4(2) includes in a taxpayer’s income an amount in respect of a restrictive covenant. The definition of a “restrictive covenant” in subsection 56.4(1) is broad and contemplates all undertakings or waivers that affect or are intended to affect the acquisition or provision of property. In our view, the undertakings of NRco under the Distribution Agreement would satisfy the definition of a “restrictive covenant”.

The Directorate went on to find that the sum likely was Treaty-exempt notwithstanding the applicability of s. 212(1)(i) under domestic law.

Locations of other summaries Wordcount
Tax Topics - Income Tax Act - Section 212 - Subsection 212(1) - Paragraph 212(1)(d) - Subparagraph 212(1)(d)(i) Farmparts likely excluded application to product distributorship right/product name on product not a valuable use of trademark 477
Tax Topics - Income Tax Act - Section 212 - Subsection 212(1) - Paragraph 212(1)(d) lump sum non-contingent payment for distributorship right was not a royalty 99
Tax Topics - Income Tax Act - Section 212 - Subsection 212(1) - Paragraph 212(1)(i) a lump sum paid to a non-resident for granting an exclusive right to distribute its product in Canada was subject to s. 212(1)(i) withholding 199
Tax Topics - Treaties - Income Tax Conventions - Article 12 lump sum paid for distributorship rights was not a royalty 231

20 November 2014 Internal T.I. 2014-0539631I7 - Restrictive Covenants-Part XIII (Luxembourg)

restrictive covenant definition is broad

After CanCo had sold shares of a partly-owned subsidiary (SubCo), it made a payment to the other share vendor (LuxCo) pursuant to what was assumed to be a "restrictive covenant" in a related agreement, and withheld and remitted 25% of the payment. Luxco was unsuccessful in a refund claim based on Arts. 7 and 21 of the Canada-Luxembourg Treaty. Before so concluding, CRA stated:

The definition of a "restrictive covenant", found in subsection 56.4(1) of the Act, is very broad and can apply to many types of agreements.

See summary under Treaties - Art. 22.

Locations of other summaries Wordcount
Tax Topics - Treaties - Income Tax Conventions - Article 22 restrictive covenant payment not eligible for relief under Lux Treaty 256
Tax Topics - Treaties - Income Tax Conventions - Article 7 restrictive covenant payment not eligible for relief under Lux Treaty 138

Articles

Sze Yee Ling, Nathan Wright, "Restrictive Covenants: Some Reminders", Canadian Tax Focus, Vol. 7, No. 1, February 2017, p. 7

Two examples of what arguably are restrictive covenants (p. 7)

[T]ypical commercial transactions may unknowingly trigger the restrictive covenant rules. For example, suppose that X Co has a three-year rental agreement with an upfront payment. A contract term providing that X Co will not unreasonably interfere with the usage of the property will cause it to fall into the restrictive covenant regime. As a result, X Co will be unable to amortize payments on the lease. …

[M]any provisions found in a typical shareholders' agreement (such as a clause requiring that the parties not carry on any other businesses) could trigger the application of the restrictive covenant regime upon a sale of shares, because any sale would be subject to the terms of the agreement.

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.]

Subsection 56.4(2) - Income — restrictive covenants

Administrative Policy

16 February 2016 External T.I. 2015-0618601E5 - Earned or Unearned Revenue

no deferral of lump sum received on signing 15-year supplier loyalty agreement

The taxpayer received a lump-sum payment (the “Payment”) from a major supplier (“ACo”) in consideration for entering into a supplier loyalty agreement (the “Agreement”). Damages equal to the Payment plus interest are payable for breach during the first five years of the Agreement; and the damages amount is reduced on a pro rata basis over the remaining 10-year term. Can the taxpayer include the Payment in income on an amortized basis over the life of the Agreement consistently with its accounting treatment? CRA responded:

[T]he Payment appears to be in respect of a “restrictive covenant”… . This is because it appears to affect, in any way whatever, the acquisition or provision of property or services by the Taxpayer. Where this is the case, the amount in respect of the restrictive covenant is required to be brought into income when received or receivable pursuant to subsection 56.4(2)...unless a specific exception applies. ... [T]he accounting practice of deferring and amortizing such income would be inconsistent with the provisions of the Act and is specifically prohibited under paragraph 18(1)(e)... .

Locations of other summaries Wordcount
Tax Topics - Income Tax Act - Section 12 - Subsection 12(1) - Paragraph 12(1)(x) lump sum received on signing 15-year supplier loyalty agreement was immediately recognized inducement 194
Tax Topics - Income Tax Act - Section 20 - Subsection 20(1) - Paragraph 20(1)(m) no deferral for amount included under s. 56.4(2) or 12(1)(x) 120

Articles

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

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.

Julie A. Colden, "Restrictive Covenant Update", Canadian Current Tax, Vol. 15, No. 11, August 2005, p. 97.

Nathan Boidman, Michael Kandev, "Controversies in Canada Respecting the Taxation of Non-Competition and Related Payments", Bulletin for International Fiscal Documentation, Vol. 58, No. 10, October 2004, p. 494.

Subsection 56.4(3) - Non-application of subsection (2)

Paragraph 56.4(3)(b)

Articles

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

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.

Paragraph 56.4(3)(c)

Administrative Policy

22 August 2017 Internal T.I. 2017-0688301I7 - Restrictive Covenant

agreement not to solicit employees not assimilated

When presented with an agreement for the sale of the shares of a private company under which various shareholders were required to agree to a non-competition covenant (“NCC”) and a non-solicitation covenant (“NSC”), the Directorate found that “essentially, the terms of the NCC and NSC … reflect the conditions that one might normally expect to see in a typical non-competition agreement,” so that they “could be treated as a single RC [restrictive covenant] that is in respect of a non-compete covenant.” As the other conditions of s. 56.4(7) also were met, s. 68 did not apply.

Before so concluding, the Directorate noted that, in dealing with the similar language in s. 56.4(3)(c)(ii), it had considered that

s. 56.4(3)(c)(ii) … 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 ...

and that

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).

Locations of other summaries Wordcount
Tax Topics - Income Tax Act - Section 56.4 - Subsection 56.4(7) - Paragraph 56.4(7)(b) non-solicitation covenant included in non-compete 183

11 October 2013 APFF Roundtable, 2013-0495691C6 F - Clause restrictive

non-solicitation clause/divergence of covenanter and seller

Mr. X sells all the shares of Holdco, which holds all the shares of Opco 1 and Opco 2, to Buyco, which is at arm's length. He grants a non-compete and non-solicitation covenant to Buyco respecting the business of each of Opco 1 and 2.

Q.19(b)

If it is agreed that a portion of the amount received by Mr. X is attributable to the non-compete covenant, would the exception in s. 56.4(3) not be available, so that the amount would be income to him?

Response

After noting that the facts did not potentially engage the exceptions in s. 56.4(3)(a) and (b), CRA turned to s. 56.4(3)(c), and stated (Tax Interpretations translation) that s. (c) of the definition of "eligible interest" did not extend to the situation where 90% or more of the shares of a corporation was "attributable to eligible interests in two other corporations," and then stated:

As the restrictive covenant granted by Mr. X related to businesses carried on by Opco 1 and Opco 2, the election under paragraph 56.4(3)(c) could not be made by Mr. X as 90% of the FMV of the shares in the capital of Holdco were not attributable to the eligible interests in a corporation. Holdco held shares in the capital stock of two other corporations, Opco 1 and Opco 2, which each carried on a business to which the restrictive covenant related.

Q.19(c)

Would the answers differ for a non-solicitation clause?

Response

After adverting to the fact that s. 56.4(3)(c)(ii) and s. 56.4(7)(b) refer only to an undertaking not to provide a competitive property or service, CRA stated (Tax Interpretations translation):

If the wording of the non-solicitation covenant is considered as an integral part of the non-compete covenant, the non-solicitation covenant would not by itself disqualify the restrictive covenant for the purposes of the exceptions provided in subparagraph 56.4(3)(c)(ii) or subsection 56.4(7). In such case, the responses ... would be the same.

Q.19(d)

Would the answer change if Holdco sold Opco 1 and 2, with Mr. X still granting the non-compete and non-solicitation covenant to Buyco?

Response

CRA stated that the election in s. 56.4(3)(c) was not available as "it is Mr. X, not Holdco, who provides the restrictive covenant to Buyco."

Locations of other summaries Wordcount
Tax Topics - Income Tax Act - Section 56.4 - Subsection 56.4(1) - Eligible Interest must be one, rather than more than one, underlying corp 88
Tax Topics - Income Tax Act - Section 56.4 - Subsection 56.4(7) - Paragraph 56.4(7)(b) non-solicitation clause could be treated as part of a non-compete 153
Tax Topics - Income Tax Act - Section 56.4 - Subsection 56.4(7) - Paragraph 56.4(7)(f) maintenance of Holdco fmv/divergence of seller and covenanter 233

Subsection 56.4(6) - Application of subsection (5) — if employee provides covenant

Articles

Kenneth Keung, Riaz S. Mohamed, "Restrictive Covenants for Departing Executives", Taxation of Executive Compensation and Retirement (Federated Press), Vol. 23 No. 4, November 2012, p. 1604.

Receipt of non-compete otherwise than as s. 6(3) income (pp. 1605-6)

The second scenario reviews a situation where a departing employee is also a significant shareholder of the employer:

  1. Mr. A, a Canadian resident, was employed at ABC Co.
  2. Mr. A, Mr. B, and Mr. C are all unrelated to each other, and each held one-third of the shares of ABC Co.
  3. On December 31, 2014, Mr. A terminated his employment at ABC Co. As part of the termination agreement, Mr. B and Mr. C each purchased one-sixth shares of ABC Co from Mr. A, and Mr. A granted a restrictive covenant to Mr. B and Mr. C that he is not to compete with ABC Co for a period of five years. In return, Mr. A will receive $1 million from Mr. B and Mr. C.
Unavailability of s. 56.4(6) safe harbour from s. 68 (p. 1606)

The exception in subsection 56.4(6) is available in situations where an employee grants a restrictive covenant not to compete with an arm's length party resulting from an acquisition involving the employer. At first blush, this provision appears to apply. However, the amount received by Mr. A actually falls outside of a number of the conditions of subsection 56.4(6), all of which (amongst others in the subsection) are required to be met:

  • paragraph 56.4(6)(c) requires the covenant grantor to deal at arm's length with the employer and with the vendor in the acquisition – here, the vendor of the shares of ABC Co includes Mr. A himself, so this condition cannot be met;
  • paragraph 56.4(6)(d) requires the covenant be an undertaking not to compete with the purchaser in the acquisition or with a person related to the purchaser – here, Mr. A entered into the covenant agreement with Mr. B and Mr. C not to compete with ABC Co, and ABC Co is not related to Mr. B or Mr. C (since each only owns 50% so neither controls and since Mr. B and Mr. C do not form a related group), so this condition cannot be met either; …
Unavailability of s. 56.4(7) safe harbour (p. 1607)

Subsection 56.4(7) provides another exception to the section 68 deemed reallocation rule. This subsection is directed for a seller of a business, but again, Mr. A will fall outside its conditions. Similar to subsection 56.4(6), subsection 56.4(7) also requires the covenant be an undertaking not to compete with the purchaser (or a related person), and requires the grantor to have received no consideration for the covenant. As discussed in the context of subsection 56.4(6), Mr. A will fail the first and the second may be impossible to meet.

Unavailability of s. 56.4(2) capital treatment rule (p. 1607)

As neither of the above exceptions are met, section 68 applies to deem a portion of the $1 million proceeds to be consideration for the non-compete agreement, the amount of which would be fully includable in Mr.. A's income under subsection 56.4(2), unless Mr. A qualifies for an exception contained in subsection 56.4(3).

Paragraph (a) and (b) of subsection 56.4(3) allows a taxpayer to avoid income inclusion under subsection 56.4(2) where the amount received is treated as either employment income or sale of an eligible capital property. [fn 17: Paragraphs 56.4(3)(a) and 56.4(3)(b) provided exceptions for the amount included under section 5, section 6 and in the description of E in the definition of "cumulative eligible capital" in subsection 14(5) of the Act.] Since the amount received is neither characterized as employment income to Mr. A nor proceeds for a sale of eligible capital property, paragraphs (a) and (b) cannot be met. The last exception, paragraph 56.4(3)(c), is for a non-compete covenant granted as part of a sale of shares, but again, the non-compete must be for the taxpayer not to provide services in competition with the purchaser (or by a person related to the purchaser)….

Capital treatment to payers (p. 1607)

[F]rom Mr. B's and Mr. C's perspective, each of them is deemed to have paid the $1 million under the same allocation as Mr. A is deemed to have received it.

However, the mirror treatment breaks down when Mr. B and Mr. C looks to subsection 56.4(4) – which at first glance appears to align the tax treatment of the restrictive covenant payment between payer and payee. Paragraph 56.4(4)(a) provides a deduction to the employer when the amount is paid to its employee, while paragraph 56.4(4)(b) and (c) applies to require capitalization where the payee elected under subsection 56.4(3). None of these apply to the covenant portion here. With no specific provisions to rely on, the portion relating to the covenant is likely a payment on capital account under general principles even though it is treated as income at the hands of Mr. A.

Mark Woltersdorf, "Restrictive Covenants – The Final Chapter (For Now) – Part II", CCH Tax Topics, No. 2135, 7 February 2013, p. 1 at p. 4:

Paragraphs 56.4(6)(e) (arm's length employee exception) and 56.4(7)(d) ("goodwill amount" and "disposition of property" exceptions) provide that no proceeds can be received or receivable by the individual granting the RC. Under common law, a contract is not valid unless consideration is given, even where the amount of consideration is nominal (for example, many commercial agreements refer to consideration of $1 paid between the parties, "the receipt and sufficiency of which is hereby acknowledged"). As such, where consideration of any amount is paid, it is uncertain if a vendor will ever be able to utilize subsection 56.4(5) to prevent the application of paragraph 68(c) unless the contract relating to the RC is executed under seal (i.e., a contract without consideration).

Paragraph 56.4(6)(e)

Administrative Policy

2 December 2014 CTF Roundtable Q. 3, 2014-0547251C6 - Q.3 - Restrictive Covenants

recital of nominal consideration

Would CRA reconsider 2014-0522961C6, so that the allocation in an agreement of $1 of consideration to a restrictive covenant does not constitute proceeds for the purpose of paragraphs 56.4(6)(e) and (7)(d)? CRA responded that it:

is now prepared to accept that where a contract relating to granting a restrictive covenant uses words such as "$1 and other good and valuable consideration" simply to ensure that the contract is legally binding…such consideration will not, in and of itself, constitute proceeds received or receivable by the particular party for granting the RC for purposes of paragraph 56.4(6)(e) and paragraph 56.4(7)(d). However, this treatment is subject to the potential application of anti-avoidance rules such as subsection 56.4(10)... .

If more than nominal consideration of $1 is paid…the amount of proceeds (or any additional amount deemed to be proceeds by paragraph 68(c)) received or receivable by the taxpayer for the RC would be taxable as ordinary income under subsection 56.4(2) unless one of the three exceptions in subsection 56.4(3) otherwise applies.

16 June 2014 STEP Roundtable, 2014-0522961C6 - STEP CRA Roundtable - June 2014

nominal consideration tainting of non-compete - partly reversed immediately above

Does the fact that a contract of a restrictive covenant stipulates the amount of $1 as consideration mean that there is consideration, such that the elections, provided under subsection 56.4(7) are inapplicable? CRA stated:

While we understand that a nominal amount of consideration may be given by the parties in a contract relating to a restrictive covenant to ensure that the contract is legally binding, it is the CRA's view that this would still constitute an amount of proceeds received or receivable by the particular party for granting the RC. As such, the exceptions set out in subsections 56.4(6) and (7) could not apply because the respective conditions in paragraph 56.4(6)(e) and paragraph 56.4(7)(d) would not technically be met. In such cases, the amount of proceeds (or any additional amount deemed by paragraph 68(c)) received or receivable by the taxpayer for the RC would be taxable as ordinary income under subsection 56.4(2) unless one of the three exceptions in subsection 56.4(3) otherwise applies.

Locations of other summaries Wordcount
Tax Topics - Income Tax Act - Section 56.4 - Subsection 56.4(7) - Paragraph 56.4(7)(d) nominal consideration tainting of non-compete 157

Subsection 56.4(7) - Application of subsection (5) — realization of goodwill amount and disposition of property

Paragraph 56.4(7)(b)

Administrative Policy

22 August 2017 Internal T.I. 2017-0688301I7 - Restrictive Covenant

non-solicitation covenant included in non-compete

Pursuant to an agreement for the sale of the shares of a private company (the SPA”), various shareholders were required to agree to a non-competition covenant (“NCC”) and a non-solicitation covenant (“NSC”). In finding that the NSC essentially also was a non-compete covenant as described in the preamble to s. 56.4(7)(b), CRA stated:

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 [restrictive covenant] that is in respect of a non-compete covenant.

After noting that s. 56.4(7)(a)(i) (respecting an arm’s length purchaser) appeared to apply, CRA indicated that the ss. 56.4(7)(d) to (g) conditions also were met: no proceeds were received for granting the RC (s. (d)); the disposition was not a redemption etc. transaction (s. (e)); the covenant maintained the share value (s. (f)); and it pertained to shares so that no election was required (s. (g)). Accordingly, s. 68 did not apply.

Locations of other summaries Wordcount
Tax Topics - Income Tax Act - Section 56.4 - Subsection 56.4(3) - Paragraph 56.4(3)(c) agreement not to solicit employees not assimilated 198

11 October 2013 APFF Roundtable, 2013-0495691C6 F - Clause restrictive

non-solicitation clause could be treated as part of a non-compete

Mr. X sells all the shares of Holdco, which holds all the shares of Opco 1 and Opco 2, to Buyco, which is at arm's length. He grants a non-compete and non-solicitation covenant to Buyco respecting the business of each of Opco 1 and 2.

Q.19(c)

CRA first addressed the potential availability of the exemptions in s. 56.4(7 and s. 56.4(3)(c) in respect of Mr. X's non-compete covenant. Would the answers differ for a non-solicitation clause?

Response

After adverting to the fact that s. 56.4(3)(c)(ii) and s. 56.4(7)(b) refer only to an undertaking not to provide a competitive property or service, CRA stated (Tax Interpretations translation):

If the wording of the non-solicitation covenant is considered as an integral part of the non-compete covenant, the non-solicitation covenant would not by itself disqualify the restrictive covenant for the purposes of the exceptions provided in subparagraph 56.4(3)(c)(ii) or subsection 56.4(7). In such case, the responses ... would be the same.

Locations of other summaries Wordcount
Tax Topics - Income Tax Act - Section 56.4 - Subsection 56.4(1) - Eligible Interest must be one, rather than more than one, underlying corp 88
Tax Topics - Income Tax Act - Section 56.4 - Subsection 56.4(3) - Paragraph 56.4(3)(c) non-solicitation clause/divergence of covenanter and seller 360
Tax Topics - Income Tax Act - Section 56.4 - Subsection 56.4(7) - Paragraph 56.4(7)(f) maintenance of Holdco fmv/divergence of seller and covenanter 233

Articles

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

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?

Manu Kakkar, "Paragraph 56.4(7)(b ) Related-Person Problem and Arm's Length Minority Acquisitions", Tax For The Owner-Manager, Volume 14, Number 2, April 2014, p. 8.

Example

a group of unrelated holdcos purchase a holdco of the vendor and the non-compete is given to the Opco owned by them (pp. 8-9)

Mr. A, Mr. B, Mr. C, and Mr. D each own 25 percent of their shares of Opco through wholly owned holdcos called, respectively, Holdco A, Holdco B, Holdco C, and Holdco D….

Mr. D wishes to sell his shares of Holdco D on a pro rata basis to Holdco A, Holdco B, and Holdco C. Holdco D would be subsequently amalgamated with Opco. Mr. D provides a non-compete to Opco to not compete in the line of business of Opco. No amount is allocated to the non-compete….

S. 56.4(7)(b) requirement re recipient of non-compete (p.9)

Paragraph 68(c) will not apply if subsection 56.4(5) applies. In this example, subsection 56.4(5) will apply if all the conditions in section 56.7 are met. For paragraph 56.4(7)(b) to apply, the vendor (here, Mr. D) must grant a restrictive covenant "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)" [emphasis added].

Opco is ineligible recipient of non-compete (p. 9)

Opco is the entity providing the property or services and Holdco A, Holdco B, and Holdco C are the purchasers of Mr. D's shares in Holdco D. Holdco A, Holdco B, and Holdco C are holding companies and are not providing property or services to which the non-compete relates. Furthermore, none of the holding companies is related to Opco. Therefore, the condition in paragraph 56.4(7)(b) is not met and the CRA may allocate a value to the non-compete,…

Manu Kakkar, "Section 56.4 Restricted Covenant Trap", Tax for the Owner-Manager, Volume 13, Number 4, October 2013, p. 4:

Assumed facts (Holdco sale transaction) (p. 4)

Assume that Mr. A and Mr. B deal with each other at arm's length. Mr. A and Mr. B are each 100 percent shareholders of Holdco A and Holdco B, respectively. Holdco A and Holdco B each own 50 percent of the issued common shares of Opco. There is a unanimous shareholders' agreement, but it does not override the de jure control of Mr. A and Mr. B, which enables them, as a group, to elect the majority of the board of directors of Opco. Mr. A sells his Holdco A shares to Holdco B for cash. At the same time, Mr. A enters into a covenant not to compete with the property or services that Opco provides in the course of carrying on its business. No amount is allocated to Mr. A's restrictive covenant. Mr. A is an employee of Opco…Opco is an "eligible interest" of Holdco A pursuant to subsection 56.4(1).

S. 56.4(6) is unavailable (employee is Holdco vendor) (p. 4)

Unless prevented from doing so by subsection 56.4(5), the Minister may allocate a portion of the sale proceeds to the restrictive covenant under section 68, notwithstanding that the parties have not allocated any amount to the restrictive covenant. …Subsection 56.4(5) applies only if it is made operational by subsection 56.4(6) or (7). Subsection 56.4(6) is not available in this case because Mr. A (the employee and grantor of the covenant) does not deal at arm's length with himself in the role of the vendor…

S. 56.4(7) is unavailable (Opco not yet related to purchaser) (pp. 4-5)

For paragraph 56.4(7)(b) to apply, Mr. A must provide a restrictive covenant not to compete with the provision of goods or services by Opco and, at the time that the covenant is entered into, the purchaser, Holdco B, must be related to Opco. Holdco B is not related to Opco at that time because it does not own more than 50 percent of its voting stock at that time (see subparagraph 251(2)(c)(i)).

Paragraph 56.4(7)(d)

Administrative Policy

16 June 2014 STEP Roundtable, 2014-0522961C6 - STEP CRA Roundtable - June 2014

nominal consideration tainting of non-compete

Does the fact that a contract of a restrictive covenant stipulates the amount of $1 as consideration mean that there is consideration, such that the elections, provided under subsection 56.4(7) are inapplicable? CRA stated:

While we understand that a nominal amount of consideration may be given by the parties in a contract relating to a restrictive covenant to ensure that the contract is legally binding, it is the CRA's view that this would still constitute an amount of proceeds received or receivable by the particular party for granting the RC. As such, the exceptions set out in subsections 56.4(6) and (7) could not apply because the respective conditions in paragraph 56.4(6)(e) and paragraph 56.4(7)(d) would not technically be met. In such cases, the amount of proceeds (or any additional amount deemed by paragraph 68(c)) received or receivable by the taxpayer for the RC would be taxable as ordinary income under subsection 56.4(2) unless one of the three exceptions in subsection 56.4(3) otherwise applies.

Locations of other summaries Wordcount
Tax Topics - Income Tax Act - Section 56.4 - Subsection 56.4(6) - Paragraph 56.4(6)(e) nominal consideration tainting of non-compete - partly reversed immediately above 157

Articles

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

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… .

Paragraph 56.4(7)(e)

Articles

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

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….

Paragraph 56.4(7)(f)

Administrative Policy

11 October 2013 APFF Roundtable, 2013-0495691C6 F - Clause restrictive

maintenance of Holdco fmv/divergence of seller and covenanter

Mr. X sells all the shares of Holdco, which holds all the shares of Opco 1 and Opco 2, to Buyco, which is at arm's length. He grants a non-compete and non-solicitation covenant to Buyco respecting the business of each of Opco 1 and 2.

Q.19(a)

If it is agreed that no part of the amount received by Mr. X is attributable to the non-compete covenant, will s. 56.4(7) be satisfied so that s. 68 does not apply to the sales proceeds?

Response

Before indicating that there were insufficient facts provided to reach a conclusion and after paraphrasing the applicable requirements of s. 56.4(7), noting that s. 56.4(7)(a)(i) rather than (ii) applied, quoting only (iii) of s. 56.4(7)(f), and specifying an assumption that Holdco did not carry on any business and that its only assets were the shares of Opco 1 and 2, CRA stated (Tax Interpretations translation):

[I]t is possible that the conditions of subsection 56.4(7) are satisfied, in particular by reason that the restrictive covenant provided by Mr. X could have the effect of maintaining or protecting the fair market value of Holdco.

Q.19(d)

Would the answer change if Holdco sold Opco 1 and 2, with Mr. X still granting the non-compete and non-solicitation covenant to Buyco?

Response

CRA stated that the exception in s. 56.4(7) "could apply if all the conditions of that subsection were satisfied, taking into account that Opco 1 and Opco 2 could each be an eligible corporation."

Locations of other summaries Wordcount
Tax Topics - Income Tax Act - Section 56.4 - Subsection 56.4(1) - Eligible Interest must be one, rather than more than one, underlying corp 88
Tax Topics - Income Tax Act - Section 56.4 - Subsection 56.4(3) - Paragraph 56.4(3)(c) non-solicitation clause/divergence of covenanter and seller 360
Tax Topics - Income Tax Act - Section 56.4 - Subsection 56.4(7) - Paragraph 56.4(7)(b) non-solicitation clause could be treated as part of a non-compete 153

Subsection 56.4(12) - Clarification if subsection (5) applies

Articles

Mark Woltersdorf, "Restrictive Covenants – The Final Chapter (For Now) – Part II", CCH Tax Topics, No. 2135, 7 February 2013, p. 1 at pp. 3-4:

Discussions with the Department of Finance indicate that the intent of paragraph 56.4(12)(b) is to prevent a taxpayer from arguing that an amount received or receivable by that taxpayer that reasonably relates to an RC granted by another taxpayer should not be included in that taxpayer's income because paragraph 68(c) prevents the Minister from allocating any portion of the RC to them. However, the Department of Finance did acknowledge that this provision might result in the shifting of capital gains between taxpayers in some non-arm's length situations.