Section 56.4

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.

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.

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.]

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?

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,…

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)).

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….