Proposed NCA legislation needs a review Several anomalies should be ironed out before the amendment becomes law By Sean Cavanagh Last year started out well for non-competition agreements (NCAs), with the Federal Court of Appeal confirming their non-taxability in the Manrell case (see Manrell vs. the Queen in the box below). Vendors of a business who offered an NCA to the purchaser, thereby agreeing to restrict their activities after the sale, would receive tax-free receipts upon the sale because a portion of the price would be allocated to the NCA. The pronouncement However, the Department of Finance obviously feared the loss in tax revenue from business acquisitions would escalate. So Finance Minister John Manley ended the NCA freebee last October 7 by issuing a proposed amendment to the Income Tax Act (2003-0490) that would make all NCAs taxable either as capital or income. It also increased the scope of the proposed legislation to all restrictive covenants. This means other agreements such as marital and shareholder agreements might get caught in the net along with NCAs. The legislation is worded in such a way that the buyer of an NCA might not receive a tax deduction or adjusted cost base for the NCA allocation. For the vendor, the NCA might be treated as income in one situation, and as capital in another. Even no allocation to the NCA may receive value under reassessment. The changes will apply to all written agreements subsequent to October 7, 2003 and all amounts received (receivable) after 2004. Changing the rules in the middle of the game is a little harsh for amounts received or receivable after 2004 resulting from agreements prior to October 7, 2003.  The NCA has to increase the value of the business vis-à-vis no inclusion of an NCA in the sale. The following example, used in the pronouncement, is instructive in terms of how the legislation will be implemented: Terence and Isabelle each own 50 of 100 common shares of X Ltd., which carries on a business. The adjusted cost base of their shares is nil.  In 2004, a person with whom they deal at arm's length, Y Ltd., offers to acquire all of the shares of X Ltd.. for $2 million provided Terence (who has been much more closely involved in the management and operations of X Ltd.'s business) agrees not to compete with the business of Y Ltd. and X Ltd. after the sale. If no covenant is provided, Y Ltd. will pay $1.8 million. Terence and Isabelle agree to accept the offer to sell X Ltd., with the proceeds broken down as follows: $1.8 million for shares ($18,000 a share) plus $200,000 for Terence's covenant not to compete after the sale. Of total amounts payable to Terence and Isabelle, Terence will receive total proceeds of $1.1 million ($900,000 for shares and $200,000 for his covenant) and Isabelle will receive $900,000.  Isabelle:  Capital gain = $900,000 ($900,000 proceeds less nil ACB).  Terence:  Capital gain = $1,000,000 ($1,000,000 of proceeds less nil ACB).                           Income = $100,000 ($200,000 less $100,000 allocated to POD) The proposed formula allows the NCA provider to increase his proceeds of disposition to a maximum of what his percentage shareholding is with the NCA - in this case, $1 million. Hence the value of the NCA is determined by the change in value of the business with and without the NCA. However, let's change the facts and say Y Ltd.. paid to both Isabelle and Terence $100,000 for an NCA while still assuming Isabelle was not active in the business. The legislation proposes Isabelle would get an additional $100,000 income inclusion under the assumption her NCA has no value. Terence could only increase his proceeds by $50,000, leaving the balance as income. The reasoning is the fair market value (FMV) of the NCA is really $100,000, as it was in the original scenario. The business is now deemed to be worth $1.9 million, not the FMV of $2 million stated above, notwithstanding that $2 million was paid. Terence's 50% is now only $950,000. This is important as the proposed legislation only allows the capital treatment of the NCA to the extent it increases the FMV of the business according to each shareholder. Y Ltd. paid $1.8 million for the business and $200,000 to get Terrence off the street. Regardless of how Terrence and Isabelle split it, $2 million was paid and that is what the FMV is deemed to be. Finance is now going to say the FMV is $1.9 million and the other $100,000 is a "nothing" – not deductible and not added to the ACB of the shares. Isabelle would fall into indirect payments or anti-avoidance for her $100,000 and her capital proceeds would still be $900,000. Conversely, if Isabelle's $100,000 NCA was legitimately received by virtue of her relationship to the company, then capital treatment could be expected. Equity in the NCA is represented by the share ownership and not by en bloc corporate value. The FMV of the NCA drives the capital increase, not the FMV of the company, notwithstanding that the latter limits the increase. In the first scenario when Terence receives the $200,000, he increases his capital gain by $100,000 because it is half of $200,000 – not because it increased his share value to $1 million. In the second scenario, the FMV of his NCA was $100,000, increasing the capital allocation to $950,000; the $50,000 difference between $1 million and $950,000 is treated as ordinary income under the current proposal. Finance is aware of this issue and will be considering it in the course of drafting the related legislation. The complication arises when allocating between business and NCA value. Professionals can see how difficult this can be in most owner/managed business, since goodwill attributable to key people varies widely from one business or industry to the next. Documenting and properly valuing the business and the NCA, preferably independently, will avoid prolonged reviews  Valuation With the income inclusion, assessing authorities are now going to be concerned with how the NCA is allocated between income and capital. As an example, a key employee's NCA receipt by virtue of his employment is an income inclusion under Section 5 or 6 of the ITA. If that same employee owns 1% of the company, is the NCA by virtue of his employment or by virtue of his shareholding? How about 40%, or 80%? We may assume this will not be an issue with 100% ownership; however, Section 68 could kick in for other percentage levels.  The purchaser of a business pays an amount over the value of the assets to compensate the vendor for the goodwill in the company. This goodwill comes in two forms: business and personal. Business goodwill stays with the business after sale and comes in the form of location, brand name, etc. Personal goodwill stays with the person regardless of the business operations. This is why there is a need for employment contracts and NCAs. Some commentators distinguish between personal and individual goodwill and its commercial value. (They say personal goodwill is represented in the personal skills and abilities the person may have, whereas individual goodwill could be represented as business contacts.)  However, Manrell clearly states there is commercial value to both through the use of an NCA. Further restricting the specific talents of an individual through monetary compensation (i.e., the person refrains from making contact with existing customers/suppliers) is a sale of individual goodwill.      That being said, the value of the goodwill attributable to the individual is the value of the NCA. Professional judgment in this process is substantial. Unlike the old days, a nil allocation to the NCA could be reviewed to see if an income allocation exists, especially in cases where ownership is less than 100%. In an M&A transaction that brings an NCA into play, it would be prudent to support the value for both the business and NCA. The value of the NCA is determined by the possibility that the vendor will compete with the business after transfer, and how much that would affect the business. If the vendor was retiring, the NCA value would be lower. If the market was expanding, it would be higher. As the proprietary nature of the product increases, the value of the NCA decreases. Arguments can be made back and forth. It's easy to see that, depending on the individual's tax position, the value of the NCA and its treatment as either capital or income becomes a planning priority. The NCA is a valuable bridging tool in the M&A arena that is no longer a silent partner to the purchase and sale agreement. It will most likely be scrutinized to determine its value in the same way the business value is determined in non-arm's-length transactions. The treatment to the payer has not been addressed in the proposed legislation; therefore, both parties could be in limbo pending any review.  The proposed legislation could greatly restrict normal business practice, since it goes far beyond what Manrell put on the table. Planning and care in determining NCA value are necessary for the orderly transition of business interests. Since the legislation is still in its initial stages of development, application should be pushed back until all potential anomalies have been ironed out. Fortunately, there is still time for tax and valuation specialists to provide input before this legislation becomes law. Sean Cavanagh, CA, CBV (seanden@rogers.com), practises in Toronto and is currently a level 3 CFA candidate.    Manrell vs. the Queen* Tod T. Manrell owned or controlled substantial interests in three operating companies. In 1995, a purchaser agreed to purchase the shares and shareholder debt of the three companies. One of the terms of the share purchase agreement required the purchaser to pay $4 million to the selling shareholders as consideration for the delivery and performance of "non-compete agreements." The Minister assessed the taxpayer for 1996 and 1997 on the basis that his share of such payment for his non-compete agreement gave rise to a taxable capital gain. The Tax Court of Canada dismissed the taxpayer's appeal. The taxpayer appealed to the Federal Court of Appeal, arguing that the "right to compete" did not fall within the statutory definition of "property," so there was no disposition of property giving rise to any taxable capital gain. The central issue in the Manrell decision was whether an NCA is property. The Federal Court of Appeal confirmed Fortino (Fortino (Appellant) v. The Queen (Respondent) 2000 DTC 6060 Federal Court of Appeal), deciding an NCA is not taxable. This case presented a single question: Is the "right to compete" a "right of any kind whatever," and thus "property" as defined in subsection 248(1) of the Income Tax Act?  The court addressed the question from three perspectives: the ordinary meaning of the word "property," the statutory context, and the relevant jurisprudence. The court concluded property is not a thing, but a right or collection of rights enforceable against others. It further concluded a general right to do something that anyone can do or that belongs to everyone is not the property of anyone. The Crown lost on ordinary meaning in two ways: it denied taxability of the NCA in the hands of the recipient and affirmed the payer of the NCA to have property; property that would be deductible. Interestingly, in 1957, the Crown argued an NCA was not. The court's discussion of statutory interpretation started with the Income War Tax Act, S.C. 1917 and wound its way into current literature. In the property definition, the court focused a person's commonly held right to carry on a business to qualify as a right of any kind whatever. The court could not find anything that would support extending the definition to the NCA. The final pillar of analysis was founded in jurisprudence. The court stated: "The phrase upon which the Crown relies in this case, a right of any kind whatever, like the word "property," has a very broad meaning. But it is not a word of infinite meaning. It cannot include every conceivable right. It cannot be given a meaning that would extend the reach of the Income Tax Act beyond what Parliament has conceived. Even counsel for the Crown conceded that it does not include a human right, or a constitutional right." The Crown came back with alternative positions but the court concluded with the death knell statement: "Given that the Income Tax Act has many specific anti-avoidance provisions and rules, it follows that courts should not be quick to embellish the provisions of the Act in response to concerns about tax avoidance when it is open to Parliament to be precise and specific with respect to any mischief to be prevented.… To do otherwise would be to fail to give appropriate weight to the well-established principle that, absent a provision to the contrary, taxpayers are entitled to arrange their affairs for the sole purpose of achieving a favourable position regarding taxation." The decision in Manrell was not ambiguous, since three approaches lead NCAs to fall short of the definition of property for income tax purposes. Because NCAs are not conditional, Section 42 is not in play. And selling the shares rather than the assets does not constitute carrying on a business, so eligible capital is not applicable. This decision put Finance in a position where it was directed to specifically address each situation statutorily if these agreements can be argued to conform to Manrell and not already be referred to statutorily. An insurmountable task given the varied agreements incorporated into a business sale. *Tod T. Manrell (Appellant) v. Her Majesty the Queen (Respondent) 2003 DTC 5225 Federal Court of Appeal March 11, 2003 (Court File No. A-662-01.)                                                      Non-competition agreements A non-competition agreement is a contract incorporated into most business acquisitions (mainly in owner-manager/key employee transition) and is sometimes accompanied with an employment contract. The latter is a familiar agreement that ties the vendor to the company for a period of time until the purchaser is satisfied that goodwill has been transferred or at least that it has expired for the vendor. The NCA seeks to eliminate competition from the purchase equation by prohibiting the vendor from competing against the purchaser in his or her operating territory. Note that Finance assumes the non-taxability of NCAs subsequent to a business acquisition only when the business in not carried on. Otherwise, Sections 6 and 14 of the Income Tax Act will apply to NCAs.  Furthermore, unless the NCA is part of a business interest sale, the NCA will be treated as ordinary income under Section 3 of the ITA. Even if there is a business sale associated with the NCA, there can be an income receipt when shares are sold. This legislation applies only to agreements that are not treated as a disposition of property in the context of a direct or indirect business sale.