Cost of competition

By Veronica Prokop & Ryan Storey
Illustration: Gary Clement

Before signing any noncompete agreements, purchasers and sellers should carefully consider the tax treatments of such covenants

A prospective purchaser of a business will generally place significant value on obtaining restrictive covenants from the seller of the business. Often these covenants are referred to as noncompete clauses and are documented in the contract of purchase and sale or in separate collateral agreements. Noncompete agreements may be used in both asset and share acquisitions. The agreements are generally entered into with shareholders and certain key employees of the business who possess the ability to threaten the anticipated profitability of the acquisition had such agreements not been put in place prior to the sale. The value that a prospective purchaser places on a restrictive covenant can be a significant portion of the overall purchase price. The appropriate characterization of amounts received by taxpayers in respect of such restrictive covenants has been unsettled for some time due to re-cent court decisions that have overturned Canada Revenue Agency’s long-standing administrative and assessing positions. However, there may be a greater measure of certainty for taxpayers in light of recent draft income tax legislation.

On October 7, 2003, the minister of Finance announced proposed changes to the Income Tax Act in respect of the taxation of restrictive covenants, and on February 27, 2004, Finance introduced draft legislation in this regard. This legislation treats an amount received in respect of a restrictive covenant as income, but provides for limited exceptions whereby such receipts will be treated on capital account. These proposed amendments were introduced in response to Fortino et al v. The Queen (FCA), 2000 DTC 6060, and Manrell v. The Queen (FCA), 2003 DTC 5225, decisions in which it was held that amounts received in respect of restrictive covenants were not taxable. As a result of these decisions, many taxpayers structured the sale of their businesses such that significant amounts were allocated to restrictive covenants in the expectation they would be received free of tax.

In 1999, the Federal Court of Appeal upheld the tax court’s decision in the case of Fortino. The case held that amounts received in respect of noncompete agreements were nontaxable as they could not be said to emanate from any source of income of the recipient. The tax court concluded that the amounts received by the taxpayers should not be viewed as income from a source under Section 3 of the tax act, nor were they proceeds of disposition of eligible capital properties. Somewhat gratuitously, the court also noted that the amounts received did not have the character of contingency necessary for characterization as consideration for the types of covenant contemplated by Section 42 of the act. The Crown attempted to argue that the amount should be viewed as proceeds of disposition of a capital property, being the right to compete. As the Crown had not introduced this argument in its pleadings, the tax court precluded it from making such an argument at trial. The Federal Court of Appeal confirmed the decision of the tax court.

In Manrell, the taxpayer sold his shares in numerous companies. Under the share purchase agreement, the purchaser was to make predetermined payments over a number of years directly to the selling shareholder for the delivery and performance of a noncompete agreement. The Crown made the argument that it was precluded from making in Fortino — that the definition of property in the tax act was sufficiently broad to encompass the disposition of a right to compete and therefore the receipts should be treated as proceeds of disposition of a capital property. However, after analyzing the ordinary meaning of the word “property,” the appeal court found the statutory context and relevant jurisprudence, that the statutory definition of property did not embody the disposition of rights such as the right to compete. Therefore, the amounts received by the taxpayer were determined to be nontaxable capital receipts.

Legislative proposals
The draft legislation set out in proposed Section 56.4 of the tax act is applicable to amounts received or receivable in respect of a restrictive covenant by a taxpayer after October 7, 2003 other than amounts received by the taxpayer before 2005 under an arm’s-length written agreement made on or before October 7, 2003.

Central to the application of the draft legislation are the definitions of “eligible interest” and “restrictive covenant.” An eligible interest of a taxpayer, which for these purposes includes a partnership, is a capital property of the taxpayer that is either an interest in a partnership that carries on a business or a share of the capital stock of a corporation that carries on a business. A restrictive covenant is broad enough to include an “agreement entered into, an undertaking made or a waiver of an advantage or right by the taxpayer… whether legally enforceable or not.” Its scope is much broader than simply an agreement not to compete.

The provision specifically includes the full amount received or receivable by the taxpayer into income. However, exceptions are provided where an amount is received or receivable from an arm’s-length person (purchaser) and one of the following applies:

• the amount is otherwise included in the taxpayer’s income as income from employment;
• the amount is deducted in determining the taxpayer’s cumulative eligible capital in respect of a business and the taxpayer and the purchaser elect in prescribed form for this exception to apply; or
• the disposition is made to the purchaser of an eligible interest of the taxpayer in which case the amount is determined to be additional proceeds of disposition in respect of the eligible interest and is therefore taxed as a capital gain. To qualify for this exception, the taxpayer must undertake not to provide services or property in competition with the purchaser (or a person related to the purchaser). The maximum amount that may be treated as incremental proceeds of disposition is the difference between the fair market value of the eligible interest, if the covenant were granted for no consideration, and the fair market value of the eligible interest, if no covenant were granted by the taxpayer. For this capital treatment to apply, the taxpayer and the purchaser must elect in prescribed form.

The proposed legislation also confirms the tax treatment to the purchaser where these exceptions apply, allowing for the amount paid or payable by the purchaser to be:

• deduction of wages where the amount is included in computing the income of an employee of the purchaser;
• an eligible capital expenditure, where business assets are being purchased and the election to have such treatment has been made;
• a capital cost of the eligible interest acquired, where shares of a corporation or a partnership interest are being purchased and the election to have such treatment is made.

However, the draft legislation is silent on the tax treatment to the purchaser where the grantor of the noncompete cov- enant simply includes the amount received in income. It would appear that, depending on the particular circumstances, the payment could be a deductible amount to the purchaser, an eligible capital expenditure of the purchaser, or even a depreciable capital property of class 14 of the purchaser. There may even be circumstances where the payment would be viewed simply as a nondeductible capital outlay.

Finally, the proposed legislation confirms that Section 42 (consideration for warranties, covenants or other obligations) does not apply to an amount received or receivable as consideration for a restrictive covenant.

Where does this take us?
The draft legislation provides for both income and capital treatment; however, the latter is applicable only when certain criteria are met. This could have undesirable results in many situations. A simple example will illustrate the types of pitfalls that may arise. Assume that an individual owns all the shares in a holding company (Holdco), which in turn owns all of the shares in an operating company (Opco). The Opco shares are sold by Holdco to a third-party purchaser and the terms of the agreement include a payment to Holdco for the Opco shares and a payment to the individual for entering into a noncompete arrangement. Under the proposed legislation, the amount received by the individual would be fully includable in income and thus taxed at ordinary rates. The capital gain exception would not apply as it is not the individual but Holdco that is disposing of an eligible interest.

As a result, corporate structures may need to be reorganized to ensure that the person receiving the noncompete payment is a direct shareholder of the company being sold. In the example, if the Opco shares are the only asset of Holdco, it may be possible to wind Opco into Holdco or amalgamate the two companies prior to the disposition of the Holdco shares, so that the grantor of the noncompete covenant will also be the vendor of the eligible interest. To ensure that the Holdco shares will be an eligible interest to the individual, it will be necessary that Holdco carry on the business for a period of time before the sale of the Holdco shares.

It is no surprise that after Fortino and Manrell, Finance acted to deny the tax benefits that could flow to a taxpayer grant- ing a noncompete covenant. However, the proposed amendments are more complex and more restrictive than many would have anticipated. It will therefore be necessary for both purchasers and vendors of businesses (whether in the form of assets or shares) to carefully consider the tax treatment of any related noncompete agreement.

This article was prepared October 28, 2004, based on the law and guidance as of that time.