Non-competition agreements can be a valuable tool for purchasers who want to protect their investments in new businesses. However, non-competition agreements can have unintended and unexpected tax consequences, particularly to sellers who grant non-competition agreements to purchasers.
The Income Tax Act (Canada) (the Act) contains specific provisions regarding the taxation of “restrictive covenants”, a broadly defined term that includes, among other things, non-competition agreements, regardless of whether such agreements are legally enforceable.
Under section 56.4 of the Act, the portion of the purchase price allocated to the granting of a restrictive covenant (whether by the parties or as a result of a deemed allocation, as discussed below) will generally be taxable to the seller as regular income, as opposed to a capital gain. This treatment is significantly less favourable for the seller because regular income is subject to tax at the seller’s normal tax rate, whereas only half of a capital gain is subject to tax.
However, the Act allows a seller that deals at arm’s length with the purchaser to avoid this unfavourable tax treatment with respect to the amount allocated (or deemed to be allocated) to non-competition agreements in certain circumstances, including:
- if the amount would, absent the restrictive covenant rules, be included in the calculation of “cumulative eligible capital” under the Act and the parties file a joint election; or
- if the amount is proceeds of disposition from the disposition of an “eligible interest” (as defined in the Act), the parties file a joint election, and a number of other specific conditions are met.
It is important to note that, subject to certain rules discussed below, the portion of the purchase price that can be reasonably regarded as payment for the restrictive covenant will be deemed to have been payment for the restrictive covenant. This will be the case even when the parties have allocated a portion of the purchase price to the restrictive covenant if the allocation chosen by the parties is not reasonable. This rule would result in any amount so deemed generally being treated as regular income to the seller.
The deeming rule will not apply with respect to non-competition agreements in certain circumstances, most notably where the parties deal at arm’s length and, among other things:
- the amount that can reasonably be considered consideration for the non-competition agreement is allocated to a “goodwill amount” (as defined in the Act) and the parties file a joint election in respect of the non-competition agreement; or
- no amount is allocated to the non-competition agreement and it is reasonable to conclude that the non-competition agreement is integral to an agreement in writing whereby the seller sells either property or shares to the purchaser.
If the deeming rule does not apply, no amount will be treated as regular income to the seller in respect of the non-competition agreement.
The rules regarding the taxation of restrictive covenants are complex. Parties wishing to use non-competition agreements in their transactions should ensure that they consider whether their non-competition agreements will result in additional tax being payable and whether any elections are necessary to prevent such treatment.
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