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Restrictive covenants

Much of our firm’s day-to-day tax planning and research involves issues surrounding the purchase and sale of businesses. Such purchase and sales will often involve the acquisition and/or granting of a restrictive covenant. In many cases, the granting of the restrictive covenant could be as simple as the vendor agreeing not to compete with the purchaser’s business for a limited period of time in a specified geographical area.

Prior to 2003, some significant tax planning occurred with respect to the granting of restrictive covenants. Case law, such as the cases of Fortino and Manrell, suggested that the receipt of restrictive covenant proceeds were not taxable. The government was not amused, and on October 7, 2003 the Department of Finance announced its intention to change the law so as to fully tax, with certain exceptions, restrictive covenant proceeds for any restrictive covenants granted after October 7, 2003.

The draft proposals with respect to the taxation of restrictive covenants was first released in February 2004 by introducing new section 56.4 of the Income Tax Act. Since that time, there have been two more releases of draft legislation (one on July 18, 2005 and another on November 9, 2006). The draft proposals, now currently in bill form, have passed the House of Commons and also received second reading in the Senate (Bill C-10). It is widely believed that it is only a matter of time before Bill C-10 is passed and receives Royal Assent (although not free from doubt as Bill C-10 contains controversial proposals for non-resident trusts and foreign investment entities that are being studied by the Senate). The draft legislation is very complex with many time sensitive dates that need to be adhered to. Generally, the draft legislation will have retroactive effect so that any restrictive covenant that was granted after October 7, 2003 requires that the new rules apply. In a worst case scenario, the new rules will require a full income inclusion for the value of the restrictive covenant. The draft proposals also contain many joint elections that may be required to be filed between the grantor of the covenant and the purchaser (especially if certain exceptions to the rules are desired).

In practice, it is our experience that many advisors are simply not aware of or are ignoring these rules. However, quite the opposite should be the case. It is our view that these rules should significantly impact a purchase and sale transaction in any case where a restrictive covenant is granted. Such modifications to the business transaction may, for example, require joint elections to be filed by the grantor and purchaser so as to ensure preferential treatment with the new restrictive covenant rules. Please ensure that if you are involved in any transaction involving the purchase or sale of a business with a restrictive covenant that new section 56.4 is reviewed.