Restrictive Covenants: Some Reminders

Section 56.4, which was enacted in 2012 but is retroactively applicable to amounts received as far back as 2003, outlines a complex set of rules affecting restrictive covenants that are potentially disastrous for the unaware. In this article, we discuss a few commonly encountered traps and tricks, and the CRA's recent confirmation of the extensive reach of this regime.

Section 56.4 operates to include in regular income, in that taxation year, any amounts received by a taxpayer in respect of a restrictive covenant. A restrictive covenant is defined in subsection 56.4(1) to include agreements, whether legally enforceable or not, that affect the acquisition or provision of property or services by the taxpayer (for example, non-competition or non-solicitation clauses). The CRA has the discretion under section 68, if reasonable, to reallocate proceeds from a contract to a restrictive covenant.

As many have noted, a restrictive covenant is extremely difficult to value; one could argue that it has nil standalone value while simultaneously requiring the purchaser to agree to the sale. To date, the CRA has provided no clear guidance on how to value a restrictive covenant.

The combined effect of income treatment and uncertain value is that most drafters now strive to avoid the application of section 56.4 and section 68. They do this by fitting the taxpayer into one of two main tiers of exceptions. Generally speaking, the first tier (subsection 56.4(3)) can apply to amounts received in respect of restrictive covenants included in employment income, relating to the preservation of goodwill, or relating to a disposition of shares. Items falling into this tier retain their normal character (that is, they are not deemed to be on income account by the restrictive covenant rules).

However, satisfaction of the requirements of these first-tier provisions does not prevent the CRA from reallocating proceeds: only the second-tier provisions (subsections 56.4(6) and (7)) do that. One of the easiest ways to fail to meet the requirements is to provide in a contract that proceeds are received for granting the restrictive covenant (parties traditionally have done this to make the covenant legally enforceable). At one time the CRA took the position that even nominal consideration would violate the no-proceeds requirement, but consideration of $1 is now acceptable (2014-0547251C6, December 2, 2014). However, many commercial agreements (perhaps those that were drafted without tax advice) continue to provide an allocation in excess of $1 to a restrictive covenant.

The CRA has reiterated (2015-0618601E5, February 16, 2016) how broadly it interprets the definition of "restrictive covenant." The CRA was asked about the inclusion of a lump-sum payment as income for the year, and whether the payment could instead be amortized over the duration of the contract. The contract was a "supplier loyalty" agreement whereby the lump sum was paid to secure the taxpayer's continued purchases from the other party (its supplier). The CRA's response was that the payment was in respect of a restrictive covenant, and the entire amount was includible in the year received on the basis that the agreement affected the taxpayer's acquisitions of property.

Other typical 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.

Shareholders' agreements may also be caught: many 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. Drafters should take additional care to ensure that one of the exceptions applies on a subsequent transfer of shares.

Sze Yee Ling and Nathan Wright
JGW Business and Tax Law LLP, Toronto

Canadian Tax Focus
Volume 7, Number 1, February 2017
©2017, Canadian Tax Foundation