Restrictive covenants are commonly included in agreements such as in the sale of a business. A restrictive covenant is defined as an agreement, undertaking or waiver, whether legally enforceable or not, that affects the acquisition or provision of property or services by the taxpayer. They typically cover a specific period and possibly a specific geographical location. Common examples are non-disclosure, non-competition, or non-solicitation agreements. There are rules regarding the tax treatment of restrictive covenants that can be punitive to those who are unaware.
The proceeds of sale allocated to a restrictive covenant are fully taxable as ordinary income. This can increase the income taxes payable by you since capital gains are afforded preferential tax treatment. Proceeds allocated to the sale of shares or assets will be afforded capital gains treatment resulting in lower taxes payable than proceeds allocated to the restrictive covenant.
Sellers have an inherent bias to allocate a lesser amount of the proceeds to the restrictive covenant. As a result, Canada Revenue Agency has discretion to reallocate proceeds to the restrictive covenant if they consider the amount allocated in the agreement to be unreasonable. Clear guidance has not been provided on how to accurately value these covenants and must be assessed on a case-by-case basis. The valuation of the covenant can be a contentious point in negotiations and impact the sale price.
Three exceptions may apply to the general income inclusion rule on a sale to an arm’s length person:
Employment income—this exception may apply if the amount would already be taxable as employment income.
Eligible capital property—this exception may apply if the amount would be treated as a sale of eligible capital property, such as goodwill. A joint election between the buyer and seller is required.
Shares and partnership interest—this exception may apply on the disposition of an eligible interest in a corporation or partnership if certain additional requirements are met. A joint election between the buyer and seller is required.
An exception may also apply which prevents Canada Revenue Agency from reallocating proceeds to the restrictive covenant. The rules of this exception are complex, but it may apply if no portion of the purchase price is allocated to the restrictive covenant, and it is reasonable to assume that the restrictive covenant was granted to preserve the market value of the assets disposed of.
The rules regarding restrictive covenants are complex and require careful analysis prior to finalizing any agreements.
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