Restrictive Covenants

Transcription

1 Restrictive Covenants Fondation canadienne de fiscalité 2015 Philippe Dunlavey, Ernst & Young Erica Lawee, Ernst & Young

2 Agenda Introduction Overview of the relevant provisions of the Income Tax Act (the Act ) Practical examples Best practices 2

3 History Section 56.4 was introduced in response to the Federal Court of Appeal decisions in Fortino and Manrell where it was held that the amounts received by a seller for entering into a non-compete agreement were non-taxable. 3

4 What is a restrictive covenant? Restrictive covenant ((56.4)(1)): of a taxpayer, means an agreement entered into, an undertaking made, or a waiver of an advantage or right by the taxpayer, whether legally enforceable or not, that affects, or is intended to affect, in any way whatever, the acquisition or provision of property or services by the taxpayer or by another taxpayer that does not deal at arm's length with the taxpayer, other than an agreement or undertaking (a) that disposes of the taxpayer's property; or (b) that is in satisfaction of an obligation described in section

5 General Concept Basis of taxation 56.4(2) provides that a taxpayer must include in computing income for a taxation year the total of all amounts each of which is an amount in respect of a restrictive covenant; received or receivable in the taxation year by the taxpayer (or a taxpayer with whom the taxpayer does not deal at arm s length); Excludes an amount that has been included in the taxpayer s income for a preceding taxation year, or in the taxpayer s eligible corporation s income (a taxable Canadian corporation), in the taxation year or in a preceding taxation year 5

6 Exceptions to 56.4(2) Subsection 56.4(3) Employment income exception 56.4(3)(a): Restrictive covenant granted by the taxpayer to an arm's length purchaser and amount received is included as the taxpayer's employment income 56.4(4): Amount can be deducted by purchaser as wages paid or payable Ensure that payroll tax is appropriately withheld 6

7 Exceptions to 56.4(2) Subsection 56.4(3) Eligible capital property exception 56.4(3)(b): Restrictive covenant granted by the taxpayer to an arm's length purchaser and amount received would be required by the description of proceeds of disposition in the definition of cumulative eligible capital in subsection 14(5) to be included in computing the CEC in respect of the business to which the restrictive covenant relates The taxpayer granting the restrictive covenant must be the one carrying on the business Essentially, the business reduced its CEC as opposed to a full income inclusion under section 54.6 Joint election in prescribed form 7

8 Exceptions to 56.4(2) Subsection 56.4(3) Shares and partnership interests exception 56.4(3)(c): Restrictive covenant granted by the taxpayer to an arm's length purchaser to the extent that the amount directly relates to the disposition of a property that is an eligible interest in the partnership or corporation that carries on the business to which the restrictive covenant relates Eligible interest is defined in subsection 56.4(1) as capital property to the taxpayer that is: 1. Interest in a partnership that carries on a business; 2. Shares of a corporation that carries on a business; or 3. Shares of a corporation, 90% or more of the fair market value of which is attributable to eligible interests in one corporation 8

9 Exceptions to 56.4(2) Subsection 56.4(3) The following criteria must be met for the exception in paragraph 56.4(3)(c) to apply: The eligible interest is disposed to the purchaser of the restrictive covenant (or a person related to the purchaser); The restrictive covenant is a non-compete covenant type only; The restrictive covenant may reasonably be considered to have been granted to maintain or preserve the value of the eligible interest ; Subsection 84(3) does not apply to the disposition; The amount received or receivable in respect of the restrictive covenant is added to the proceeds of disposition of the eligible interest for capital gains purposes; and Joint election in prescribed form 9

10 Non-compete agreements 56.4(5), (6) & (7) Subsection 56.4(5) - Where the conditions in subsections 56.4(6) or (7) are met, section 68 will not apply to deem consideration to be received or receivable by the taxpayer for the restrictive covenants 10

11 Paragraph 68(c) If an amount received or receivable from a person can reasonably be regarded as being in part the consideration for the disposition of a particular property of a taxpayer, for the provision of particular services by a taxpayer or for a restrictive covenant as defined by subsection 56.4(1) granted by a taxpayer, [ ] (c) the part of the amount that can reasonably be regarded as being consideration for the restrictive covenant is deemed to be an amount received or receivable by the taxpayer in respect of the restrictive covenant irrespective of the form or legal effect of the contract or agreement, and that part is deemed to be an amount paid or payable to the taxpayer by the person to whom the restrictive covenant was granted. 11

12 Non-compete agreements 56.4(5), (6) & (7) CRA position (revised) (see C6): The CRA is now prepared to accept that where a contract relating to granting a restrictive covenant uses words such as "$1 and other good and valuable consideration" simply to ensure that the contract is legally binding, and means in effect that "no more than a $1 worth of consideration" is conveyed by a purchaser for the restrictive covenant, such consideration will not, in and of itself, constitute proceeds received or receivable by the particular party for granting the RC for purposes of paragraph 56.4(6)(e) and paragraph 56.4(7)(d). However, this treatment is subject to the potential application of anti-avoidance rules such as subsection 56.4(10) of the Act where warranted. 12

13 Non-compete agreements 56.4(6) Exception The CRA may be prevented from reallocating the proceeds allocated to a noncompete agreement in certain arm s-length employee relationships The following criteria must be met for the exception to apply: The restrictive covenant is granted by an individual to another taxpayer (purchaser) with whom the individual is dealing at arm s length; The individual deals at arm s length with the employer and with the vendors; The restrictive covenant relates to the acquisition of an interest in the individual s employer, in a corporation related to the employer or in a business carried on by the employer (vendor); The restrictive covenant is a non-compete agreement; No consideration is received or receivable by the employee for granting the restrictive covenant, and The amount that can reasonably be regarded to be consideration for the restrictive covenant is received or receivable only by the vendors. 13

14 Non-compete agreements 56.4(7) Exception 56.4(7) applies to non-compete agreements granted as part of the sale of: 1. a goodwill amount 56.4(7)(b)(i) and 56.4(7)(c)(i)(A); 2. property other than shares 56.4(7)(b)(ii)(A) and 56.4(7)(c)(ii)(B)(I); or, 3. shares 56.4(7)(b)(ii)(B) and 56.4(7)(c)(ii)(B)(II) 14

15 Non-compete agreements 56.4(7) Exception Subsection 56.4(7) applies to non-compete agreements granted as part of a sale of assets or shares if no proceeds are received for the granting of the covenant to: 1. an arm's length purchaser (determined without reference to paragraph 251(5)(b)); or 2. a purchaser that is an eligible individual (56.4(1) individual related to the vendor that is at least 18 years old) Additional conditions: Vendor is a Canadian resident; and Vendor does not have any interest or rights in the target company (must sell all shares see 56.4(7)(c)(iii)) 15

16 Non-compete agreements 56.4(7) Exception Other conditions 56.4(7) Restrictive covenant should be integral to an agreement in writing e.g., included in a share or asset purchase agreement Joint election to be filed in the case of a disposition of a goodwill amount to which 56.4(7)(b)(i) and 56.4(7)(c)(i)(A) applies N/A where disposition is a redemption, acquisition or cancellation of shares to which 84(3) applies Must be granted to maintain or preserve the FMV of the property disposed of Subject to anti-avoidance rules in 56.4(10) if 56.4(10) applies, section 68 applies 16

17 Filing elections under 56.4(3)(b), 56.4(3)(c) or 56.4(7) Subsection 56.4(13) No prescribed form - per CRA website, the grantor and seller must file a jointly-signed letter to make the election Filing-due date: If recipient of restrictive covenant was resident in Canada at the time of receipt: recipient s filing due-date for taxation year in which the restrictive covenant was granted Otherwise: six months after the date on which the restrictive covenant was granted Reg. 600 provides for late-filing (subject to late-filing penalty) 17

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19 Other considerations Part XIII 212(1)(i): 25% withholding tax on amounts paid or credited by a resident to a non-resident in respect of a restrictive covenant that would be included pursuant to subsection 56.4(2). (reduction under a tax treaty needs to be considered) Part XIII 212(13)(g): amount payable by a non-resident to another non-resident for a restrictive covenant that affects Canada. 19

20 Practical Examples 20

21 Example 1 Joe, the only Canadian shareholder of a Canadian corporation ( Opco ), enters into an agreement to sell his shares of Opco to Purchaser, a Canadian corporation, for total consideration of $10M Joe undertakes not to provide directly or indirectly services in competition to Opco for a 5 year period The non-competition is granted in favor of the Purchaser Opco carries on a business The value assigned to the shares is $9M and $1M to the noncompetition covenant Joe and Purchaser deal at arm s length The $1M is added to the proceeds of disposition of Joe from the disposition of the shares of Opco. 21

22 Solution - Example 1 Joe and the Purchaser can jointly elect under 56.4(3)(c): The Restrictive covenant must be granted to maintain or preserve the value of the eligible interest disposed of to the Purchaser Subparagraph 56.4(3)(c)(iii) Subsection 84(3) does not apply to the disposition Subparagraph 56.4(3)(c)(iv) The amount allocated must not be otherwise included in the income of Joe from a source that is either an office or employment or a business - specific antiavoidance rule in subsection 56.4(9) needs to be considered 56.4(7) is not available since proceeds are receivable paragraph 56.4(7)(d) Joe and the Purchaser must elect in prescribed form 22

23 Example 2 Same facts as Example 1 but Joe and Purchaser are deemed not to deal at arm s length pursuant to paragraph 251(5)(b) at the time the covenant is granted since Purchaser has an option to acquire the shares of Opco; No consideration is received in consideration for the granting of the restrictive covenant. 23

24 Solution - Example 2 Clause 56.4(7)(b)(ii)(B) applies (i.e., section 68 does not apply) Subsection 56.4(7) must be read without reference to 251(5)(b)) 56.4(3) must also be read without reference to 251(5)(b). 24

25 Example 3 Holdco enters into an agreement to sell its shares of its wholly owned subsidiary Opco to Purchaser, a Canadian corporation, for total consideration of $10M The value assigned to the shares is $9M and $1M to the noncompete agreement Jane, the only shareholder of Holdco, undertakes not to provide directly or indirectly services in competition to Opco for a 5 year period The non-compete agreement is granted in favor of the Purchaser Opco carries on a business Jane and Purchaser deal at arm s length The $1M is added to the proceeds of disposition from the disposition of the shares of Opco 25

26 Solution - Example 3 The amount of $1M attributable to the restrictive covenant will be subject to tax under 56.4(2). No 56.4(3)(c) election is not available since Jane is not the taxpayer disposing of the shares of Opco Holdco is. The exception in subsection 56.4(7) is not available since the taxpayer receives proceeds from granting the restrictive covenant. It may be preferable from a tax perspective that no amount be allocated to the restrictive covenant. 26

27 Example 4 Same facts as Example 3 but Jane is the taxpayer disposing of the shares of Holdco and the amount that relates to the restrictive covenant is added to Jane s proceeds of disposition. 27

28 Solution - Example 4 Jane and the Purchaser can jointly elect under 56.4(3)(c) since the taxpayer (i.e., Jane) disposes of an eligible interest: The restrictive covenant must be granted to maintain or preserve the value of the eligible interest disposed of to the Purchaser Subparagraph 56.4(3)(c)(iii) Subsection 84(3) does not apply to the disposition Subparagraph 56.4(3)(c)(iv) The amount allocated must not be otherwise included in the income of Joe from a source that is either an office or employment or a business - specific antiavoidance rule in subsection 56.4(9) needs to be considered Subsection 56.4(7) is not available since proceeds are receivable paragraph 56.4(7)(d) Jane and the Purchaser must jointly elect in prescribed form 28

29 Example 5 Joe enters into an agreement to sell his shares of Holdco to Purchaser, a Canadian corporation, for total consideration of $10M The value assigned to the shares is $9M and $1M to the noncompete agreement and the $1M is added to Joe s proceeds of disposition from the disposition of the shares of Holdco Holdco owns all of the issued and outstanding shares of Subco, which in turn owns all of the shares of Opco, the corporation carrying on the business to which the restrictive covenant relates Joe undertakes not to provide directly or indirectly services in competition to Opco for a 5 year period The non-compete agreement is granted in favor of the Purchaser Joe and Purchaser deal at arm s length. 29

30 Solution - Example 5 The amount of $1M attributable to the restrictive covenant may be subject to tax under subsection 56.4(2) based on the interpretation of the definition of eligible interest No 56.4(3)(c) election may be available since Joe has not disposed of an eligible interest. It can be argued that the definition of eligible interest is limited to the first tier corporations The exemption in subsection 56.4(7) is not available since the taxpayer receives proceeds from granting the restrictive covenant It may be preferable from a tax perspective that no amount be allocated to the restrictive covenant. 30

31 Example 6 Joe, a resident of Canada, enters into an agreement to sell all of his shares of Opco to Jane, his sister, for total consideration of $10M Joe undertakes not to provide directly or indirectly services in competition to Opco for a 5 year period No value assigned to the non-compete agreement and the $10M is added to Joe s proceeds of disposition from the disposition of the shares of Opco Opco is the corporation carrying on the business to which the restrictive covenant relates The non-compete agreement is granted in favor of Jane. 31

32 Solution - Example 6 The exception in clause 56.4(7)(c)(i)(B) applies since Jane is an eligible individual in respect of Joe. Also: The restrictive covenant must be granted to maintain or preserve the value of the eligible interest disposed of to the Purchaser Subparagraph 56.4(7)(f) Subsection 84(3) does not apply to the disposition Subparagraph 56.4(7)(e) The amount allocated must not be otherwise included in Joe s income from a source that is either an office or employment or a business - specific antiavoidance rule in subsection 56.4(10) needs to be considered More specifically for 56.4(7)(c): Joe is a resident of Canada at the time the restrictive covenant is granted Joe does not, at any time after the restrictive covenant is granted, have an interest, or for civil law a right, in Opco (whether directly or indirectly in any manner whatever) 32

33 Best Practices: Drafting Restrictive Covenants Clauses Language that no or a $1 consideration is received Sufficient language to ensure that the restrictive covenant is granted to preserve the value of the goodwill, property other than shares, shares or the eligible interest, as the case may be Undertaking by the Purchaser to file late elections Language to clarify that the particular taxpayer receives the amount in his/her capacity as shareholder if applicable Must be reasonable to conclude that the restrictive covenant relates to an agreement in writing under 56.4(7)(b)(ii). 33

34 Questions? 34