Anonymised, illustrative composite. The advisor's precedent checklist filed the asset-sale restrictive-covenant election on a share sale. Section 56.4 has no Class 14.1 property for it to attach to on a share deal — and the correct paragraph does something the wrong one never could.
At a glance
The vendor of a British Columbia specialty engineering firm sold all of the issued shares to an arm’s-length buyer for $6,400,000. The share purchase agreement included a four-year non-competition covenant from the vendor, with $350,000 of the price separately identified as consideration for it — the buyer wanted a defined figure to point to if it ever needed to enforce the covenant, the same commercial logic as the parent file’s asset sale.
The advisor had run this exact election on the parent file’s Nova Scotia asset sale a few months earlier, and used the same election paragraph again here: s.56.4(3)(b).
s.56.4(3)(b) preserves proceeds-of-disposition treatment only for an amount that would, absent s.56.4, be “required to be included in the proceeds of disposition of a property included in Class 14.1 of Schedule II to the Income Tax Regulations… in respect of the business to which the restrictive covenant relates.” Class 14.1 is goodwill, and goodwill is disposed of when a business is sold as assets. On a share sale, the corporation’s own goodwill is never disposed of at all — the vendor disposes of shares, and the corporation keeps everything it owns, goodwill included. There was no Class 14.1 disposition here for paragraph (b) to attach to, so filing that election would not have engaged it, whatever form it took.
$350,000 allocated to the covenant, out of $6,400,000 total consideration. Left where the misfiled election would have left it — unengaged, and therefore governed by s.56.4(2)’s default — the full $350,000 would have stood as ordinary income to the vendor, taxed at full inclusion in the year of closing, the identical default the parent file’s missed election produced.
s.56.4(3)(c) is the route for a covenant tied to the disposition of shares. It applies, subject to subsection (9), where the amount “directly relates to the particular taxpayer’s disposition of property that is, at the time of the disposition, an eligible interest in the partnership or corporation that carries on the business to which the restrictive covenant relates,” and:
“(i) the disposition is to the purchaser (or to a person related to the purchaser), (ii) the amount is consideration for an undertaking by the particular taxpayer not to provide, directly or indirectly, property or services in competition with the property or services provided or to be provided by the purchaser… (iii) the restrictive covenant may reasonably be considered to have been granted to maintain or preserve the value of the eligible interest disposed of to the purchaser; (iv) if the restrictive covenant is granted on or after July 18, 2005, subsection 84(3) does not apply to the disposition, (v) the amount is added to the particular taxpayer’s proceeds of disposition, as defined by section 54, for the purpose of applying this Act to the disposition of the particular taxpayer’s eligible interest, and (vi) the particular taxpayer and the purchaser elect in prescribed form to apply this paragraph in respect of the amount.”
Read the unit. Paragraph (b) adds the amount to the proceeds of disposition of the corporation’s Class 14.1 goodwill — a property the corporation itself disposed of. Paragraph (c) adds the amount to the proceeds of disposition of the vendor’s own eligible interest — the shares. These are not two labels for the same fix; they attach the covenant amount to two different dispositions by two different taxpayers, and only one of those dispositions happened here.
Subsection (9) is the further difference paragraph (b) does not carry: “Paragraph (3)(c) does not apply to an amount that would, if this Act were read without reference to subsections (2) to (14), be included in computing a taxpayer’s income from a source that is an office or employment or a business or property.” If the $350,000 were, in substance, compensation for the vendor’s continued services rather than genuinely tied to the share sale, (3)(c) would be blocked regardless of how the parties labelled it — an anti-avoidance test paragraph (b) does not need, because Class 14.1 proceeds are already a business-property characterisation on the corporate side.
The election was refiled under s.56.4(3)(c) before the vendor’s filing-due date for the year of closing — the same s.56.4(13) deadline the parent file turns on — with the covenant attached as that subsection requires. All six conditions in (3)(c)(i) through (vi) were satisfied on these facts: the disposition ran to the purchaser, the covenant was a genuine non-compete tied to preserving the value of the shares sold, s.84(3) did not apply, and both parties elected jointly. The $350,000 was added to the vendor’s proceeds of disposition of the shares.
That did more than avoid ordinary-income treatment. Because the shares were being sold as qualified small business corporation shares, adding the $350,000 to their proceeds of disposition put that portion of the price inside the pool of gain the vendor was claiming the lifetime capital gains exemption against — a route the Class 14.1 election could never have produced, because a Class 14.1 amount is a corporate-side capital-cost-allowance pool, not a share disposition, and is never LCGE-eligible property. Whether the exemption limit and the shares’ qualified status actually absorbed this portion is a separate test under s.110.6 that was not worked through for this file.
Filed as originally drafted, the (3)(b) election would not have engaged — there was no Class 14.1 disposition for it to operate on — and CRA reviewing the return would have found $350,000 sitting outside any valid exception to s.56.4(2)’s default. The result is the same $350,000-as-ordinary-income exposure the parent file’s missed election produced, but reached by filing a paperwork step that looked complete and was never capable of working on these facts.
The tell was a precedent checklist copied from an asset deal onto a share deal without asking what property each transaction actually disposes of. “File the restrictive covenant election” is not one instruction — it is two different paragraphs, attached to two different dispositions, and only one of them exists in any given transaction.
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