The buyer paid separately for the vendor's non-compete, and the payment was fully taxable as ordinary income

The situation

A Nova Scotia seafood processor sold substantially all of its business assets, including its customer relationships and brand, for $3,100,000. The asset purchase agreement specifically allocated $200,000 of that price to the vendor's covenant not to compete anywhere in Atlantic Canada for five years — a common, sensible allocation from the buyer's side, since it wanted to be able to point to a defined dollar figure if it ever had to enforce the covenant.

The problem

Nobody filed an election over that $200,000. The vendor's accountant, preparing the final corporate return, simply added the whole amount to the proceeds of disposition of goodwill along with the rest of the sale price and reported it accordingly. That is not how a separately-allocated restrictive covenant amount is taxed by default under the Income Tax Act.

The numbers

$200,000 allocated to the covenant, out of $3,100,000 total consideration. Taxed as ordinary income rather than folded into the goodwill proceeds, that allocation lost access to the more favourable treatment the rest of the sale price received — a six-figure allocation that cost real dollars in tax the moment the return was filed the way it was filed.

The rule that decided it

Section 56.4(2) includes a restrictive covenant amount in income by default. The route out of that default, for a covenant tied to the sale of a business's assets, is s.56.4(3)(b), and it is not automatic: the amount must be one that would “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, and the particular taxpayer elects (or… the particular taxpayer and the purchaser jointly elect) in prescribed form to apply this paragraph in respect of the amount.” Without that election, on prescribed form, filed by the deadline, s.56.4(3)(b) simply does not engage, and s.56.4(2)'s default income inclusion stands.

There is a second, parallel route that also fails without a filing: s.56.4(5) and (7) can turn off section 68's deeming rule for a vendor's own covenant — but only where, among other conditions, “no proceeds are received or receivable by the vendor for granting the restrictive covenant” and a joint election in prescribed form is filed under s.56.4(7)(g). That route was never available here either, because $200,000 in identified, separately-allocated proceeds is exactly what condition (d) rules out — the vendor did receive proceeds for the covenant, by the purchase agreement's own terms.

Every route that gives a restrictive covenant amount anything other than full ordinary-income treatment under s.56.4(2) runs through a prescribed-form election. There is no version of this provision where silence produces the favourable result by default.

The deadline is its own trap. Section 56.4(13) requires an election under s.56.4(3)(b), (3)(c) or (7) to include a copy of the restrictive covenant itself and, for a vendor resident in Canada, to be filed “on or before the person's filing-due date for the taxation year that includes the day on which the restrictive covenant was granted.” That is the vendor's ordinary tax-return filing deadline for the year of closing — not the assessment date, not the reassessment period, and not a date measured from when anyone notices the omission. Catch the missing election after that filing-due date has passed, and s.56.4(3)(b) is no longer available to elect into at all.

The outcome

The return was amended before the vendor's filing-due date for the year of closing had passed. The vendor and purchaser filed a joint election in prescribed form for the $200,000, attaching a copy of the restrictive covenant as s.56.4(13) requires, and the return added the amount to the proceeds of disposition of the Class 14.1 property instead of reporting it as standalone income. The purchase agreement was also revised for the vendor's remaining working files: any future allocation to a restrictive covenant now carries a closing checklist item requiring the joint election to be prepared and filed with the return, not chased down afterward.

What it would have cost otherwise

Missing the election deadline entirely would have locked in the $200,000 as ordinary income with no further route back to proceeds-of-disposition treatment — a result the purchase agreement's own allocation clause never intended and neither party would have chosen if either had understood the filing was required.

The tell

The tell was in the accountant's own assumption: that an amount the purchase agreement called consideration for a covenant would automatically get the same tax treatment as the rest of the sale price. The allocation clause decides what the buyer pays for; it does not decide how the vendor is taxed on it.

Takeaways

• • s.56.4(2) is the default: a restrictive covenant amount is ordinary income unless a specific exception applies.
• • s.56.4(3)(b) preserves proceeds-of-disposition treatment for a Class 14.1 amount only with a joint election in prescribed form — not automatically.
• • s.56.4(5)/(7) is a separate route, also election-gated, and it requires that the vendor receive no separately identifiable proceeds for the covenant — incompatible with a purchase agreement that names a dollar figure for it.
• • Build the election into the closing checklist, not the post-closing accounting cleanup — s.56.4(13) ties the deadline to the vendor's ordinary filing-due date for the year the covenant was granted, not to when the mistake is noticed.

Sources

• • Income Tax Act — s.56.4(2) (default income inclusion); s.56.4(3)(b) (Class 14.1 proceeds-of-disposition election); s.56.4(5) and (7) (non-application of s.68, its own joint-election route and condition (d) barring separately received proceeds); s.56.4(13) (election filing requirements and deadline).
• • Treadstone Law — non-compete payment tax treatment on a business sale — general background on allocating and taxing a vendor's covenant payment; the election mechanics above are the operative point for this file.