The non-compete a vendor could sign for free

The situation

Meridian Trade Supply Inc., the same distributor from the companion file, had a second key person the buyer wanted a personal covenant from: the operations VP, who held an 8% minority shareholding acquired through an earlier phantom-equity conversion, and who was selling those shares in the same transaction as the two founders. Unlike Patricia the sales director, she was a vendor in her own right, not solely an employee being asked to sign something extra.

The buyer's term sheet allocated $180,000 of the total purchase price specifically to her personal non-competition and non-solicitation covenant, described in the share purchase agreement as part of the consideration for her disposition of shares, rather than as a standalone payment for her signature on a separate agreement.

The problem

The deal team's first instinct, having just worked through the sales director's file, was to run the identical analysis: does the payment survive s.56.4(6)'s six conditions for a free employee covenant? It does not — condition (e), no proceeds received by the individual, fails the moment $180,000 is allocated to her at all, exactly as it failed for Patricia.

That instinct stopped one step too early. Section 56.4(6) protects only an employee's covenant under s.56.4(5); it was never the only route available to someone who is also disposing of shares. The operations VP's shareholding put an entirely different exception in play — one the sales director, who owned no shares, could never have reached no matter how the payment had been structured.

The numbers

$180,000, allocated in the purchase agreement's consideration schedule to the operations VP's restrictive covenant, disposed of contemporaneously with her 8% shareholding. Contrast the sales director's identical $75,000 figure in the companion file, framed in the term sheet as consideration “for entering into the non-competition and non-solicitation agreement” with no share disposition anywhere in her facts — the framing was similar, but only one of the two taxpayers had shares to dispose of, and that difference decided which provision could apply.

The rule that decided it

Section 56.4(3) sets out exceptions to the s.56.4(2) income-inclusion rule, and paragraph (c) is the one built for a selling shareholder, not an employee. It applies 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 purchaser's business. “Eligible interest” is defined at s.56.4(1) to include “a share of the capital stock of a corporation that carries on a business” — precisely what the operations VP held and was disposing of.

This is the exception the sales director's file explicitly could not use: her disposition-based exceptions under s.56.4(3) never applied because she was “not disposing of anything.” The operations VP was disposing of something — her 8% shareholding — in the same transaction as the covenant, to the same purchaser, which is exactly what paragraph (c) requires.

Two conditions keep this from being a loophole rather than a rule. First, s.56.4(9)'s anti-avoidance guard: “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.” Had the $180,000 been paid through payroll, described as a retention or performance bonus, or tied to her continued employment rather than to the share disposition itself, (9) would have pulled it back out of (3)(c) and into ordinary employment income regardless of the share sale happening alongside it. The allocation had to be genuine, not a relabelled bonus.

Second, the election requirement at s.56.4(13): for paragraph (3)(c) to apply, “an election in prescribed form filed under any of those provisions is to include a copy of the restrictive covenant and be filed… by the person with the Minister on or before the person's filing-due date for the taxation year that includes the day on which the restrictive covenant was granted.” Without a timely, properly documented election, s.56.4(2)'s default income inclusion reasserts itself even where paragraph (c)'s substantive conditions are otherwise met.

Once both conditions were satisfied, the $180,000 was not simply excluded from her income the way it never applies to Patricia's facts at all — it was converted, becoming part of her proceeds of disposition for the shares rather than a s.56.4(2) income inclusion, opening the door to capital-gains treatment on the amount in a way no structuring of the sales director's payment could ever have achieved, because she had no eligible interest for any amount to relate to.

The outcome

The parties filed the s.56.4(13) election with the operations VP's return for the year of closing, supported by a copy of the restrictive covenant and a written allocation schedule showing the $180,000 tied to her share disposition rather than to continued employment. Her tax counsel confirmed the amount was reported as proceeds of disposition, not employment income, consistent with s.56.4(3)(c).

What it would have cost otherwise

Had the parties instead followed the sales director's fix — dropping the standalone covenant payment and folding it into ordinary post-closing compensation — the operations VP would have lost the disposition-based treatment entirely and been taxed on the full $180,000 as employment income, the outcome her own shareholding was specifically capable of avoiding. That fix is correct for an employee with nothing to sell; applied to a selling shareholder, it throws away the better answer that was actually available.

The tell

The tell is assuming the sales director's fix is the fix for every key-employee covenant payment on a sale, when it is really the fix for one specific taxpayer: someone with no shares to dispose of. The first question for any covenant-giver on a sale is not how to structure the payment — it is whether the person receiving it is also a vendor. A vendor's covenant payment and a pure employee's covenant payment sit under different paragraphs of the same section, and only one of them has a path to anything other than full income inclusion.

Takeaways

• • ITA s.56.4(3)(c) lets a payment for a restrictive covenant relate to a taxpayer's own disposition of an eligible interest — including a share of the corporation carrying on the business — converting the amount into proceeds of disposition instead of s.56.4(2) income.
• • That exception is available only to someone actually disposing of an eligible interest. A non-shareholder employee, however the payment is structured, can never reach s.56.4(3)(c) — see the companion file for exactly that outcome.
• • s.56.4(9)'s anti-avoidance rule pulls the amount back into ordinary income if it would, on the facts, really be employment income — the allocation to the share disposition has to be genuine, not a relabelled bonus or retention payment.
• • s.56.4(13) requires a timely, prescribed-form election with a copy of the covenant attached, filed by the vendor's filing-due date for the year the covenant was granted — without it, s.56.4(2)'s default income inclusion applies regardless of the underlying facts.
• • Before defaulting to "fold it into ordinary compensation" for a key-employee covenant payment on a sale, confirm whether the covenant-giver is also disposing of shares — if so, a materially better result may be available under s.56.4(3)(c) instead.

Sources

• • Income Tax Act — s.56.4(1) (definition of “eligible interest”), s.56.4(3)(c) (disposition-based exception for a covenant relating to the taxpayer’s own disposition of an eligible interest), s.56.4(9) (anti-avoidance — non-application of paragraph (3)(c) to amounts that are really employment or business income), s.56.4(13) (prescribed-form election and filing deadline).
• • See the buyer offered a key employee $75,000 to sign a non-compete for the non-shareholder-employee mechanic (s.56.4(2), (5), (6)) this file contrasts with, and for why that file’s fix does not fit a selling shareholder.
• • Treadstone Law — how is a non-compete payment taxed on an Ontario business sale? — adjacent: general guidance on non-compete payment tax treatment. It does not distinguish the employee versus vendor analysis under s.56.4(3)(c) and (6), which is the rule this file turns on.