A buyer asks to allocate part of the price to the non-competition covenant. It sounds like a drafting detail and it is a tax decision. The Income Tax Act has a rule that brings restrictive covenant payments into income, and the definition of “restrictive covenant” is far wider than most people expect.
Key takeaways
SECTION 01 OF 09
Late in a negotiation, the buyer’s advisers propose allocating a portion of the purchase price — often a round number that looks small against the total — to the seller’s non-competition covenant.
From the buyer’s side there are sensible reasons to want it identified. From the seller’s side it can be an expensive concession dressed as a drafting point, and the seller frequently agrees to it without pricing it.
SECTION 02 OF 09
Income Tax Act s. 56.4(2), under the marginal note Income — restrictive covenants, is direct: “There is to be included in computing a taxpayer’s income for a taxation year the total of all amounts each of which is an amount in respect of a restrictive covenant of the taxpayer that is received or receivable in the taxation year by the taxpayer or by a taxpayer with whom the taxpayer does not deal at arm’s length”.
Included in income. Not proceeds of disposition, not a capital gain of which only a portion is taxable, and not eligible for the lifetime capital gains exemption in s. 110.6.
Treadstone Law states the practical effect plainly: “An amount specifically identified as consideration for a seller’s promise not to compete is often treated as fully taxable ordinary income to the person receiving it, rather than benefiting from the more favourable tax treatment that can apply to proceeds from selling shares or goodwill.”
SECTION 03 OF 09
This is the part that catches advisers as well as owners. The section defines a restrictive covenant as “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”.
Read the qualifiers. “Whether legally enforceable or not” — so a covenant that would fail as a matter of contract law is still within the definition. “In any way whatever” — which is about as wide as statutory language gets.
A non-solicitation undertaking, a standstill, a waiver of a right, a promise not to interfere with customers: the label on the clause is not what determines whether the section is engaged.
SECTION 04 OF 09
Because the number offered is usually small relative to the deal, and because it arrives at a stage when the seller has already mentally banked the transaction and does not want to reopen the price.
The asymmetry is that the allocation is often worth more to the buyer than it costs to offer, and worth more to lose than the seller realises. That is a bad position to negotiate from at the end of a process rather than the beginning.
SECTION 05 OF 09
Section 56.4(3), Non-application of subsection (2), disapplies the inclusion in defined circumstances where the covenant is granted to a purchaser “with whom the particular taxpayer deals at arm’s length”.
The conditions are specific. One limb concerns amounts to which the employment income provisions applied or would have applied. Another concerns amounts that would otherwise be included in the proceeds of disposition of property in Class 14.1 of Schedule II to the Income Tax Regulations, and requires the taxpayer to elect.
The practical point is not the detail of each limb — that is work for a tax adviser on the actual facts — but that relief is conditional and in places elective. An election is something you have to make, correctly and on time, which means it has to be identified before closing rather than discovered at filing.
SECTION 06 OF 09
The inclusion in s. 56.4(2) reaches amounts received by the taxpayer “or by a taxpayer with whom the taxpayer does not deal at arm’s length”, and the principal relieving provision is framed around arm’s-length dealing.
Succession sales within a family therefore sit in a different position from third-party sales by default, which is worth knowing before covenants are drafted on the assumption that they are equivalent. Treadstone Law addresses the covenant itself in that setting in non-competition clauses in family business succession.
SECTION 07 OF 09
On a share sale the seller is usually aiming at capital gain treatment and, if the shares qualify, the lifetime capital gains exemption. Every dollar moved from share proceeds to a covenant is a dollar moved out of that treatment.
On an asset sale the allocation exercise is already contested for other reasons, since the schedule drives recapture and capital cost allowance on the other side — the wider structural trade-off is set out in Treadstone Law’s asset purchase versus share purchase. A covenant allocation is one more line in the same argument, with its own rule attached.
SECTION 08 OF 09
Worth understanding, because it explains why the request is not simply an attempt to shift tax. A buyer paying for goodwill wants confidence that the person who generated it will not rebuild it across the street, and an identified consideration for the covenant is a familiar way of demonstrating that the promise was bargained for.
There are also third-party dimensions — consents, and conditions that have to be satisfied at closing — which Treadstone Law covers in non-competition consent and third-party closing conditions.
None of that makes the tax consequence go away. It means the two interests are genuinely in tension rather than one side being unreasonable.
SECTION 09 OF 09
Raise the allocation early, not at the end. It is a price term, and it should be negotiated when price is being negotiated rather than presented as documentation once the commercial deal feels settled.
Have the covenant reviewed against the statutory definition rather than by its heading. Undertakings and waivers scattered through an agreement can fall inside the definition without anyone labelling them a non-compete.
And if an exception is being relied on, confirm what it requires — including any election — and put the obligation to make it into the agreement while both signatures are still available.
Sources
