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Legislative proposals relating to the treatment of restrictive covenants: February 10, 2006.

On February 10, 2006, Tax Executives Institute submitted comments to the Canadian Department of Finance on proposed legislation relating to the treatment of restrictive covenants. The comments were prepared by TEI's Canadian Income Tax Committee whose chair is David V. Daubaras of General Electric Canada. Contributing substantially to the development of TEI's letter was Alan E. Wheable of Toronto Dominion Bank.

On behalf of Tax Executives Institute (TEI), I am writing to express TEI's concerns about proposed amendments to the Income Tax Act (hereinafter "the ITA" or "the Act") to revise the tax treatment of restrictive covenants. The amendments are part of the Legislative Proposals initially released by the Department of Finance on February 27, 2004, and subsequently revised and reissued in News Release 2005-049 (July 18, 2005). The provisions address the Department's concerns about the tax treatment of payments for non-competition payments that were identified in News Release 2003-049 (October 7, 2003).

TEI Background

Tax Executives Institute is the preeminent international association of business tax executives. The Institute's 5,800 professionals manage the tax affairs of 2,800 of the leading companies in North America, Europe, and Asia. Canadians constitute 10 percent of TEI's membership, with our Canadian members belonging to chapters in Calgary, Montreal, Toronto, and

Vancouver, which together make up one of our nine geographic regions, and must contend daily with the planning and compliance aspects of Canada's business tax laws. Our non-Canadian members (including those in Europe and Asia) work for companies with substantial activities in Canada. In sum, TEI's membership includes representatives from most major industries including manufacturing, distributing, wholesaling, and retailing; real estate; transportation; financial services; telecommunications; and natural resources (including timber and integrated oil companies). The comments set forth in this letter reflect the views of the Institute as a whole, but more particularly those of our Canadian constituency.

TEI concerns itself with important issues of tax policy and administration and is dedicated to working with government agencies to reduce the costs and burdens of tax compliance and administration to our common benefit. We are convinced that the administration of the tax laws in accordance with the highest standards of professional competence and integrity, as well as an atmosphere of mutual trust and confidence between business and government, will promote the efficient and equitable operation of the tax system. In furtherance of this principle, TEI supports efforts to improve the tax laws and their administration at all levels of government.

Legislative Background and Overview of TEI Comments

On February 27, 2004, the Department of Finance released Legislative Proposals to amend various provisions of the Income Tax Act, including the taxation of amounts received or receivable in respect of granting a restrictive covenant. The proposed amendments, which were revised and reissued on July 18, 2005, were developed in response to the court decisions on the treatment of restrictive covenants in Fortino (1) and Manrell. (2) In those cases, the courts ruled that amounts received by a vendor for a non-competition agreement in connection with the sale of the vendor's shares of a corporation were not taxable. Briefly, Fortino held that the payment for the non-competition agreement is not income in respect of a source and thus is not taxable. (3) In Manrell, the court expanded the Fortino doctrine, holding that a "right to compete," which a taxpayer disposes of when entering into a non-competition agreement, is not a "right" that constitutes "property" for income tax purposes. Since the taxpayer had not disposed of "property," the proceeds allocated to the right were determined to be nontaxable.

The two court decisions have spawned uncertainty about the proper treatment of non-competition payments received in connection with the sale of a business (whether of shares in a corporation or an interest in a partnership). TEI generally agrees that such payments, which are analogous to other forms of capital receipts, should not be excluded from the taxable income of the recipients. Hence, legislation to clarify the treatment of such amounts and ensure consistency among taxpayers receiving such amounts is necessary and appropriate.

TEI believes, however, that the proposed restrictive covenant provisions are overbroad, going beyond the government's legitimate concern about reversing the results in the Fortino and Manrell decisions. The proposed amendments would change the longstanding treatment of some forms of non-compete payments and would also apply to many agreements to which they should not, thereby disrupting the well-settled tax treatment of many transactions, confusing taxpayers and CRA alike, and causing inequitable and untenable tax results. We urge the Department to consider TEI's comments and recommendations and revise the legislation accordingly.

Description of Legislative Proposal

The Legislative Proposal would add section 56.4 to the Act. Subsection 56.4(1) defines "restrictive covenant" broadly and sweeps in contractual provisions that strictly speaking are neither restrictive nor covenants. (4) Under subsection 56.4(2), all amounts received or receivable in respect of the grant of a restrictive covenant would, except for three narrowly prescribed exceptions set forth in subsection 56.4(3), be taxed to the recipient on income account. Under subsection 56.4(4), an amount paid or payable by the purchaser of the restrictive covenant would, unless a limited exception for amounts paid for employment income applies or one of two other elective provisions applies, be treated as being made on capital account. Under an amendment to section 68, consideration would be deemed to be received or receivable in respect of a restrictive covenant--even where taxpayers would not otherwise make an allocation--unless subsection 56.4(5) applies. Subsection 56.4(5) would apply if the conditions in subsection 56.4(6) or subsection 56.4(7) (for treating the amount as either eligible capital expenditures or for the acquisition of an eligible interest in property) are satisfied. (5) Subsections 56.4(8)-(10) make other clarifications and set forth the rules governing the filing of the prescribed forms for the elective provisions. Finally, draft paragraph 212(1)(i) would impose a withholding tax on non-residents for payments in respect of a restrictive covenant to which sub-section 56.4(2) applies.

Overbroad Definition of Restrictive Covenant

Regrettably, the definition of restrictive covenant is so broad that it encompasses agreements that are far beyond the limited concerns relating to non-competition payments that were identified by the Department in its October 7, 2003 release. Indeed, any agreement that includes restrictions, undertakings, or waivers of rights as a standard contractual term would be swept into the proposed provision. Examples of agreements that would arguably come under the definition of a "restrictive covenant" include:

(a) a pledge, often included as a standard term in small business loans, to refrain from selling or encumbering assets of the business during the term of the loan (i.e., a negative pledge);

(b) a waiver of a bequest under a will;

(c) a promise to permit quiet enjoyment under a residential lease;

(d) a promise to refrain from crossing a picket line (whether directly or indirectly in return for strike pay); (6)

(e) a covenant entered into in connection with a sale of shares in a corporation (or a sale of a partnership interest) pledging to carry on business in the ordinary course through the closing of the sale or to pay dividends (or partnership distributions) consistent with past practice prior to closing; and (f) a child support payment. (7)

Under current law, the mere act of granting a restrictive covenant (or entering into agreements containing such terms) generally would not produce any direct tax consequences. In addition, the parties to such agreements would rarely allocate consideration or payments to these "restrictive covenants," especially items (a) through (c) above. Under the proposed amendments, the making of a promise about or the surrender of such rights arguably gives rise to a potentially substantial tax burden because (i) the rights associated with each promise are valuable and (ii) the proposed amendment to section 68 of the Act would seemingly require an allocation of consideration to such promises even where it would be unusual or commercially impractical to do so. The proposals to amend sections 56.4 and 68 might not be intended to affect the current tax results for the foregoing items, but consider the following:

(a) A negative pledge is often provided in order to obtain financing from a lender. In the absence of such a pledge, most small business loans would not be made. As a sine qua non for obtaining the loan, the negative pledge would arguably make the entire loan proceeds an amount "received or receivable" in respect of the covenant.

In other cases, the interest rate negotiated by the borrower might have been higher but for the negative pledge. In such a case, the borrower would arguably "receive" a payment from the lender equal to the amount by which the interest rate is reduced. Consequently, a portion of the loan proceeds to the borrower would seemingly be converted to an amount "received or receivable" in respect of the negative pledge. In either case, some or all the loan advance might be considered income to the borrower.

(b) Assume the son of a deceased person waives a bequest under a will in favour of either the widow of the deceased or the infant siblings (with whom the son does not act at arm's length) of the son. Is the full amount of the bequest subject to the waiver treated as income to the son? Arguably, a waiver of a bequest would produce a taxable receipt to the person making such a waiver.

(c) Under a real estate lease, a tenant is generally entitled to a promise from the landlord for quiet enjoyment of the premises and consequently obtains a valuable right. The proposed legislation seemingly requires that the rent receivable by the landlord be deemed to be greater than the actual payment (as a result of the surrender of the quiet enjoyment right) with an offsetting payment deemed made by the tenant.

As we understand it, the proposed legislation is not intended to change the current tax results in any of these situations, but the examples illustrate the unwarranted and unanticipated tax consequences that the overbroad definition of restrictive covenant may produce. We urge the Department to narrow the definition.

Receipts for Restrictive Covenants Treated as on Income Account

Under the proposed amendments, all payments received or receivable because of a restrictive covenant would, with certain limited exceptions, be taxable on income account to the recipient. As a result, even payments that are clearly capital in nature and generally treated as on capital account under current law would default to income account treatment.

TEI believes that the proposed automatic default treatment as on income account is as improper as the exclusion of a non-competition payment from taxation under the Fortino or Manrell decisions. Indeed, TEI recommends that the Department consider reversing the default rule in order to treat payments for restrictive covenants as on capital account. At a minimum, the legislation should be revised to provide relief where the restrictive covenant relates to the disposition of capital property. Specifically, the rules should provide that any amount allocated to a restrictive covenant arising from the disposition of capital property should be treated in a manner similar to the property being disposed of. Similarly, where the underlying property is disposed of on a rollover basis (e.g., under section 85, 85.1, or 86), rollover treatment should apply to the payment for any restrictive covenant relating to the rollover property (e.g., by treating the payment on the covenant as additional proceeds on the underlying property).

Proposed Exceptions from Treatment as on Income Account

Proposed subsection 56.4(3) provides three exceptions from the income inclusion rule of proposed section 56.4(2). Under paragraph 56.4(3)(a), if certain conditions are satisfied, amounts that are treated as employment income under section 5 or 6 of the Act are not subject to inclusion under this section. In addition, if certain conditions are satisfied (including the making of a joint election by the vendor and the purchaser), paragraph 56.4(3)(b) provides an exception for amounts treated as proceeds of a disposition under description E of the cumulative eligible capital definition in subsection 14(5). Finally, subject to certain conditions (including the making of a joint election by the vendor and purchaser), paragraph 56.4(3)(c) affords an exception for amounts received or receivable for an "eligible interest."

TEI believes it would be more appropriate to treat amounts allocated to restrictive covenants in connection with the sale of shares of a corporation (or an interest in a partnership) carrying on a business as additional proceeds on the shares (or partnership interest) rather than deeming such amounts to be on income account from a separate source. Similarly, in connection with the sale of the assets of a business, it would be appropriate to treat the amounts received either as cumulative eligible capital or as additional proceeds on the disposed-of assets.

If the restrictive covenant provisions are retained in their current form, the conditions for qualifying for treatment of the amounts paid as additional proceeds of disposition or as cumulative eligible capital are so stringent that they make the proposed exceptions largely meaningless. Although TEI's analysis of the proposed provisions is ongoing, some of the issues identified with operation of proposed subsection 56.4(3) and the conditions in proposed subsection 56.4(7) are, as follows:

(a) Paragraph 56.4(7)(a) requires that the restrictive covenant be granted directly by the vendor of the shares or partnership interest. For practical commercial and legal reasons, restrictive covenants are frequently made by the parent entity of a business group rather than by a subsidiary entity actually disposing of shares or a partnership interest in another entity. As a result, the relief afforded by paragraph 56.4(5) will rarely, if ever, be available to corporate groups with multiple tiers of entities below a parent holding company.

(b) The description of the condition in subparagraph 56.4(7)(d)(ii) is extremely confusing and the facts and circumstances to which it would apply to permit a taxpayer to avail itself of subsection 56.4(5) are unclear (since the latter provision never directly or indirectly uses the term "eligible corporation"). Under certain circumstances, where a corporation is being disposed of, it must seemingly be (or hold an interest in) an "eligible corporation." An "eligible corporation" is one where "the taxpayer holds not less than 90% of the issued and outstanding share capital having full voting rights under all circumstances and having a fair market value of not less than 90% of fair market value of the issued and outstanding shares" of the corporation. The tax policy rationale for making the availability of the proposed relief dependent upon a requirement of holding 90 percent of the votes at all times is unclear. Moreover, the requirement is more a trap for the unwary than a curb against any perceived abuse or limitation on the ability of a taxpayer to qualify for the relief. For example, assume that under a voting rights agreement one shareholder is entitled to elect 10 of 11 directors of a corporation and the minority shareholder is entitled to elect 1 director. Neither the majority nor minority shareholder is entitled to vote for the director(s) elected by the other. Under these facts, the taxpayer does not have 90 percent of the voting rights of the corporation at all times. (8) Many other facts and circumstances exist where the taxpayer will have full control of the entity even though it may not at all times possess shares with 90 percent of the voting rights. (9) TEI urges the Department to (1) clarify the drafting of subparagraph 56.4(7)(d)(ii) and (2) consider eliminating the 90 percent of votes and value requirement. If a control threshold is necessary for the operation of this provision--and we are not persuaded that it is necessary--we recommend the 90-percent ownership threshold be reduced to a more-than-50-percent ownership requirement.

(c) To qualify for the exception in paragraph 56.4(3)(c) a taxpayer must dispose of an "eligible interest." An "eligible interest" is capital property of the taxpayer that is either an interest in a partnership that carries on a business or a share in a corporation that carries on a business. In addition, an eligible interest includes "a share of the capital stock of a corporation 90% or more of the fair market value of which is attributable to eligible interests in one other corporation." (Emphasis added.) The exception is seemingly intended to permit the proceeds from the sale of interests in holding companies to qualify as "additional proceeds of disposition." It is unclear why the exception is limited to shares of a holding company where the value is attributable to "one other corporation" rather than to "one or more other corporations or partnership interests." TEI recommends that Department expand the definition of an "eligible interest" to include interests in "one or more other corporations or partnerships."

(d) After entering into a purchase and sale agreement, the vendor of a subsidiary may be deemed related to an arm's-length purchaser under paragraph 251(5)(b) of the Act. As a result, the relieving exception in proposed paragraph 56.4(3)(c) is not available (owing to the preamble of subsection 56.4(3)).

(e) The exceptions in proposed paragraphs 56.4(3)(b) and (c) apply only to a narrow subset of restrictive covenants and do not apply, for example, to covenants to refrain from acquiring a competitor. Moreover, as discussed above, the exceptions do not address agreements that might be swept into the provision by the overbroad definition of "restrictive covenant."

Payment on Capital Account

Under the proposed legislation, the default treatment of the proceeds of disposition to a vendor granting a restrictive covenant is ordinary income. The proposed default treatment of the proceeds to the payor (or purchaser) of the restrictive covenant, however, is on capital account. Although there are situations where purchasers and sellers may, on a principled basis, be treated differently, it is unclear what policy principle justifies treating purchasers and sellers disparately under these provisions. If, in a commercial arm's-length transaction, the recipient of a payment is taxed on an income basis, TEI believes it would be appropriate to permit the purchaser to treat the payment as an expense on income account.

Expenses Attributable to the Grant of the Restrictive Covenants

The proposed legislation seemingly provides no basis for deducting the costs or expenses related to or associated with an item includible in income under this provision. We urge the Department to clarify that the costs associated with granting the covenant are deductible. Double Taxation

Section 248(28) is a fairness provision that generally precludes double taxation and prevents items from being deducted more than once. The proposed restrictive covenant provisions include multiple and specific cross references to other sections of the Act (such as in proposed subsection 56.4(3)) that are seemingly sufficient to preclude the application of subsection 248(28) to many payments. For example, the definition of a restrictive covenant is broad enough to encompass items such as scholarships that are already taxable. Hence, we are concerned that such amounts might be subject to double taxation. Double taxation may also occur in connection with the direct, indirect, or imputed receipt of income in connection with the grant of restrictive covenants in the examples set forth above in the discussion of the overbroad definition of restrictive covenant.

Mandatory Allocation of Amounts to Restrictive Covenants

Under a proposed amendment to section 68, an amount received or receivable for a 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. ..." In effect, the provision requires that the value of a restrictive covenant be allocated and taxed in a fashion consistent with its substance regardless of the form of legal agreement or manner in which it is structured. TEI believes the proposed change mandating the allocation of amounts to restrictive covenants goes far beyond eliminating the incentive to allocate payments to non-competition payments in order to take advantage of the income exclusion afforded by the Fortino and Manrell decisions. Indeed, the proposed mandatory allocation potentially changes longstanding and well-settled tax rules governing the timing of taxation as well as the character of many transactions by converting capital receipts into income amounts and potentially subjecting such amounts to withholding tax. Although TEI believes the entire restrictive covenant regime of section 56.4 is flawed and should be abandoned, the overbreadth of the proposed changes can be addressed by eliminating the proposed amendments to section 68, especially in arm's-length transactions where the parties to the agreement make no initial allocation to a "restrictive covenant." At a minimum, TEI urges the Department to eliminate the changes to section 68. The mandatory allocation is unnecessary to curb any abuses of concern to the Department.

Valuation Disputes

Finally, the proposed changes to section 68 will likely increase the scope and number of valuation disputes with CRA. Restrictive covenants are usually so interwoven with a transaction that the covenant itself has little or no independent value. Nonetheless, since many transactions will not be consummated without the covenants, the entire value of a transaction may be attributed to the covenant on the basis of it being a sine qua non. As a result, taxpayers and CRA will frequently find themselves at odds over the allocation of amounts to restrictive covenants. Again, by abandoning the proposed change to section 68 potential valuation disputes will be avoided.

Recommended Approach to the Treatment of Restrictive Covenants

We recommend that the current legislative proposal to tax payments received or receivable in respect of restrictive covenants be abandoned. Instead, narrower legislation should be crafted to address the treatment of non-competition agreements entered into in connection with the sale of shares in a corporation or an interest in a partnership. We suggest the following principles be employed to craft that legislation:

1. Substantially narrow the definition of restrictive covenant.

2. Exclude from the definition of restrictive covenant any items that are already addressed by other provisions of the Act.

3. Make no changes to the rules governing payments for a non-competition agreement except to address the "source" and "property" issues in Fortino and Manrell. Current tax principles are sufficiently clear to address whether the character of a payment is on capital or income account for the recipient and payor.

4. Where an item is treated as on income account, the source of the payment should be same as the related property or service to which the restrictive covenant relates. If the treatment of the item remains unclear following the application of this rule, the default characterization of the payment should be as income from employment, thereby ensuring mirror treatment of the payor and recipient.

5. Where payment for an item is on capital account, adopt rules analogous to section 138 of the Excise Tax Act in order to treat the payment as part of the related property or service. Where a payment cannot be made part of a related property or service, the payment should be treated as proceeds for cumulative eligible capital.

6. Abandon the proposed amendments to section 68 and make no attempt to apply section 68 to amounts received or receivable in respect of restrictive covenants.

7. Where a payment for an item is includible in income, allow the amount to be deducted by the payor, subject to the application of paragraph 18(1)(a).


TEI would be pleased to meet with representatives of the Department of Finance at their earliest convenience in order to discuss these comments and recommendations.

TEI's comments were prepared under the aegis of the Institute's Canadian Income Tax Committee, whose chair is David V. Daubaras. If you should have any questions about the submission, please do not hesitate to call Mr. Daubaras at 908.858.5309 or Monika M. Siegmund, TEI's Vice President for Canadian Affairs, at 403.691.3210.

(1) Fortino v. The Queen, 97 DTC 55, [1997] 2 CTC 2184 (TCC), aff'd, 2000 DTC 6060, [2000] 1 CTC 349 (FCA).

(2) Manrell v. The Queen, 2003 DTC 5225, [2003] 3 CTC 50 (FCA).

(3) The Crown failed to plead as an alternative that the amounts were capital receipts and was precluded from raising that argument at the trial and appeal.

(4) Specifically, "restrictive covenant, of a taxpayer, means an agreement entered into, an undertaking made, or a waiver of an advantage or right by the taxpayer (other than an agreement or undertaking for the disposition of the taxpayer's property or for the satisfaction of an obligation described in section 49.1 that is not a disposition), 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."

(5) Proposed section 56.4(5) would make section 68 inapplicable if the conditions set forth in proposed section 56.4(6) are satisfied. Although our analysis of the provisions is ongoing, TEI currently has no comments in respect of the employment income exception.

(6) Currently, strike pay is excluded from taxation under the Supreme Court of Canada's decision in Fries v. The Queen, [1990] 2 CTC 439. The proposed legislation arguably reverses that result because, as a condition for receiving strike pay, a union worker promises not to cross the picket line. At a minimum, the government should clarify explicitly whether it intends to revise the treatment of strike pay.

(7) The potential inclusion of child support payments under section 56.4 seems contrary to the intended exclusion of such amounts under paragraph 56(1)(b). Again, the Department should consider clarifying whether the restrictive covenant provisions would change the current treatment of child support payments.

(8) To ensure that the relief is available, a prudent taxpayer would structure the voting rights agreement to permit it to cast a de minimis number or percentage of votes for the director elected by the minority interest.

(9) Many voting rights agreements afford a minority interest a right disproportionate to its interest in order to block an extraordinary action (e.g., a liquidation or merger) that might terminate the minority interest or cause the interest holder to receive less than full value for its interest.
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Title Annotation:Canada
Publication:Tax Executive
Date:Mar 1, 2006
Previous Article:Letter to Canada's Department of Finance regarding subsection 17(8) of the Income Tax Act: March 9, 2006.
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