Highlight: Many business brokers, lawyers and even accountants are not protecting their clients from the new income inclusion rules in the Income Tax Act. As a professional advisor, failing to do this may expose you to liability.


Since the Federal Court of Appeal decisions in Fortino (2000 DTC 6060 (F.C.A.)) and Manrell (2003 DTC 5225 (F.C.A.)) held that payments received for granting a restrictive covenant (such as entering into a non-competition agreement) were not taxable, the Department of Finance has been trying to implement new legislation to amend the Income Tax Act (the “ITA”) to prevent this from happening.  This legislation has now been implemented and, among other things, has the effect of taxing amounts received by a Vendor pursuant to a non-competition agreement (or restrictive covenant) as income and not a capital gain.  If you are thinking – then let’s just not allocate any amount to the non-competition agreement – well, the amendments give the CRA a way to make this allocation on behalf of the Vendor (S.68(c)).  Obviously the tax cost is much less if taxed as capital gains as opposed to income.

So what’s the solution?  There is a way to swing the results back into the Vendor’s favour by filing a joint election between the Purchaser and the Vendor.   Surprisingly, many business brokers, lawyers and even accountants are not protecting their clients from these new provisions.  As a professional advisor, failing to do this may expose you to liability under negligence.  This article will explain to you how to protect yourself and your client from this unwanted outcome.  But first I will give you the nutshells explanation of this legislation, as I’m sure you would prefer to leave the technicalities to us.

The Legislation – Section 56.4(2) – The Income Inclusion Rule

The basic rule is that a taxpayer must include as income the full amount received in respect of a restrictive covenant granted by him or her.  The ITA defineds   “restrictive covenant” very broadly so for the purposes of this article we can assume that most, if not all, non-competition agreements will be considered a “restrictive covenant” (S.54.4(1)) under the ITA.

In order to characterize the amount received as a capital gain or a gain arising from cumulative eligible capital, in which case only half of the gain is included in income, certain conditions must apply, namely:

            1. Section 56.4(3)(a): the amount received is required to be included in the taxpayers income as income from employment;

            2. Section 56.4(3)(b): the amount received is an eligible capital amount in respect of the business to which the restrictive covenant relates; or

            3. Section 56.4(3)(c): the amount received directly relates to the 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.  An “eligible interest” (S.54.4(1)) would include the sale of a partnership interest in a partnership that carries on a business or shares in the capital stock of a corporation that carries on a business, either of which gives rise to a capital gain.

In order for the Vendor to take advantage of the above mentioned exemptions from the income inclusion rule, the Vendor (or the taxpayer if the individual granting the restrictive covenant) and the Purchaser much file an election in the prescribed form with Revenue Canada.  There are rules that apply on how and when to file an election.  Please contact me for more details on this.

In the world of private company transactions the election under Section 56.4(3)(c) will be our preferred election.  An election under Section 56.4(7) would generally apply in the case of a business asset sale.  It is important to note that a number of conditions must be met in order to have the benefit of any of the above mentioned exemptions, you can find these at Section 56.4(3) or 56.4(7) of the ITA or contact me for more details.

In either event, prior to determining which exemption applies, it is important to consult with an experienced accountant in addition to your lawyer so as to ensure that all avenues are considered.

How to Protect YOU (the Business Broker) and YOUR CLIENT

Brokers are the first point of contact with the Vendor and very often prepare the Letter of Intent or Offer to Purchase which is signed before it is shown to the lawyer.  A prudent business broker will want to ensure that they add a joint election clause in the LOI which has the effect of obliging the Vendor and the Purchaser to file this joint election if the Vendor deems it to be appropriate.  This will at a minimum prevent any claims being made against you, the business broker, for a failure to do so.  Keep in mind that not all lawyers will automatically recommend or think to add a joint election clause to the definitive agreement as not all lawyers (a) are up to date with the Income Tax Act amendments or (b) work on a sufficient amount of M&A transactions to have this insight.  Placing a joint election clause in your LOI or OTP will protect you, and your client.  If you need a sample clause to use in your agreements please contact me and I will happily provide one to you.

In Conclusion

This is a very basic and non-exhaustive summary – the intent of which is to draw your attention to this issue so that it is in your mind on every transaction you work on.  There is a plethora of literature on this topic on the internet and analyses which are in much more detail.  I am happy to point you in this direction.

Your best approach as a business broker is to insert the joint election clause and then leave the details for the definitive agreement.