Can a selling shareholder be paid tax-free for a non-compete?

A buyer often asks the selling shareholder for a non-compete, and the question that follows is whether any money paid for it can escape tax. The Income Tax Act answers with a default and a short list of exceptions. None of them exempts the payment; they decide how it is treated, and any relief then depends on that treatment.

The default: it is income

Section 56.4 defines a restrictive covenant broadly, covering an agreement that affects the acquisition or provision of property or services, whether or not it is legally enforceable. An amount received or receivable for one is included in income. That reaches amounts received by a person who does not deal at arm’s length with the seller, so directing the payment to a connected person does not by itself avoid the rule.

The share-sale exception

Where the covenant is given to an arm’s-length purchaser, relates directly to the sale of shares of the corporation carrying on the business, and is meant to preserve the value of those shares, and the section’s other conditions are met, the seller and purchaser can jointly elect in the prescribed form. The amount is then added to the seller’s proceeds on the shares and taxed as part of the gain, and the purchaser adds it to the cost of the shares.

Pricing it inside the share price

A second route is to pay nothing separately for the covenant. Under section 56.4(5) and (7), where the conditions are met, including that the covenant is integral to the written share sale agreement and no proceeds are received for granting it, section 68 does not deem any part of the price to be consideration for the covenant.

The share gain’s own rules still apply

Because the amount joins the share gain, any relief applies to it only on the gain’s own terms. The CRA’s guidance for sellers points to the capital gains deduction for qualified small business corporation shares, so whether any of it is sheltered turns on those tests, not on the non-compete. See also whether non-competes are enforceable.