How does a buyer treat a payment for the seller’s non-compete for tax?

A buyer who agrees to pay for a seller’s non-compete should know how the Income Tax Act describes that payment on the buyer’s side. That is subsection 56.4(4), headed “Treatment of purchaser”, which sets out three cases. This page follows its wording. It is not a view on how any deal should be taxed.

The three cases in subsection 56.4(4)

The subsection starts: an amount paid or payable by a purchaser for a restrictive covenant is, under paragraph (a), if section 5 or 6 requires it to be included in computing the income of an employee of the purchaser, to be considered wages paid or payable by the purchaser to the employee. Under paragraph (b), if an election has been made under paragraph (3)(b), it is considered incurred by the purchaser on account of capital for the purpose of determining the cost of the property or for subsection 13(35), and not an amount paid or payable for all other purposes of the Act. Under paragraph (c), if an election has been made under paragraph (3)(c) and the amount relates to the purchaser’s acquisition of property that is, immediately after, an eligible interest of the purchaser, it is included in computing the cost to the purchaser of that eligible interest, with the same “all other purposes” wording.

Why the seller’s election matters to the buyer

Paragraphs (b) and (c) each apply “if an election has been made” under the matching paragraph of subsection (3), which covers a covenant granted to a purchaser who deals at arm’s length with the seller (determined without reference to paragraph 251(5)(b)) and sets its own conditions in each paragraph. Under paragraph (3)(b) the seller elects, or, if the amount is payable by the purchaser in respect of a business carried on in Canada by the purchaser, the seller and the purchaser jointly elect. Under paragraph (3)(c), which is subject to subsection (9), the seller and the purchaser both elect. Under subsection 56.4(13), the election is to include a copy of the covenant and be filed with the Minister by the date that subsection sets. Subsection (4) itself lists only those three cases, so if a payment fits none of them, ask a tax adviser how it is treated.

Allocation under section 68

Section 68 says that where an amount received or receivable from a person can reasonably be regarded as being in part the consideration for a restrictive covenant granted by a taxpayer, the part that can reasonably be regarded as consideration for the covenant is deemed to be an amount received or receivable by the taxpayer in respect of the covenant, irrespective of the form or legal effect of the contract or agreement, and to be an amount paid or payable to the taxpayer by the person to whom the covenant was granted. Subsection 56.4(5) says that, where it applies, section 68 does not apply to deem consideration to be received or receivable by the taxpayer for the covenant; subsections 56.4(6) and (7) set out when it applies, and (7) is subject to subsection (10). The sellers’ side is covered in restrictive covenant tax rules and paying a selling shareholder for a non-compete. The Canada Revenue Agency’s covenant page says the topic is under review.

What to ask before the agreement is signed

• Which paragraph of subsection 56.4(3) is the seller relying on, and does it need an election?
• If the election is joint, who prepares it and who signs for the buyer?
• Is the payment to an employee, and is the buyer set up for wages?
• How does the agreement allocate the price, and does the allocation hold up under section 68?