We all know that section 56.4 of the Income Tax Act (Canada) is a hot mess. A recent CRA technical interpretation (2017-0688301I7) (TI) illustrates well one of the reasons why.
The broad definition of “restrictive covenant” (RC) in subsection 56.4(1) sweeps into the section’s ambit any conceivable covenant given by the seller of a business. The TI notes “that, in addition to typical non-competition clauses, an RC could include: exclusivity clauses, signing bonuses, break fees, supplier loyalty agreements, confidentiality agreements, franchise agreements, and referral fees.”
The TI was provided in response to an internal audit division inquiry. It appears audit was reviewing a share sale where a non-competition (NCC) and non-solicitation (NSC) covenant had been given by the vendors of the shares. The TI analyzes the circumstances in which section 68 won’t apply so that the CRA is prevented from reallocating proceeds to the RC (the entire amount of which proceeds must be included in the income of the person giving the RC per subsection 56.4(2)). The circumstances are specified in subsection 56.4(7). On a share sale, a “non-compete” covenant can be excluded from the ambit of section 68. A non-compete is defined as
an undertaking of the vendor not to provide, directly or indirectly, property or services in competition with the property or services provided by the purchaser (or by a person related to the purchaser) in the course of carrying on the business to which the restrictive covenant relates (a non-compete covenant)
Does this include a confidentiality covenant? A covenant not to solicit employees? A covenant not to solicit customers? The TI states the following. It begins by quoting a CRA response to another similar inquiry (no reference is given for the prior response).
“Our understanding of the requirement of subparagraph 56.4(3)(c)(ii) of the Act when applied in the course of the sale of shares is that the subparagraph would allow an election with respect to the undertaking not to solicit the clients of the corporation that is sold, but it would not allow such an election with respect to the value of an undertaking not to solicit the employees to change employment.”
A similar issue was also discussed in XXXXXXXXXX. In particular, we considered whether a confidentiality clause would preclude a taxpayer from making an election under paragraph 56.4(3). After considering the issue, XXXXXXXXXX, we concluded the following:
“… the fact that a non-competition agreement may include both a non-competition and a confidentiality clause would not in and of itself disqualify the entire non-competition agreement for the purposes of the exceptions in subsection 56.4(3) or 56.4(7).”
In the current fact situation, the NSC appears to be an integral part of the NCC. That is, no meaningful distinction can be made between the NCC and the NSC, as both appear to be fundamental elements needed to restrict a Shareholder’s ability to compete with Targetco.
Essentially, the terms of the NCC and NSC, which are in the same section of the SPA, also appear to reflect the conditions that one might normally expect to see in a typical non-competition agreement. Thus, the NSC and NCC could be treated as a single RC that is in respect of a non-compete covenant.
The TI, then, concluded that the NCC and NSC composed a single RC not to compete as per the definition cited above.
Unfortunately, the TI does not specify the exact terms of the NCC and NSC, and so it impossible to determine why the TI concluded they were inextricably linked. It’s also impossible to tell whether the NSC was, or whether it included, a covenant not to solicit employees.
The difficulty is that “non-competes” usually include covenants not to disclose confidential information and covenants not to solicit employees, which the CRA seems to think is a Bad Thing. Is any covenant that is usually given with a non-compete ok even if it wouldn’t be acceptable on its own (per the CRA position above, at the beginning of the quote)? Or do certain kinds of covenants render the exception in 56.4(7) unavailable because the “bad” covenants taint the “good” ones? Or is the taxpayer giving the RC able to make an election in respect of the good covenants? If the covenants can be separated in this manner, is the taxpayer then required to allocate some portion of the proceeds to the bad covenants and then include the portion in income, as required by subsection 56.4(2)?
As is usual with section 56.4, I have no idea.