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To paint the picture, we start with a successful business owner looking to sell a business. The business owner finds a willing purchaser and they negotiate a purchase price. Typically, the purchase will include a goodwill component, for example, customer lists, business name, telephone number, etc.. In order to protect that goodwill the agreement of purchase and sale will generally include some form of non-competition, non-solicitation or other similar clause, generically referred to as restrictive covenants. The tax treatment of these types of clauses in the context of a business sale has gone through somewhat of an upheaval over the last several years. Let us review where we have been, how we got there and where we are now. Unfortunately, as you will see, we are not in a happy place.

The starting point for any discussion of the taxation of restrictive covenants has got to be the Fortino case. This case which came out in 2000 was truly the dawn of a new millennium. The story in that one was a couple sold their shares in a business corporation to Loblaws and entered into a non-competition clause as part of the transaction. A substantial amount of the purchase price was allocated to the non-competition covenant and payable to the individuals. Canada Revenue Agency took a run at this in the courts and the case went up to the federal Court of Appeal. The court found that these payments were not taxable because they were not received in respect of a business carried on by the individuals. The business was carried on by the corporation. This case had a bit of a quirk in that there was an administrative hiccup on the CRA side and certain arguments in favour of the payments being taxable never made it to the court. In any event the case stood for the proposition that non-competition payments were not taxable.

As is often the case with a favourable result like Fortino, the news spread like wildfire. Despite the uncertainty raised by the glitch in Fortino, business owners and their tax advisors took the non-taxable proposition as gospel and ran with it. In the few years following Fortino, vendors became more and more aggressive and allocated more and more to restrictive covenants upon the sale of a business. They took the position, following Fortino, that there was no tax to pay. It was only a matter of time before CRA would take another run at this practice and there would be a new case before the courts.

Sure enough a few years later we got it. The next stop on this brief historical tour is the Manrell case. This case also went up to the Federal Court of Appeal. Much to the surprise of most people, the Court again found that the non-competition payments were not taxable. Now there was going to be a real free-for-all.

The reaction from the tax authorities was swift. Not willing to take a chance on the *three strikes and you*re out* principle, the Department of Finance gave word almost immediately that the landscape was going to change. There was a press release issued within a few months of Manrell, followed by the first cut at proposed amendments to the Income Tax Act on this issue less than six months later. Not unexpectedly, these proposals were met with an onslaught of criticisms and Finance went back to work. In the summer of 2005, further amendments came out, followed by further criticisms and concern, followed by further changes and proposals culminating in what is now Bill C-33.

Surely, after all the back and forth discussions between knowledgeable tax people we would have a clear understanding of where we stand. Guess again. The tax treatment of restrictive covenants is now laden with uncertainty. Here are some of the issues and concerns:


The definition of *restrictive covenant* is very broad and could capture situations where the parties do not even realize that they are caught.

If you are found to be offside the provisions, the result could be that the amounts will be taxed as ordinary income and not as a capital gain. This means that the effective tax rate on the restrictive covenant portion could be double what it otherwise would be.

CRA has the power to allocate a reasonable amount to the restrictive covenant and tax on that basis.

A taxpayer may be subject to tax under these provisions even if they do not receive any portion of the payment.

An election may have to be filed to achieve the desired results in some circumstances but not in others.

If the transaction involves related parties and/or non-residents the rules may be different.


In the end, what we are left with in this area is somewhat of a minefield. Unfortunately, there are no simple answers and planning tips. Each transaction must be looked at independently with proper tax, legal and accounting advice. The only thing we know for certain is that the days of using over-inflated non-competition payments to reduce tax on the sale of a business are gone for good.

Harold Feder is a partner with the law firm of BrazeauSeller LLP. He practices in the areas of tax and estate planning for individuals and business owners.