Principal Issues: In a situation where an individual sells shares of a management corporation of which he is the sole shareholder, and where he gives a restrictive covenant, do the exception of subsections 56.4(2) of the Income Tax Act (the Act), which are indicated at a) subsection 56.4(7) or b) subsection 56.4(3), apply?
c) What is the impact of a non-solicitation clause with respect to the exceptions indicated at subsection 56.4(7) or 56.4(3) of the Act?
d) In a situation where a management corporation sells shares of two corporations which has businesses and the unique shareholder of the management corporation gives a restrictive covenant, do the exceptions of subsections 56.4(3) and 56.4(7) of the Act apply?
Position: a) Depending if all the conditions of subsection 56.4(7) of the Act are respected.
b) All the conditions of subsection 56.4(3) of the Act are not respected.
c) General comments.
d) Not all the conditions of subsection 56.4(3) of the Act are respected. However, conditions of subsection 56.4(7) of the Act may all be respected.
Reasons: The writing of the legislation.
APFF FEDERAL TAX ROUNDTABLE 7 OCTOBER 2013
APFF CONFERENCE 2013
Question 19
Section 56.4
On October 24, 2012, a Notice of Ways and Means Motion was tabled proposing, among other things, amendments to section 56.4 as was proposed in the revised technical proposals of July 16, 2010.
In light of these provisions, what is the CRA's position on the application of the various provisions of proposed section 56.4 to the following facts.
Mr. X is the sole shareholder of Holdco. Holdco holds 100% of the shares of the capital stock of Opco 1 and 100% of the shares of the capital stock of Opco 2.
Mr. X sells all of the shares he holds in the capital stock of Holdco to Buyco, a corporation that deals at arm's length with Mr. X.
In connection with the sale, in order to protect the value of Opco 1 and Opco 2, Mr. X grants non-compete and non-solicitation covenants to Buyco respecting the business of each of Opco 1 and Opco 2.
Subsection 84(3) does not apply to the transaction.
Questions to the CRA
(a) If it is agreed between the parties that no part of the amount received by Mr. X is attributable to the non-compete covenant, will subsection 56.4(7) be satisfied so that section 68 does not apply to the sales proceeds? If this is the case, then we understand that to the extent that no part of the amount received is attributed to the non-compete covenant by the parties, the CRA will not be able to use section 68 in order to deem a portion of the consideration to be received or receivable by Mr. X for his granting of the non-compete covenant.
(b) In the event that it is agreed between the parties that a portion of the amount received by Mr. X is attributable to the non-compete covenant, would the exception in s. 56.4(3) not be available, so that Mr. X would be required to include that amount in his income as a consequence?
(c) Are the answers to sub-questions (a) and (b) the same for the non-solicitation covenant?
(d) Are the answers to questions (a) and (b) the same if Holdco sells the shares of the capital stock of Opco 1 and Opco 2 to Buyco, with Mr. X granting a non-compete and non-solicitation covenant to Buyco?
CRA response to question 19(a)
Bill C-48 (the Technical Tax Amendments Act, 2012), which included amendments to sections 56.4 and 68, received Royal Assent on June 26, 2013. We have assumed that for questions (a) through (d), the restrictive covenant was granted after the date of Royal Assent, so that our comments will not consider the transitional provisions with respect to section 56.4.
Paragraph 68(c) provides, inter alia, that the part of the amount that can reasonably be regarded as being consideration for the restrictive covenant within the meaning of subsection 56.4(1), granted by a taxpayer, is deemed to be an amount received or receivable by the taxpayer in respect of the restrictive covenant irrespective of the form or legal effect of the contract or agreement, and that part is deemed to be an amount paid or payable to the taxpayer by the person to whom the restrictive covenant was granted.
Nevertheless, where subsection 56.4(5) is applicable to a restrictive covenant granted by a taxpayer, section 68 does not apply to deem consideration to be received or receivable by the taxpayer for the restrictive covenant. However, subsection 56.4(5) only applies only if all the conditions of subsection 56.4(7) are satisfied.
Subparagraph 56.4(7)(a)(i) provides that, subject to subsection 56.4(10), subsection 56.4(5) applies, under certain conditions, to a restrictive covenant if it is, inter alia, granted by the taxpayer (referred to as the “vendor”) to another taxpayer (referred to as the “purchaser”) with whom the vendor deals at arm's length (determined without reference to paragraph 251(5)(b)) at the time of the grant of the restrictive covenant.
The limited facts submitted in relation to question (a) exclude the application of subparagraph 56.4(7)(a)(ii) and paragraph 56.4(7)(c), since the restrictive covenant is not granted to an eligible individual. In addition, we are unable to determine whether subparagraph 56.4(7)(b)(i) or clause 56.4(7)(b)(ii)(A) apply.
In addition, the preamble to paragraph 56.4(7)(b) provides that where subparagraph 56.4(7)(a)(i) applies, the restrictive covenant is an undertaking of the vendor not to provide, directly or indirectly, property or services in competition with the property or services provided or to be 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. In addition, clause 56.4(7)(b)(ii)(B) adds that it must be reasonable to conclude that the restrictive covenant is integral to an agreement in writing, under which shares of the capital stock of a corporation (referred to as the "target corporation") are disposed of to the purchaser or to another person that is related to the purchaser and with whom the vendor deals at arm’s length (determined without reference to paragraph 251(5)(b)).
For the purposes of clause 56.4(7)(b)(ii)(B) the other conditions, set out in paragraphs 56.4(7)(d) to (f), for subsection 56.4(5) to apply, are as follows:
(d) no proceeds are received or receivable by the vendor for granting the restrictive covenant;
(e) subsection 84(3) does not apply in respect of the disposition of a share of the target corporation or family corporation, as the case may be;
(f) the restrictive covenant can reasonably be regarded to have been granted to maintain or preserve the fair market value of any of
[…]
(iii) the shares referred to in clause (b)(ii)(B) or subclause (c)(i)(B)(II).
Based on the limited facts submitted in respect of question (a), assuming that Holdco does not carry on any business and holds only the shares of the capital stock of Opco 1 and Opco 2 as its assets, it is possible that the conditions of subsection 56.4(7) are satisfied, in particular because the restrictive covenant granted by Mr. X could have the effect of maintaining and protecting the fair market value of Holdco.
However, the CRA cannot make a final determination as to whether all of the conditions in subsection 56.4(7) are satisfied without a full review of all facts and documents, either during an audit or as part of an advance ruling request.
CRA response to question 19(b)
Subsection 56.4(2) provides that there is to be included in computing a taxpayer’s income for a taxation year the total of all amounts each of which is an amount in respect of a restrictive covenant of the taxpayer that is received or receivable in the taxation year by the taxpayer or by a taxpayer with whom the taxpayer does not deal at arm’s length (other than an amount that has been included in computing the taxpayer’s income because of this subsection for a preceding taxation year or in the taxpayer’s eligible corporation’s income because of this subsection for the taxation year or a preceding taxation year).
Subsection 56.4(3) provides specific exceptions for subsection 56.4(2) to not be applicable. The limited facts in question (b) do not allow us to conclude that the exceptions in paragraphs 56.4(3)(a) and (b) apply.
Indeed, the first exception, provided for in paragraph 56.4(3)(a) provides in particular that an amount is not taxable by virtue of subsection 56.4(2) if the amount was included, under section 5 or 6, in computing the taxpayer's income for the year. However, the facts submitted in respect of (b) do not indicate whether Mr. X is an employee of Holdco and do not specify whether it is the purchaser Buyco or Holdco who pays the amount attributable to the restrictive covenant to Mr. X.
The second exception to the general inclusion, which is provided in paragraph 56.4(3)(b), includes the amount that would, in the absence of this section, be required by the description of E in the definition of “cumulative eligible capital” in subsection 14(5) to be included in computing the particular taxpayer’s cumulative eligible capital in respect of the business to which the restrictive covenant relates. However, according to the limited facts submitted, the proceeds of disposition of the shares of the capital stock of Holdco would not be proceeds from an eligible capital property and Mr. X does not personally carry on a business.
Furthermore, under paragraph 56.4(3)(c), subsection 56.4(2) does not apply to an amount received or receivable by a particular taxpayer in a taxation year in respect of a restrictive covenant granted by the particular taxpayer to another taxpayer (referred to in subsection 56.4(3) and 56.4(4) as the “purchaser”) with whom the particular taxpayer deals at arm’s length (determined without reference to paragraph 251(5)(b)), if the following facts are true:
c) subject to subsection 56.4(9), the amount directly relates to the particular 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, or that is at that time an eligible interest by virtue of paragraph (c) of the definition eligible interest in subsection (1) where the other corporation referred to in that paragraph carries on the business to which the restrictive covenant relates, and
(i) the disposition is to the purchaser (or to a person related to the purchaser),
(ii) the amount is consideration for an undertaking by the particular taxpayer not to provide, directly or indirectly, property or services in competition with the property or services provided or to be provided by the purchaser (or by a person related to the purchaser),
(iii) the restrictive covenant may reasonably be considered to have been granted to maintain or preserve the value of the eligible interest disposed of to the purchaser;
(iv) if the restrictive covenant is granted on or after July 18, 2005, subsection 84(3) does not apply to the disposition,
(v) the amount is added to the particular taxpayer’s proceeds of disposition, as defined by section 54, for the purpose of applying this Act to the disposition of the particular taxpayer’s eligible interest, and
(vi) the particular taxpayer and the purchaser elect in prescribed form to apply this paragraph in respect of the amount.
Subsection 56.4(1) defines the term "eligible interest" as capital property of the taxpayer that is, inter alia, a share of the capital stock of a corporation that carries on a business or a share of the capital stock of a corporation 90% or more of the fair market value of which is attributable to eligible interests in one other corporation. This definition excludes a corporation with at least 90% of the fair market value attributable to eligible interests in two other corporations.
In light of the wording of the definition of "eligible interest", the shares that Mr. X holds in the capital stock of Holdco would not qualify as eligible interest since Holdco holds shares in more than one corporation.
As the restrictive covenant granted by Mr. X related to businesses carried on by Opco 1 and Opco 2, the election under paragraph 56.4(3)(c) could not be made by Mr. X as 90% of the FMV of the shares in the capital of Holdco were not attributable to the eligible interests in a corporation. Holdco held shares in the capital stock of two other corporations, Opco 1 and Opco 2, which each carried on a business to which the restrictive covenant related.
CRA response to question 19(c)
One of the conditions for the application of paragraph 56.4(3)(c), provided for in subparagraph 56.4(3)(c)(ii), is that the amount is consideration for an undertaking by the particular taxpayer not to provide, directly or indirectly, property or services in competition with the property or services provided or to be provided by the purchaser (or by a person related to the purchaser). Paragraph 56.4(7)(b) restates the same condition by stating that the restrictive covenant must be a commitment by the taxpayer in the course of carrying on the business to which the restrictive covenant relates.
However, the question of whether or not a non-solicitation covenant obliges a person who grants a restrictive covenant not to provide, directly or indirectly, property or services in competition with the property or services provided or to be provided by the purchaser (or by a person related to the purchaser), and whether this covenant satisfies all of the above conditions, is a question of fact. In addition, the question of whether a non-solicitation covenant is or is not an integral part of a non-compete commitment is also a question of fact.
If the wording of the non-solicitation covenant is considered as an integral part of the non-compete covenant, the non-solicitation covenant would not by itself disqualify the restrictive covenant for the purposes of the exceptions provided in subparagraph 56.4(3)(c)(ii) or subsection 56.4(7). In such case, the responses to questions (a) and (b) would be the same.
On the other hand, if the wording of a non-solicitation covenant is not considered to be an integral part of the non-compete covenant, it is a question of fact whether the conditions of paragraph 56.4(3)(c) and subsection 56.4(7) are satisfied. In the absence of details surrounding the non-solicitation covenant, we are unable to make a final determination.
CRA response to question 19(d)
In light of our comments made in response to question (b), and the limited facts provided in question (d), the exceptions in paragraph 56.4(3)(a) and paragraph 56.4(3)(b) cannot apply.
In addition, we are of the view that Holdco could not avail itself of the exception in paragraph 56.4(3)(c) Indeed, the election under paragraph 56.4(3)(c) would not be available to Holdco since, although it disposes of shares of the capital stock of Opco1 and Opco 2, it is not the taxpayer who granted the non-compete covenant. Indeed, as suggested in the limited facts described in relation to question (d), it is Mr. X and not Holdco who grants the restrictive covenant to Buyco.
Furthermore, assuming that Holdco deals at arm's length with Buyco, the exception in subsection 56.4(7) could apply if all the conditions of that subsection were satisfied, since Opco 1 and Opco 2 may each be a target corporation. However, a definitive answer in this regard would require a thorough examination of all the facts surrounding the disposition of the shares of the capital stock of Opco 1 and Opco 2, as well as the written agreement containing the restrictive covenant.
Lucie Allaire
(613) 957-2046
2013-049569