What are the tax implications of section 56.4 when a vendor sells a business?
When allocating any amount received for a restrictive account, the amount received will be treated as ordinary income for tax purposes instead of a capital gain. Therefore, if you can satisfy an exemption under section 56.4(2), the portion allocated to the restrictive covenant can attract gains tax treatment as opposed to ordinary income tax, which is preferable.
What are some examples of restrictive covenants for which section 56.4 applies?
A restrictive covenant is essentially a commitment not to perform a certain activity. Common restrictive covenants in buy-sell transitions include:
- Non-competition agreements—agreements not to compete with a particular business within a specified geographical area for a certain period of time;
- Non-solicitation agreements—agreements not to solicit employees or customers of a certain business;
- Confidentiality agreements—agreements to maintain privacy with respect to the confidential information of a certain business or person.
When does section 56.4 not apply?
There are 3 exceptions that apply to the requirement to have full income inclusion for consideration of restrictive covenants. They are the employee exception, whereby an employee claims consideration for a restrictive covenant as employment income; eligible capital property exception, whereby the amounts received for a restrictive covenant are on account of an eligible capital property such as goodwill, and the share sale exception, whereby the amount allocated to the restrictive covenant directly relates to the disposition of an “eligible interest” in a partnership or corporation. Thus, this exception only applies in the context of a share sale or a sale of a partnership interest.
