Kalfa Law Firm | s.56(4) Election | Pay Less Tax On Sale Of Business

Pay Less Tax on the Sale of your Business: Understanding the Impact of Allocations to Restrictive Covenants and the s.56(4) Election

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; and
confidentiality agreements—agreements to maintain privacy with respect to the confidential information of a certain business or person.

A “restrictive covenant” of a taxpayer under proposed section 56.4(1) ITA stipulates that any amount received or receivable for a restrictive covenant will be treated as ordinary income for tax purposes instead of receiving capital gain treatment, subject to certain exceptions. Thus, any shareholder or owner of a corporation who grants a restrictive covenant on the sale of their shares or assets must take careful note of this new provision.

Income Exclusions

Provided that the grantor of the restrictive covenant (the vendor) and the party benefiting from the restrictive covenant (purchaser) deal at arm’s length, the CRA has provided 3 exceptions to the requirement to have full income inclusion for consideration of restrictive covenants. In some cases, the vendor and purchaser must file an election to void adverse income tax treatment.

Exception #1

Employee Exception

Subsection 56.4(2) does not apply to an amount that is received or receivable by an employee who has reported and characterized the payment for the restrictive covenant as employment income. Essentially, paragraph 56.4(3)(a) ensures that a payment that is received for a restrictive covenant that is granted to an employee of a business is taxed only once. No election is required to take advantage of this exception.

Exception #2

Eligible Capital Property (ECP) Exemption

Income treatment may be avoided when amounts received for a restrictive covenant are on account of eligible capital property (ECP) (e.g. goodwill). This exception is targeted at a sole proprietor or corporation making an asset sale. An election is required and must be filed by both the vendor and purchaser. Where elected, the amount is an eligible capital amount to the vendor and an eligible capital expenditure to the purchaser.

Exception #3

Share Sale Exception

Income treatment may be avoided if 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.

As for the purchaser, this election treats the purchase of the “eligible interest” in a partnership or a corporation that is allocated to a restrictive covenant as capital, deemed as part of the cost of acquiring an eligible interest.

This third exception to the application of section 56.4 is granted provided the following conditions are met:

If the amount would not otherwise be included in the vendor’s income from employment, business or property (as a full income inclusion), the amount must directly relate 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 a business in which the restrictive covenant relates;
The share must be disposed of to the purchaser (or a person that is related to the purchaser);
The amount must be a consideration for an undertaking by the particular taxpayer not to provide, directly or indirectly, property or service in competition with the property or services provided or to be provided by the purchaser (or by a person related to the purchaser). This essentially must be a non-competition covenant;
The restrictive covenant may reasonably be considered to have been granted to maintain or preserve the value of the eligible interest that is disposed of to the purchaser;
Neither section 85, which permits the transfer of income from a taxpayer or partnership to a corporation, nor subsection 97(2), which permits certain eligible property to be transferred by a taxpayer to a Canadian corporation on a tax-deferred basis, can apply to the disposition of the eligible interest by the particular taxpayer.

In summary, to avoid the income inclusion rule for consideration received for restrictive covenants, the restrictive covenant must be a non-competition agreement, the sale must involve the sale of shares or partnership interest of a business to a non-arm’s length person who agrees not to compete to preserve the value of the shares purchased, and there must be a joint election to be filed by the purchaser and vendor. Where any of these exceptions applies, the taxpayer, consideration received for restrictive covenants will be treated as capital gains as opposed to full income inclusion.

How to elect?

The CRA has not published a prescribed form for the elections under s.56.4 of the ITA. Instead, both the purchaser and seller must file a jointly signed letter to make the election.

This letter must include the following information relating to the vendor:

Full name
Social insurance number or business number
Address, and mailing address if applicable
The taxation year of the vendor in which they sold the restrictive covenant

The letter must include the following information relating to the purchaser:

Full name
Social insurance number or business number
Address, and mailing address if applicable
The taxation year of the purchaser in which they bought the restrictive covenant

The letter must include the following information relating to the covenant:

A description of the covenant
The full name of the taxpayer granting the covenant
The full name of the taxpayer receiving the consideration for the covenant
An indication that these parties deal at arm’s length
Under which provision of section 56.4 is the election being made by the parties

Filing Deadline

The filing deadline for the election is April 30, the same as the vendor’s filing due date for those who are resident in Canada (for non-resident vendors, different rules apply).

Practically speaking, this election should be completed and signed, if possible, at the closing of all other sale documents to ensure that the election is not missed.

Pro-tip: Use this to negotiate! The signing of this joint election may create significant tax savings for the vendor and thus the purchaser may be able to use this to negotiate a lower purchase price.

Don’t Forget about the Reallocation Rule – Section 68!

A vendor who is unable to meet any of the exceptions to the full income inclusion that is required under section 56.4 may be inclined to not allocate any amount of the asset or share sale proceeds to the restrictive covenant. As a result, the CRA retains the right to reallocate the proceeds under section 68 and any reallocated proceeds are fully taxable. The legislation does not provide any formula or guidance concerning the determination of a reasonable amount made by the CRA when invoking s.68.

That is why it is important for you to allocate an amount to restrictive covenants that the CRA would not consider unreasonably low.

Please call a lawyer at Kalfa Law Firm to guide you in which tax elections can be utilized so as to avoid paying more tax than required on the sale of assets of your business.

FAQ’s:

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.

-Shira Kalfa, BA, JD, Partner and Founder