Section 56.4: Tax Treatment of Restrictive Covenants on the Sale of a Business in Canada
Almost every private business sale includes a non-competition agreement the vendor commits not to compete against the buyer in the same market for a defined period. Buyers need it to protect the value they just paid for. But what happens to the tax treatment of the amount allocated to that non-compete?
Under Section 56.4 of the Income Tax Act, the default answer is unfavourable for the vendor: any amount received or receivable for a restrictive covenant is treated as fully taxable ordinary income, not a capital gain. At the highest marginal rates in Ontario, that’s a meaningful difference and for a vendor who was counting on the Lifetime Capital Gains Exemption (LCGE) to shelter gains on the sale of qualifying shares, a misallocated non-compete payment can result in an unexpected and avoidable tax bill.
Section 56.4 also provides three exceptions. When the conditions are met and, where required, an election is jointly filed, the amount allocated to the restrictive covenant can be treated as capital rather than income. Understanding which exception applies and ensuring the documentation and election are in place at closing is one of the most frequently overlooked tax planning steps in private M&A transactions.
What Is a Restrictive Covenant for Tax Purposes?
For purposes of Section 56.4, a restrictive covenant is any undertaking by a taxpayer that restricts what they can do most commonly a non-competition agreement (a commitment not to compete with the buyer in a defined market for a defined period), a non-solicitation agreement (a commitment not to solicit the buyer’s employees or customers), or a confidentiality agreement (a commitment to keep business information private). All three are common in business sale transactions and all three can attract the income inclusion rule if the applicable exception doesn’t apply.
The Default Rule: Full Income Inclusion
Under Section 56.4(1) of the ITA, any amount received or receivable by a taxpayer for granting a restrictive covenant is included in that taxpayer’s income from a source. This applies regardless of what the parties call the payment in the purchase agreement. If $100,000 of a purchase price is allocated to a non-compete, the vendor includes $100,000 in ordinary income in the year of the sale taxable at marginal rates, with no capital gains treatment and no access to the LCGE.
The Three Exceptions
Subsection 56.4(2) carves out three situations where the income inclusion rule does not apply. In two of the three, a joint election between vendor and purchaser is required.
Exception 1: Employment Income Characterization
Where the amount received for the restrictive covenant is received by an employee who has characterized and reported the payment as employment income, the Section 56.4(1) inclusion does not apply — the employment income characterization handles it instead. No election is required for this exception under paragraph 56.4(3)(a). This exception is most relevant where a key employee is selling their interest and receiving part of the consideration specifically as compensation for agreeing not to compete in their capacity as an employee, rather than as part of a broader share or asset sale.
Exception 2: Goodwill and Intangibles in an Asset Sale
Where the vendor is selling business assets rather than shares, the amount received for a restrictive covenant can be treated as proceeds for goodwill and other intangible business property rather than as ordinary income provided a joint election is filed. Under the current rules (following the 2017 replacement of the eligible capital property regime with Class 14.1 CCA), the elected amount increases the cost of the vendor’s Class 14.1 property pool and is treated as an eligible capital expenditure on the purchaser’s side, added to their own Class 14.1 pool. The practical effect is that amounts treated under this election are subject to capital treatment rather than full income inclusion. Both vendor and purchaser must jointly sign and file the election for this exception to apply.
Exception 3: Share Sale or Partnership Interest (the Eligible Interest Election)
This is the most commercially important exception in most private M&A transactions. Where the vendor is selling shares of a corporation (or a partnership interest), and the non-compete amount directly relates to that disposition, the parties can elect to have the amount treated as additional proceeds from the share sale rather than as ordinary income. For the vendor, this means capital gains treatment and potentially LCGE eligibility rather than full income inclusion. For the purchaser, the elected amount is treated as part of the cost of acquiring the shares.
For this election to apply, specific conditions must be met. The vendor and purchaser must be dealing at arm’s length. The amount must directly relate to the vendor’s disposition of an eligible interest a share or partnership interest in an entity carrying on the business to which the covenant relates. The covenant must be a non-competition agreement specifically (not a non-solicitation or confidentiality agreement in isolation). It must be reasonably considered to preserve or maintain the value of the eligible interest being sold. And neither Section 85 nor subsection 97(2) (tax-deferred rollover provisions) can have applied to the disposition of the eligible interest. Both vendor and purchaser must sign and file the joint election.
One important limitation: this exception requires that the vendor be an individual selling their own shares. If the vendor is a corporation selling shares of a subsidiary, the corporation (not the individual shareholder) is the entity granting the non-compete, and the eligible interest exception doesn’t apply in the same way. This distinction often matters in structured transactions and should be reviewed carefully.
The Connection to the LCGE
For individual sellers relying on the LCGE to shelter their capital gains on qualifying small business corporation shares, the restrictive covenant allocation is a critical planning point. If a non-compete payment is treated as ordinary income rather than capital, not only is it taxed at full marginal rates it may also reduce the proceeds allocated to the shares themselves, potentially reducing the gain that qualifies for the LCGE. Conversely, when the eligible interest election is properly filed, the non-compete amount is added to the share sale proceeds and forms part of the capital gain, potentially sheltered by the LCGE. Getting this election in place at closing can preserve LCGE access on amounts that would otherwise be fully taxable. For a detailed overview of LCGE qualification requirements, see our article on the Lifetime Capital Gains Exemption.
The Section 68 Reallocation Risk
If a vendor does not allocate any amount to the non-compete perhaps because they want to avoid triggering Section 56.4 altogether the CRA retains authority under Section 68 of the ITA to reallocate the purchase price and assign a portion to the restrictive covenant on its own assessment. That reallocated amount is then subject to full income inclusion without the benefit of any election.
The ITA provides no formula for what the CRA considers a reasonable non-compete allocation. The CRA and the Tax Court have considered factors including the duration and geographic scope of the restriction, the vendor’s actual competitive threat to the buyer’s business, the value of the business’s goodwill, and the extent to which the covenant is necessary to protect the purchase price. Where a vendor has a genuine competitive capability and the business is in a competitive market, a zero allocation to the non-compete is difficult to defend. The practical advice is to allocate a supportable amount one of the parties can document and to ensure the election is in place to get the right tax treatment on that allocation.
This dynamic can also work as a negotiating tool. Because a properly elected non-compete can produce significant tax savings for the vendor (capital treatment vs. income treatment, potentially sheltered by the LCGE), the vendor may be willing to accept a lower total purchase price in exchange for the buyer’s agreement to jointly file the election. Identifying this lever early in negotiations, not at closing, creates room for both sides to benefit.
How to Make the Section 56.4 Election
The CRA has not prescribed a specific form for the Section 56.4 election. The parties file a jointly signed letter to the CRA, which must include: the full names, SINs or business numbers, and addresses of both the vendor and the purchaser; the taxation year of each party in which the covenant was granted and received; a description of the covenant itself; a statement that the parties are dealing at arm’s length; and identification of which provision of Section 56.4 the parties are electing under.
The deadline for filing is generally the vendor’s income tax filing due date for the year in which the restrictive covenant was granted April 30 for resident individual vendors. Because that deadline can arrive quickly after a deal closes, the best practice is to prepare, sign, and retain the election letter at closing alongside the rest of the transaction documents, rather than treating it as a post-closing tax matter.
Work with a Corporate Tax Lawyer on Your Business Sale
Kalfa Law Firm advises vendors and purchasers in private M&A transactions, including the structuring of purchase price allocations, restrictive covenant treatment, and all applicable elections. We work alongside your accountant to ensure every election is properly documented and filed on time.
Related Reading
Sale of Your Business · Purchase of a Business · Lifetime Capital Gains Exemption · Asset Sale vs. Share Sale in Canada · Section 68: Purchase Price Allocation · Section 167 GST/HST Election · Non-Competition Covenants: Enforceability
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-Shira Kalfa, BA, JD, Partner and Founder
Shira Kalfa is the founding partner of Kalfa Law Firm. Shira’s practice is focused in corporate-commercial and tax law including corporate reorganizations, corporate restructuring, mergers and acquisitions, commercial financing, secured lending and transactional law. Shira graduated from York University achieving the highest academic accolade of Summa Cum Laude in 2012. She graduated from Western Law in 2015, with a specialization in business law. Shira is licensed to practice by the Law Society of Ontario. She is also a member of the Ontario Bar Association, the Canadian Tax Foundation, Women’s Law Association of Ontario, and the Toronto Jewish Law Society.
© Kalfa Law Firm 2021. Updated September 7, 2026
