On July 16, 2010, the Department of Finance released a significant package of income tax technical amendments and explanatory notes. As I am writing this blog, I have a binder of material in front of me that contains all of the material released by the Department of Finance and it is approximately 2 ½ inches thick. Oh joy! Great summer time reading!!
In all seriousness, though, this material is very welcome news given that it contains significant provisions some of which have been outstanding for approximately 8 years. Let’s hope this package gets passed into law soon.
One of the significant amendments included in the income tax technical package are the restrictive covenant proposals. Such provisions are horrifically complex. Our firm wrote a paper on the restrictive covenant draft proposals in 2008. For those interested in an exercise in complexity, feel free to read the paper. Such provisions are wide sweeping and will change how most purchase and sale agreements are handled from a taxation perspective. For further information, take a look at our blog of April 10, 2008.
For the technically inclined, the July 16, 2010 release had the following changes to proposed section 56.4 (the section of the Act that is proposed to deal with the taxation of restrictive covenant amounts):
- The definition of “eligible corporation” in subsection 56.4(1) (this definition is relevant for the purpose of determining whether the rules in subsections 56.4(5) and (7) apply to provide an exception – for goodwill amounts- from the rule in section 68 that may deem a person who grants a restrictive covenant to receive an amount for the restrictive covenant irrespective of the legal agreement) has been changed to eliminate the previous rule which required that individuals with whom the taxpayer does not deal at arm’s length not hold in aggregate, directly and indirectly, more than 10% of the issued and outstanding share capital of the subject corporation. No such 10% rule now exists in the revised definition.
- The definition of “restrictive covenant” under subsection 56.4(1) has been amended and tightened to try and provide more clarity than the previous draft definition. This is very good news.
- There is a new definition of “eligible person” in subsection 56.4(1) which is relevant for the purpose of applying new subsection 56.4(8.1) which will be discussed briefly below. In general, an eligible person in respect of a grantor (the “vendor”) of a restrictive covenant at any time means an individual who is related to the vendor and who is attained the age of 18 years at that time or before.
- Proposed subsection 56.4(8) (a provision that provides a set of conditions that, if met will cause section 68 to not apply to deem consideration to have been received or receivable by the person granting a restrictive covenant) has been amended in two places. The first is in paragraph (d) which clarifies that to the extent that any amounts have been received, essentially as goodwill, then subsection 56.4(8) cannot apply with respect to such goodwill amounts. The second is that there is now a new paragraph (h) which requires that there be no proceeds received or receivable by the vendor for granting a restrictive covenant in order for subsection 56.4(8) to apply. There are corresponding “coming-into-force” provisions with respect to these new additions as well.
- As mentioned above, there is a new proposed subsection 56.4(8.1). To the extent that the conditions in the new subsection 56.4(8.1) apply, then section 68 will not apply to deem consideration to be received or receivable by the individual for granting the restrictive covenants. Overly simplified, to the extent that the conditions apply, a restrictive covenant granted by an individual who is resident in Canada (at the time of grant) to an “eligible person” (with all the other conditions not documented here being met) then the restrictive covenant rules will not apply. This new provision will be helpful to the extent that a father, for example, sells shares of “Opco” with a restrictive covenant grant to his son and/or daughter. The previous version of the rules made it clear that the restrictive covenant proposals would apply in such an example thus causing problems in succession planning.
- There are technical amendments, beyond the scope of this blog, in proposed subsection 56.4(9), 212(13)(g) and corresponding “coming-into–force” provisions.
Although complex, taxpayers and their advisors will need to pay particular attention to the restrictive covenant proposals when acquiring or disposing of businesses.