Tax Law
February 2004
Fasken Martineau DuMoulin LLP
What’s New in the Field of Tax?
By Thomas Copeland
The following text provides an update of two recent developments in the field of tax that could have
major implications for you or your enterprise. First, the Department of Finance of Canada has
announced proposed amendments that change the way that amounts paid for a non-competition covenant
are taxed in the context of a sale of shares. Secondly, a new income tax treaty has been signed between
Canada and Ireland. As a result, now is the time to review activities or contracts that your business may
have with Ireland.
1.
Non-Competition Covenants will now be Taxable
The Department of Finance has announced its intention to change the tax treatment of amounts paid for
non-compete covenants. This announcement follows the decision of the Federal Court of Appeal that
decided, on March 11th 2003 in the case of Manrell vs. The Queen1, that a payment for a noncompetition covenant that was made in connection with a sale of shares was not taxable because the
payment did not constitute proceeds of disposition for property. The proposed amendments are
designed to overrule this decision and curtail the tax advantage arising from payments made under these
covenants.
In Manrell, the taxpayer owned substantial interests in three operating companies either directly or
through holding corporations. The taxpayer sold the shares of the operating companies to a third party
and also entered into a non-competition agreement in consideration for an additional payment.
The key issue in Manrell was whether the rights of the taxpayer granted under the non-competition
covenant constituted “property”. In order to have a taxable event, the taxpayer had to dispose of
property. Even though the word property is broadly defined in the tax legislation and specifically
includes “… a right of any kind whatever…”, the Federal Court of Appeal held that, in order for a right
to constitute property, it must have some exclusive right to make a claim against someone else.
The payment for the non-competition covenant did not constitute a taxable capital receipt because the
covenant did not entail an exclusionary right. While the taxpayer gave up his right to carry on a
business within a certain territory in Manrell, this was a right he shared with everyone else. A general
right to do something that anyone can do or a right that belongs to everyone is not property.
According to a press release issued by the Department of Finance and dated October 7, 2003, any
amount receivable in respect of a non-compete covenant will be taxable as ordinary income subject to
one exception applicable in the context of an arm’s length sale of shares. Thus, subject to the exception,
the full amount of the gain derived from the signing of a non-compete covenant will be included in
computing the income of a taxpayer on the assumption that the proposed changes are brought into law.
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By virtue of the exception that has been outlined in the press release, an amount received by a taxpayer
as a result of a non-competition covenant on the sale of shares may generally be treated as a capital gain.
The exception only applies to the extent that the non-competition covenant would increase the fair
market value of the shares being sold by the particular taxpayer if no amount was payable for the
covenant. If the amount paid for the covenant exceeds this amount, the excess will be taxable as
ordinary income for the particular shareholder signing the covenant. In this context, caution must be
exercised before attributing any amount to a non-compete covenant. Similar provisions will also apply
with regard to dispositions of partnership interests.
The proposed amendments clarify that the purchaser may deduct part of the payment made for a noncompete covenant. As such, a purchaser may prefer to allocate a certain amount to such a covenant on
the acquisition of shares.
The proposed amendments will apply to amounts received or receivable pursuant to a non-competition
covenant after October 7, 2003. However, amounts received before 2005 pursuant to a written
agreement made on or before October 7, 2003 between parties dealing at arm’s length are excluded from
the new rules.
In tax, things change quickly! This may be of little consolation to those who want to sell their shares in
a corporation and who begin negotiating the deal after October 7, 2003. These taxpayers will probably
want to avoid allocating amounts to a non-competition covenant in the context of a sale of shares.
Those who had an agreement in place concerning a payment for a non-competition clause on or before
the publication of the proposed amendments can still benefit from the finding of the Federal Court of
Appeal in Manrell. If you are in this situation, you may want to think twice before restructuring a deal
completed prior to October 7th, 2003.
2.
New Canada-Ireland Income Tax Convention May Create Opportunities for You
On October 8, 2003, a new income tax convention was signed between Canada and Ireland (the
“Convention”). Ratification procedures for the Convention are expected to be completed in 2004. If so,
the Convention would come into effect on January 1st, 2005. As a result, activities and contracts
involving taxpayers resident in Canada or Ireland should be reviewed before the Convention enters into
force.
The Convention is significantly different from the existing income tax treaty, which was signed in 1966.
It modernizes the relationship between Canada and Ireland with respect to double taxation and the
prevention of fiscal evasion.
As a result of the Convention:
(a)
Royalties for the use of, or the right to use, computer software or any patent or for
information concerning industrial, commercial or scientific experience are excluded from
source withholding tax.
(b)
Expanded rules apply to the concepts of dividends and interest;
(c)
Trusts are now subject to the terms of the Convention;
(d)
Relief from double taxation is available for certain types of capital gains.
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The Convention also establishes new withholding tax rate limits. For example, the rate of withholding
tax is 5% for dividends between affiliated companies, 15% for dividends in other cases and 10% for
interest and royalties (other than royalties mentioned in the preceding paragraph). The Convention also
enables Canada to levy withholding tax on certain periodic pension payments.
While opportunity may be lost with regard to the non-taxation of payments for certain non-competition
agreements, there is still time to benefit from the new Canada-Ireland Income Tax Convention. The
previous income tax convention with Ireland dates back to 1966. The new convention modernizes the
tax treatment of activities involving the two countries. Now is the time to prepare for the coming into
force of this treaty.
Thomas Copeland practices in all areas of taxation law as well as in the area of general corporate law. He has
given conferences and published articles on various subjects including tax avoidance and tax evasion in Canada,
the financing of and tax incentives for high technology companies, the taxation of electronic commerce and
offshore tax planning.
Tom Copeland can be reached at 514 397 7633 or at [email protected]
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1. 2003 DTC 5225 (FCA); http://www.canlii.org/ca/jug/caf/2003/2003caf128.html .