Non-compete payments are common and taxable

National Post

2007-05-19


In testimony at the Conrad Black trial in Chicago, we learned that David
Radler understood he was not required to report on his income tax the
US$19-million he received in non-compete payments during the sale of Hollinger
International newspapers.

While this may have been true back in 2000, it is no longer the case today.

Non-compete agreements are standard clauses in any business transaction and
prohibit the seller of a business from competing directly with the buyer,
usually within a specified geographic area for a fixed period of time.

They are not just for large conglomerates. Say the owner of small but popular
pizzeria sells his business -- without a noncompete agreement there is nothing
to stop him from opening a new pizzeria two doors away from his old shop and
stealing back his business. As a result, a purchaser should always demand a
noncompete agreement for which the vendor is entitled to be paid.

The question then becomes, how is the payment treated for tax purposes?

It used to be considered that such payments were tax-free. The reasoning was
that, absent a specific rule in the Income Tax Act, in order to face tax on an
amount, that amount must be categorized as income from a "source."

Employment income, business income and investment income are all examples of
sources of income that are currently taxable under the Act. By contrast, lottery
winnings are taxexempt in Canada because they do not represent income from a
source. Similarly, non-compete payments were found to be nontaxable by the
Federal Court of Appeal in two high-profile tax cases in 2000 and 2003.

Of course, when the government loses high-profile tax cases it typically
tries to change the rules. And that's exactly what happened on Oct. 7, 2003,
when Ottawa introduced legislation that stated any amounts received as
non-compete payments will be fully taxable as ordinary income.

While there are several exceptions to this rule, the most relevant one is
when a non-compete is granted in conjunction with the sale of shares of a
business. In that case, assuming a special election is filed, the non-compete
payment may be added to the proceeds of disposition when calculating the capital
gain on the shares sold. The advantage in this case is converting an amount that
would otherwise be 100% taxable income into a 50% taxable gain.

While no official election form has yet to be produced, a sample Election for
Restrictive Covenants Letter can be downloaded directly from
theCanadaRevenueAgency's Web site at www.cra-arc.gc.ca.

Jamie Golombek, CA,
CPA, CFP, CLU, TEP, is vice-president, taxation and estate planning, at AIM
Trimark Investments in Toronto.

Jamie.Golombek@aimtrimark.com