By Chad Saikaley, CPA, CA, Partner
Selling your business can be a very exciting time in your life. I work with clients and their lawyers to help structure deals that work in their best interests, which usually means maximizing the amount they can end up with on a sale, and protecting them against surprise tax consequences.
Often when I speak with lawyers about the deals they are advising clients on, we discuss restrictive covenants and the tax implications of them. A restrictive covenant is a clause in the sale agreement that most commonly addresses non-competition or non-solicitation.
Buyers will include them in the deals because they would not want to buy your business only to have you turn around and start a new competing company and go after your old customer base. That would defeat the purpose of the sale. As such, a restrictive covenant can be seen to be valuable to the buyer.
Unfortunately, if not treated correctly, the Canada Revenue Agency (CRA) can tax you on the portion of the sale price they believe is for the restrictive covenant, which is considered income, as opposed to a capital gain.
The difference in overall taxes can be immense. If CRA taxes the restrictive covenant portion as income, the top tax rate could be as high as 54%, as opposed to 27% if the restrictive covenant is treated as a capital gain. Furthermore, if treated as a capital gain, there is the possibility of no tax if the entire amount qualifies for the capital gains exemption.
It is a very convoluted process that can be very confusing. The goal of this article is to make it as comprehensive as possible, so you don’t make a costly mistake when it’s time to sell your business.
Exceptions
These rules do not apply to amounts specifically received for a restrictive covenant as an agreed-upon allocation from the sale proceeds for:
- Employment income for work you will perform after the sale;
- Payment received for a goodwill portion on a sale of business assets; or
- Payment received on a sale of a partnership interest or shares of a company.
In other words, the rules do not apply in a case where the amount being paid for the restrictive covenant is defined, as opposed to being built into the sale price.
The above scenarios have their own tax rules and CRA is not interested in taxing you twice for the same income. An election needs to be filed for scenarios (2) and (3).
Carving out
In the event the sale is made and the value of the restrictive covenant is not defined, or is deemed to be unreasonably low, CRA has the authority to reallocate the proceeds from the sale towards the restrictive covenant and apply harsh tax rules.
Let’s say you sold your business for $500,000. CRA can take that $500,000 and carve out what they believe to be the value of the restrictive covenant for tax purposes. If they decide the value of the business is $400,000, and the restrictive covenant is worth $100,000, then only $400,000 may qualify for capital gains treatment, which may allow for the capital gains exemption. As mentioned, the remaining $100,000 would be subject to tax at full rates, as opposed to half of the rate for a capital gain, or potentially no tax if the capital gains exemption is available.
Using the tax rates mentioned earlier, this can be the difference between a $54,000 tax bill and a $27,000 tax bill, or potentially no tax bill.
How you can prevent CRA from carving out
Fortunately, there are exceptions to CRA’s carving-out ability. The exceptions are as follows:
- The restrictive covenant is not meant for you, but rather to an arm’s-length, or unrelated, employee. In this situation, the purchaser is restricting your top salesman from taking customers from the store with him to another location. No actual money changes hands in this instance; it is just a condition of the sale.
- The sale includes a portion for goodwill, such as in a sale of business assets. In this instance, a joint election between the seller and the purchaser would have to be filed with CRA.
- The sale includes a portion for shares. In this instance, no election is required to be filed, but it must be reasonable to conclude that the restrictive covenant is integral to the sale/purchase. As such, it is advisable to include a statement in the sale agreement to clarify the point.
Selling your business can go a long way towards financing your next venture or setting you up for your retirement. Speak with your advisors to ensure you structure the deal in a way that protects you from unnecessary taxes.
