Canadian Intangibles, Noncompete Payments, and Allocations of Purchase Price

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1 Volume 65, Number 13 March 26, 2012 Canadian Intangibles, Noncompete Payments, and Allocations of Purchase Price by Jack Bernstein Reprinted from Tax Notes Int l, March 26, 2012, p. 1011

2 Canadian Intangibles, Noncompete Payments, and Allocations of Purchase Price by Jack Bernstein Jack Bernstein is with Aird & Berlis LLP in Toronto. This article is based in part on a paper presented by the author to the 2011 Canadian Tax Foundation Annual Meeting in Montreal in December The author would like to thank his partner Carol Burns for reviewing an earlier draft of this article. This article discusses some income tax issues 1 relating to intangibles and noncompete clauses and the allocation of the purchase price on an asset sale. Intangibles Intangible assets include both goodwill and intellectual property. Intellectual property encompasses copyright, patents, trademarks and trade names, and knowhow. The tax treatment of each of the foregoing are briefly examined below. Tax issues related to intangible assets include identifying the asset and the owner, determining if expenses are deductible or must be capitalized, dealing with the transfer of the asset, licensing, and transfer pricing. Goodwill An eligible capital expenditure is an expense made on account of capital for the purpose of gaining or producing income from a business that does not fall under a depreciation class or represent the cost of tangible property. Goodwill may be the premium a purchaser of a business is prepared to pay for a going concern. The cost of purchasing a copyright or trademark or the cost of a patent application are also eligible capital expenditures. Three-quarters of the amount paid for goodwill or other eligible capital expenditures goes into an eligible capital property pool and is depreciated at the rate of 7 percent per asset per annum on a declining balance basis. On a sale of eligible capital property, the vendor is effectively taxed on one-half of the gain. The gain is considered business income. Onehalf of the gain will be added to the capital dividend account. If goodwill was previously purchased, there is an election (discussed below) available to the vendor to treat the gain as a capital gain. Patent Act Under the Patent Act, 2 it is possible to obtain a patent for a new and useful art, process, machine, manufacture, composition of matter, or for a new and useful improvement in any of the foregoing. 3 Technology can be patented. The holder of a patent obtains 20 years of protection and has the exclusive right to own, use, or produce the patented object or technology. 4 The cost of obtaining a patent would generally be treated as 1 Arising under case law and the Income Tax Act, R.S.C., 1985, c.1 (5th Supp.), as amended. All statutory references in this article are to the ITA, unless otherwise stated. 2 R.S.C., 1985, c. P-4, as amended. 3 See definition of invention, Patent Act, id., section 2. 4 Id., sections 42 and 44. TAX NOTES INTERNATIONAL MARCH 26,

3 PRACTITIONERS CORNER a class 14 asset or class 44 asset (discussed below). Royalties paid for the right to use a patent are deductible and taxable to the recipient. A sale of a patent is generally a capital receipt. In Canadian Industries Limited v. The Queen, 5 the court concluded that the payment of a lump sum unrelated to the anticipated use of a patent was not sufficient to render the payment capital in nature, unless the license for which it was consideration amounted to a disposition or sale of part of the patent rights. In Canadian Industries, there was no such disposition or sale since the license was nonexclusive and for a limited purpose only. The court determined that the payment should be treated as income. Copyright Act The Copyright Act 6 prevents the copying of an original artistic, dramatic, musical, or literary work. Computer programs can be the subject of copyright protection. 7 Computer source code is a literary work for which copyright exists. 8 Copyright offers protection for the lifetime of the author and for 50 years following the author s death. 9 The costs of developing copyright are usually deductible. However, the cost of developing copyrighted software may be a capital expense depending on how the software is to be used and whether it will be sold or licensed. During the lifetime of the author, the acquisition of copyright would be treated as the acquisition of intangible property. The sale of the copyright by the author may be on income account. In other cases, the disposition of a copyright will be considered the disposition of an intangible or eligible capital amount. After the death of the author, the acquisition of a copyright may be treated as the purchase of a class 14 asset (discussed below). Trademarks A trademark can be protected under statute or common law. It is possible to register a trademark or trade name under the Trademark Act. 10 A trademark registration is valid for 15 years. Payment may be made for the permitted use of a trademark or a trade name. The sale of a trademark may be a disposition of eligible capital property. Know-How The Canada Revenue Agency considers know-how to include payments for special knowledge, skills, or techniques that are considered beneficial in the conduct of a business. 11 These payments may be for expertise flowing from experience, ability, or research that may be reflected in blueprints, drawings, specifications, plant layouts, designs, and secret processes and formulas. 12 Know-how can also include trade secrets and industrial, commercial, or scientific knowledge. It is not considered property for income tax purposes. For this reason, no capital cost allowance is allowed and knowhow may be viewed as an intangible. The CRA also takes the position that the development of a process used in a business is an intangible. 13 The costs of developing know-how may be deductible. A payment received for allowing someone to use know-how or a process will be treated as being on income account. In The Queen v. Canadian General Electric Company Limited, 14 it was held that the sale of knowhow will not normally be regarded as a sale of a capital asset, particularly when the sale is by way of a nonexclusive license. In the case of a nonexclusive license, the total proceeds are considered income. It may be possible to argue that the sale constitutes a disposition of an intangible or an eligible capital amount if a lump sum payment is made and the recipient of the payment undertakes to cease using the know-how. In Shaw Flexible Tubes Limited v. MNR, 15 the corporation entered into an agreement to obtain an exclusive license for use of a process (know-how) in the manufacture of flexible tubing. There was an immediate payment of C $25,000 representing the minimum annual payment of royalties for the first five years of a 20-year contract. The taxpayer amortized the C $25,000 payment over the first five years. However, the CRA disallowed the deduction and treated the initial fee as a lump sum payment that resulted in the acquisition of a revenue-producing asset. The taxpayer s appeal to the Tax Appeal Board was disallowed. Rapistan Canada Limited v. MNR 16 concerned a grant to the taxpayer company by a U.S. company of its know-how, techniques, skills and experience to enable the taxpayer to commence carrying on in Canada the particular manufacturing operation that was carried on by the grantor company in the United States. The transfer of know-how was done by way of a deed of gift. The taxpayer then valued the intangible assets at C $500,000 and attempted to claim capital cost allowance on the basis that such assets represented a patent, franchise, concession, or license regarding property within the meaning of class 14. The Supreme Court of 5 80 DTC 6163 (FCA). 6 R.S.C., 1985, c. C-42, as amended. 7 Id., section 2, definition of literary work. 8 Angoss International Limited v. The Queen, 99 DTC 567 (TCC). 9 Supra note 6, section R.S.C., 1985, c. T-13, as amended. 11 Interpretation Bulletin IT-303, Know-How and Similar Payments to Non-Residents, para Id. 13 Interpretation Bulletin IT-386R, Eligible Capital Amounts, para. 2(d) DTC 5070 (FCA) DTC 4430 (TAB) DTC 6177 (SCC) MARCH 26, 2012 TAX NOTES INTERNATIONAL

4 Canada determined that the amounts were not rights to industrial properties such as patents, copyrights, trademarks, and industrial designs, and the capital cost allowance claim was disallowed. In Services Farmico Inc. v. MNR, 17 the taxpayer acquired a franchising business, including trademarks, know-how, and rights in goodwill associated with organizational and marketing techniques. The taxpayer paid C $700,000 for these assets and attempted to deduct the amount on the basis that it represented either a current operating expense or the cost of acquiring eligible capital property. It was held that no part of the lump sum constituted a current operating expense. However, the Tax Review Board determined that a portion of the payment (C $150,000 out of the C $700,000) represented an expenditure for the acquisition of eligible capital property since the property acquired was used by the taxpayer to earn revenue by granting franchises to various pharmacies. Class 14 Class 14 property includes a patent, franchise, concession, or license for a limited period for property, but does not include a license to use computer software, a trademark, or property included in class 44. An amount paid for a limited life patent (which must be in existence to qualify as depreciable property) or for a copyright acquired after the death of a person who held the copyright is considered a class 14 depreciable property, provided it is a capital asset. No capital cost allowance (depreciation) may be claimed by a trader in patents. The cost of class 14 property includes the purchase price, legal fees, and registration and representation expenses. To the extent that representation expenses have been written off under paragraph 20(1)(cc), the expenses would be deemed to be capital cost allowance that was claimed. 18 When class 14 applies, a deduction is available on a straight-line basis over the term. For example, if an amount is paid to acquire a new patent and there is a 20-year term, one-twentieth of the costs would be written off each year. An apportionment of the costs of the class 14 property over the remaining life of the property should be on an equal per diem basis. In the case of a patent, the cost may be determined wholly or partly by reference to the use of the patent. In that case, Regulation 1100(9) contains a special provision permitting a taxpayer to deduct an amount equal to the payments for production or use for the year up to the capital cost of the patent. This provision applies to patents only and not to any other class 14 asset. In Interpretation Bulletin IT-477, a distinction is made between a patent and a license to use a patent. A DTC 208 (TRB). 18 Subsection 13(12). PRACTITIONERS CORNER license to use a patent, if it is for a limited term, will qualify as class 14 property but will not be eligible for the elective treatment under Regulation 1100(9). 19 No patent exists until the date letters patent are granted and issued as noted on the face of the patent. Capital cost allowance will not be available while a patent is pending. 20 A formal patent would qualify as a class 14 asset. A trademark will not qualify for class 14 as it generally does not have a limited life. Renewals or extensions following the original term are relevant in determining the life of the property and whether it is for a limited period. For example, when a franchise having an initial term of five years can be renewed at the option of the franchisee for a further three-year period, the life of the franchise is eight years. However, if the concurrence of the franchiser is required, the renewal period would not be included. 21 A registered industrial design is considered a franchise for a limited period and the life of the property on initial registration is 10 years. 22 The capital cost to the original owner of a patent or industrial design includes research and development expenses incurred in discovering, designing, or developing the property to the extent that those expenses have not already been deducted as scientific research expenditures or ordinary operating expenses in the computation of income. 23 Expenses incurred after the patent has been obtained will not form part of its capital cost. 24 Class 44 Class 44 property would include a patent, or a right to use patented information for a limited or unlimited period, when the property is acquired after April 26, A patent acquired before April 27, 1993, that is for a limited period is a class 14 asset, and one for an unlimited period is an eligible capital expenditure. In computing the taxpayer s income in each tax year, a deduction is permitted for an amount regarding class 44 property not exceeding 25 percent of the undepreciated capital cost of the property of the class on a declining balance basis. A taxpayer may, by registered letter addressed to the tax center at which the taxpayer customarily files tax returns, elect not to include a property in class To be effective for a tax year, an election must be made no 19 Interpretation Bulletin IT-477, Capital Cost Allowance Patents, Franchises, Concessions and Licences Consolidated, para Id., para Id., para Id., para Id., para Id., para Regulations 1103(2h) and 1103(5). TAX NOTES INTERNATIONAL MARCH 26,

5 PRACTITIONERS CORNER later than the last day on which the taxpayer may file a return of income for that tax year. 26 The election results in a patent for a limited period being included in class 14 and a patent for an unlimited period being an eligible capital expenditure. When a part or all of the capital cost of property that is a patent, or a right to use patented information, is determined by reference to the use of the property and that property is included in class 44, Regulation 1100(9.1) permits the taxpayer to deduct, in computing the taxpayer s income for a tax year, amounts determined by reference to the use of the property in the year, up to the capital cost of the property. Eligible Capital Expenditures The costs of obtaining a trademark registration to protect a trade name, design, or product are allowable as deductions in computing income. Such costs include the designing costs, legal and registration costs, and also any payment made to a person in consideration for refraining from contesting the registration. 27 If a taxpayer acquires a trademark from another person who has developed it, the amount paid for it is a capital expenditure not subject to capital cost allowance. It is treated as an eligible capital expenditure. An amount equal to three-quarters of the outlay may be depreciated at the rate of 7 percent per year on a declining balance basis. 28 An outlay or expense made or incurred to acquire, or in an attempt to acquire, a patent, franchise, license, or concession for use in a business qualifies as an eligible capital expenditure, provided the outlay or expense did not result in the acquisition of depreciable property under class 14. An amount paid to another person, either separately or as part of the purchase price paid to acquire the assets or business of that person, to stand in the place of that person in making an application for a patent, franchise, concession, license, or renewal may also qualify as an eligible capital expenditure. 29 The sale of a franchise or license for an unlimited period or the outright sale of a process may be regarded as an eligible capital amount resulting from the disposition of eligible capital property. However, when there is a payment dependent on the use of or production from that property, an income inclusion may result rather than an eligible capital amount. Interpretation Bulletin IT-386R, Eligible Capital Amounts, provides the following examples of the types of transaction that could result in an eligible capital amount: a sale of a franchise or license for an unlimited period; a sale of goodwill that would include trademarks or trade names; a sale of a process developed by an individual; and a payment made to disclose a process and allow it to be used by the payer. Knowledge of a process that has been developed would be regarded as an intangible property and is not depreciable. However, if the knowledge is not sold outright, but is merely licensed for a limited period of time, or its use is permitted under the terms of a nonexclusive license, the total proceeds are regarded as income. 30 Any amount received for eligible capital property that is dependent on the use of or production from that property does not result in an eligible capital amount but rather is taxable as income under paragraph 12(1)(g). 31 Payments Based on Production or Use Paragraph 12(1)(g) applies to any amount received that is dependent on the production from or the use of property, whether or not the amount is an installment of the sale price of the property. The recipient of such payments must report them on income account. Depending on the circumstances, the purchaser or payer may be entitled to a deduction for the payments, or may be required to treat them as part of the cost of property. The requirement to include amounts in income under paragraph 12(1)(g) applies whether the sale price is dependent on gross income or net income derived from the property or whether it depends on some other element based on production or use of the property. 32 However, when a contact provides for a fixed price and it is only the timing of the installments that varies based on production or use, paragraph 12(1)(g) will not apply since it is only the timing of payments and not the price itself that is dependent on production or use. 33 It is possible to have both capital payments plus payments for production or use. Paragraph 12(1)(g) does not apply when the sale price of property is originally set at a maximum that is equivalent to the fair market value of the property at 26 Regulation 1103(4). 27 Interpretation Bulletin IT-143R3, Meaning of Eligible Capital Expenditure, para Subsection 14(5), definition of cumulative eligible capital, and para. 20(1)(b). 29 Supra note 27, para IT-386R, para Ontario Limited v. MNR, 87 DTC 38 (TCC). 32 Interpretation Bulletin IT-462, Payments Based on Production or Use, para Id., para MARCH 26, 2012 TAX NOTES INTERNATIONAL

6 the time of the sale and the price can be then decreased if conditions relating to production or use are not met in the future. In that situation, the proceeds will be on account of capital and, if there is a reasonable expectation at the time of disposition of the property that the conditions will be met, the disposition is treated in the ordinary manner and the original maximum amount is considered the sale price of the property. If later the conditions are not met, an appropriate adjustment will be made in the year in which the amount of the reduction in the sale price is known with certainty and will not vary in the future. 34 This is known as a negative or reverse earn-out and provides a planning technique to attempt to characterize the receipt of payments as being on capital account rather than on income account. However, if the purchase price is greater but subject to a reduction if certain production is not met, this will result in the accelerated reporting of income based on the price initially stipulated. Paragraph 212(1)(d) must be considered in the context of international payments. Also, if the recipient of a payment resides outside Canada and in a country that has an income tax treaty with Canada, one must refer to the relevant tax treaty and to the definition of royalties. Services It is also common to have fees for services to be rendered in connection with the technology. For example, a franchise agreement will normally include a fee for a training program. A computer software contract may provide for upgrades. These payments may be deducted as business expenses. Representation expenses made for the purpose of obtaining a patent, license, permit, franchise, or trademark may be deducted under paragraph 20(1)(cc). An election is available to amortize the representation expenses over 10 years. 35 Sale of Patent A disposition of a patent would normally give rise to a capital gain, and if capital cost allowance has been claimed, to recaptured depreciation. Recapture will be equal to the difference between the lesser of the sale price and the capital cost of the patent minus the undepreciated capital cost of the patent. The sale or grant of exclusive licenses to a territory by someone who holds a patent will be treated in the same manner as a sale of a patent. 36 PRACTITIONERS CORNER In Porta-Test Systems Ltd. v. The Queen, 37 the taxpayer entered into a licensing agreement with a U.K. corporation that permitted the U.K. company to manufacture, use, and sell some of the taxpayer s inventions within a defined geographic area. There was a minimum payment to the taxpayer of C $150,000 over three years. The taxpayer received C $75,000 in royalties based on the sales of its products by the U.K. company and reported that amount as income. An additional C $75,040 was received by the taxpayer under the minimum payment provision, which it argued was a capital gain realized in its 1971 tax year from the sale of an exclusive right. The taxpayer was successful in maintaining that the minimum amount was a nontaxable capital receipt (this was before capital gains were taxable in Canada) divisible from the royalty aspect of the licensing agreement. The case of Shaw Flexible Tubes Limited v. MNR 38 concerned a taxpayer that made an immediate payment of C $25,000, which it argued was for minimum annual royalties for the first five years of a 20-year exclusive license for the use of certain know-how. In the termination provision of the contract, there was no right of recovery of any part of the initial payment of C $25,000, thus strengthening the presumption that this payment was not based on the use to be made of the information acquired but was a one-time lump sum payment for the right to the accumulated knowledge and know-how of the licensor. As a result, the Tax Appeal Board upheld the minister s disallowance of the annual deductions for the C $25,000 payment. A payment to cancel a patent license or a distribution agreement may be deductible. 39 A payment that is dependent on the production or use of the property will constitute income to the recipient even though it involves the disposition of a patent. Similarly, any payments received for the granting of the nonexclusive use of a patent would constitute income. Generally, an amount received in consideration for allowing someone to use a trademark will also be treated as being on income account. Noncompetition Payments A restrictive covenant is defined in proposed subsection 56.4(1). The definition is extremely broad and goes beyond an undertaking by an employee, shareholder, or company not to compete and can encompass other contractual arrangements (for example, a payment made not to solicit). Under the proposed definition, a restrictive covenant means an agreement entered 34 Id., para Subsection 20(9). 36 See Canadian Industries Limited v. The Queen, supra note 5, which treated the sale of a nonexclusive license for a limited purpose as being on income account to the recipient of the payments DTC 6046 (FCTD). 38 Supra note See Johnston Testers Ltd., 65 DTC 5069 (Ex Ct), and Angostura International Limited v. The Queen, 85 DTC 5384 (FCTD). TAX NOTES INTERNATIONAL MARCH 26,

7 PRACTITIONERS CORNER into, an undertaking made, or a waiver of an advantage or right by the taxpayer, whether legally enforceable or not, that affects or is intended to affect in any way the acquisition or provision of property or services by the taxpayer or by another taxpayer that does not deal at arm s length with the taxpayer, other than an agreement or undertaking: that disposes of the taxpayer s property; or in satisfaction of an obligation described in section that is not a disposition except when the obligation to be satisfied is for the right to property or services that the taxpayer acquired for less than its market value. A taxpayer must include in computing income all amounts regarding a restrictive covenant of the taxpayer that is received or receivable in the tax year by the taxpayer or by a person not dealing at arm s length with the taxpayer. 41 There are exceptions when the amount is already taxable employment income, or would be required to be included in computing cumulative eligible capital for the business, 42 or relates to the sale of an eligible interest and other conditions are met. Historically, noncompete payments were not controversial. The view was that a noncompete payment was taxed as employment income when made to an employee, as a capital gain when made to a shareholder on the sale of shares, and as proceeds of the sale of goodwill when made to a corporation disposing of assets. In the latter two cases, significant amounts were not allocated to the noncompete undertaking. It was generally thought to be reasonable to consider that the sale price for the shares or the assets was adequate consideration and that a violation of the noncompete could irreparably harm the business that was sold. However, in the U.S. it was more customary to allocate substantial consideration to the noncompete covenant to ensure its enforceability. There were two interesting Federal Court of Appeal decisions in Canada, The Queen v. Fortino et al. 43 and Manrell v. The Queen. 44 These decisions taken together confirmed that a noncompete payment was not taxable in Canada as it is not income from a productive source and the payment cannot be considered to be for the disposition of a capital property. The government responded with the proposed amendments in section 56.4, designed to ensure that the payments would be taxed as employment income, 40 Section 49.1 confirms that there are no tax consequences when property is acquired as a result of the execution of a contract. 41 Proposed subsection 56.4(2). 42 A joint election is required to rely on this exception DTC DTC proceeds of disposition of shares or a partnership interest, or proceeds of disposition of goodwill. The rules are extremely complicated and require an income inclusion under subsection 56.4(2) unless the amount is included in employment income or has been subject to a joint election with an arm s-length purchaser to treat the noncompete payment as proceeds of eligible capital property or proceeds of an eligible interest in the partnership or the corporation that carries on the business to which the restrictive covenant relates. There is no provision for late-filed elections. The purchaser will benefit from corresponding treatment, a deduction from income, an addition to cumulative eligible capital, or an addition to the cost of the partnership interest or shares. 45 When an amount can reasonably be regarded partly as consideration for the disposition of property or provision of services and partly for a restrictive covenant, proposed paragraph 68(c) permits the CRA to deem an amount that may reasonably be regarded as being consideration for the restrictive covenant regardless of the form or legal effect of the contract or agreement. That part is deemed to be an amount paid or payable to the taxpayer by the person to whom the restrictive covenant is granted. When proposed subsection 56.4(5) applies, section 68 will not apply. There are four circumstances discussed below in which proposed subsection 56.4(5) applies. In each of the first three cases, the person granting the restrictive covenant must deal at arm s length with the purchaser: 1. Employee Provides Covenant. The individual who grants the restrictive covenant must deal at arm s length with the employer and with the vendor. 46 Also, the restrictive covenant must relate to the acquisition by the purchaser of an interest in the individual s employer, a corporation related to the employer, or a business carried on by the employer. The restrictive covenant must be an undertaking not to provide, directly or indirectly, property or services in competition with property or services to be provided by the purchaser (or a related person) in the course of carrying on the business to which the restrictive covenant relates. No proceeds can be received or receivable for granting the restrictive covenant. The amount that could reasonably be regarded to be consideration for the restrictive covenant must be receivable only by the vendors. This clause protects an unrelated non-shareholder employee who is required to sign a restrictive covenant in the sale of the business. 2. Goodwill Amount. The restrictive covenant must be an undertaking of the vendor not to provide, 45 Proposed subsection 56.4(4). 46 Proposed subsection 56.4(6) MARCH 26, 2012 TAX NOTES INTERNATIONAL

8 directly or indirectly, property or services in competition with the property or services to be provided by the purchaser (or a related party) in connection with the business to which the restrictive covenant applies. 47 No proceeds can be received or receivable by the vendor for granting the restrictive covenant. The amount that may be reasonably regarded as being the consideration for the restrictive covenant must be included in computing a goodwill amount by the vendor or an eligible corporation of the vendor. A goodwill amount is defined in proposed subsection 56.4(1) as the amount received as consideration for the disposition by the taxpayer of goodwill and is included in computing the cumulative eligible capital of a business carried on by the taxpayer through a permanent establishment in Canada. An eligible corporation means a taxable Canadian corporation in which the taxpayer directly or indirectly holds stock. 48 The restrictive covenant must reasonably be regarded as relating to goodwill purchased from the vendor or an eligible corporation of the vendor. This exception will not apply when either the vendor or an eligible corporation of the vendor rolled the goodwill to a corporation or a partnership. No portion of the amount of consideration that can reasonably be regarded as being in part the consideration for the restrictive covenant can be received or receivable by an individual who does not deal at arm s length with the vendor or by another taxpayer in which the non-arm slength individual holds an interest. An election must be jointly filed by the vendor and the purchaser, or by the vendor, the purchaser, and the eligible corporation. 3. Disposition of Property. In order for this exception to apply, the restrictive covenant must be an undertaking not to provide, directly or indirectly, property or services in competition with the property or services to be provided by the purchaser (or a related person) in the course of carrying on the business to which the restrictive covenant relates. 49 It must be reasonable to conclude that the covenant is integral to a disposition of property (other than shares or eligible capital property) to the purchaser for consideration received by the vendor or to a disposition of shares (other than a redemption or purchase for cancellation). The disposition cannot result from a rollover to a partnership or to a corporation. The reason for this restriction is unclear (there may be a concern that the restrictive covenant is boot). No proceeds may PRACTITIONERS CORNER be received by the vendor for granting the restrictive covenant. Also, the restrictive covenant must be granted to maintain or preserve the fair market value of the property, or the shares of the target corporation, which were disposed of to the purchaser. 4. Disposition of Shares to an Eligible Person. To fit within this provision, the grantor must be an individual (the vendor) resident in Canada. 50 It must be reasonable to conclude that the restrictive covenant is integral to the sale of shares of the target corporation to an eligible person or an eligible corporation of such person. An eligible person regarding the vendor means an individual who is related to the vendor and has attained the age of 18 years. 51 The vendor must not retain any shares in the target or the eligible corporation. No proceeds can be received by the vendor for granting the restrictive covenant. Also, no portion of the consideration that can reasonably be regarded as being in part the consideration for the restrictive covenant can be received by an individual not dealing at arm s length with the vendor, or by another taxpayer in which the non-arm s-length individual holds an interest. This provision does not apply on a redemption or purchase for cancellation of shares or a rollover to a partnership or corporation. The restrictive covenant must be granted to maintain or preserve the fair market value of the transferred shares of the target corporation. If a payment is made to a non-arm s-length individual or to a taxpayer in which a non-arm s-length individual holds an interest (other than an eligible corporation), the foregoing exceptions to section 68 do not apply. However, when the only reason that exceptions 2, 3, or 4 do not apply is that an amount was received by a non-arm s-length person (the allocable portion), proposed subsection 56.4(9) provides that section 68 will only apply to the allocable portion. An election is available under proposed subsection 56.4(9) to treat the allocable portion as a goodwill amount or as proceeds of disposition of property. The vendor, rather than the non-arm s-length person, is taxable. When the election is made, the non-arm s-length party will be deemed to have received the allocable portion as agent of the vendor, to the extent that the consideration is transferred to the vendor within 180 days. There is a special deemed agency rule that applies to an allocable portion received by an eligible corporation of the individual who is the vendor of a restrictive covenant described in exception 4 above. The CRA was concerned about the possibility of income splitting by diverting the payment to an individual or a corporation in a lower tax 47 Proposed subsection 56.4(7). 48 Proposed subsection 56.4(1). 49 Proposed subsection 56.4(8). 50 Proposed subsection 56.4(8.1). 51 See definition in proposed subsection 56.4(1). TAX NOTES INTERNATIONAL MARCH 26,

9 PRACTITIONERS CORNER bracket. This provision may also apply to sales between family members in family businesses. When the deemed agency applies, the non-arm s-length recipient of the payment could transfer the amount to the taxpayer without tax consequences arising on the transfer. Proposed paragraph 68(c) adds further confusion to the complicated proposals. When an amount received or receivable can reasonably be regarded as being in part the consideration for the disposition of a particular property of the taxpayer, for the provision of particular services by a taxpayer, or for a restrictive covenant, the part reasonably regarded as consideration for the restrictive covenant is deemed to be received by the taxpayer regarding the restrictive covenant regardless of the form or legal effect of the contract or agreement. Given that the default provision in section 56.4 is an income inclusion and that the various exceptions are restricted, one wonders why proposed paragraph 68(c) is necessary. When the other conditions above are met, no payment is made. When section 68 applies, it becomes necessary to value the restrictive covenant. There will be disputes with the CRA over what amount may reasonably be considered allocable to the restrictive covenant. Given that valuation is an art and not a science, there are bound to be discrepancies between an allocation by the taxpayer and by the CRA. The CRA may have been concerned about the allocation to a sale of shares rather than employment income as it would convert ordinary income to capital gains. The joint committee in its submission dated September 17, 2010, discusses the difficulty in valuing the restrictive covenant because it is an integral part of the sale of a small or medium-size business and may not be economically separable from the sale itself. It is onerous to impose a valuation requirement in order to have a specific value attributable to the restrictive covenant. There is no guarantee that the CRA will accept a valuation obtained by the grantor, which only adds to the uncertainty caused by the legislation. Asset Sale Price Allocation In this section, the tax consequences to the vendor and the purchaser on the sale of different assets will be reviewed. The purchaser will prefer to allocate the purchase price to inventory and to depreciable property. On the other hand, the vendor may prefer to sell goodwill or capital property and allocate less to depreciable property. The allocation of the price may also have an impact on the harmonized sales tax and land transfer tax. If the vendor is compensated for prepaid expenses such as rent, interest, taxes, and services, the vendor will be taxable if the amounts had been previously deducted. The purchaser will be entitled to deduct the amount paid over the period to which the expenses relate. 52 On the sale of inventory, the three-year reserve for unpaid amounts in paragraph 20(1)(n) may be available. The purchaser will treat the amount paid as the cost of inventory. In the case of depreciable property, the vendor will be taxable on recapture, and no reserve is available. Recaptured depreciation is considered active business income for the purposes of the small business deduction. If a capital gain arises, the five-year capital gains reserve may be available if there is a balance of sale. 53 A terminal loss may arise on depreciable property when the purchase price is less than the undepreciated capital cost of the property. The purchaser will be entitled to claim capital cost allowance on depreciable property, depending on the class. Generally, the purchaser will be subject to the half-year rule (that is, only one-half of the capital cost allowance ordinarily available may be claimed in the year of purchase) unless the available-for-use rule applies. If the fiscal year of the purchaser is less than 365 days (for example, when a shelf company is used), it will be necessary to prorate the amount of capital cost allowance available in the first year based on the number of days that the purchaser was in existence. Note that the assets that are acquired may not fall into the same class in which they were held by the vendor. The rate of capital cost allowance may have been changed over the years and assets acquired by the vendor before a specific date may have continued to be in a separate class. On the disposition of nondepreciable capital property, a capital gain or capital loss may be realized or incurred. For the purchaser, the amount paid will represent the capital cost of the property. If accounts receivable are sold, the taxpayer should consider filing an election under section 22. The election is only available if at least 90 percent of the assets of the vendor used in a business carried on in Canada are sold. 54 If the accounts receivable are sold at a discount (which is common), the vendor will be entitled to deduct the shortfall. By making the election, the purchaser preserves the right to claim a deduction for a bad debt in connection with the receivables that are acquired. In the absence of such election, any uncollected amount would be treated as a capital loss. The sale of a leasehold interest is treated as a capital gain (assuming that the vendor did not claim capital cost allowance on the leasehold interest). The purchaser may deduct the amount paid for the leasehold 52 See subsection 18(9). 53 Subpara. 40(1)(a)(iii). 54 See Office Overload Co. Ltd. v. MNR, 65 DTC 690 (TAB) MARCH 26, 2012 TAX NOTES INTERNATIONAL

10 interest over the remaining term of the lease plus the first renewal period (over a minimum of six years, including the half-year rule). Often, the business will have goodwill of location, and it is possible to allocate an amount to the purchase of the lease. This may be preferable, from the standpoint of the purchaser, to making a greater allocation to goodwill. If goodwill is sold, the vendor will effectively be taxed on half the gain. No reserve is available if payments for goodwill are made over time. The portion that is taxable is treated as active business income for purposes of the small business deduction. If a loss is realized and the business is not to be carried on, the remaining cumulative eligible capital may be written off by the vendor. There is a limited election under subsection 14(1.01) available to a vendor of eligible capital property to treat an eligible capital amount as a capital gain. In order to make the election, the actual proceeds of disposition must exceed the taxpayer s eligible capital expenditure for the acquisition of the property. The election is not available on the disposition of goodwill 55 or other eligible capital property for which the original expenditure cannot be determined. For example, it will not apply on a sale of goodwill that the vendor did not previously purchase. The amount paid for goodwill is regarded as an eligible capital expenditure. The purchaser may write off three-quarters of the amount paid for goodwill at the rate of 7 percent per annum on a declining balance basis. 56 A vendor may pay a purchaser to assume future undertakings of the vendor for which the vendor has received payment, which was included in the vendor s 55 Para. 14(1.03)(b). 56 Supra note 28. PRACTITIONERS CORNER income under paragraph 12(1)(a). In such circumstances, the vendor will be entitled to claim a deduction for the payment, and the purchaser may be able to claim a reserve for the payment if the vendor and purchaser have so elected. 57 If there is an unreasonable allocation of the purchase price, section 68 of the Income Tax Act provides the CRA with the authority to reallocate the purchase price between the assets. Unless the parties do not deal at arm s length or one side is not taxable (for example, if any of the parties is a nonresident or a pension, or has a loss carryforward), the CRA will usually accept the allocation provided both parties make the same allocation. As long as the parties have competing interests the allocation should be considered reasonable. Evidence of negotiations and hard bargaining will reduce the risk of section 68 applying. In the recent case of TransAlta Corporation v. The Queen, 58 the parties, who acted at arm s length, agreed to allocate C $190 million to goodwill out of a total asset purchase price of more than C $800 million. The Tax Court of Canada determined that while the parties had relatively equal bargaining positions regarding the overall negotiation, TransAlta (the purchaser) had a stronger hand on the goodwill allocation. AltaLink (the purchaser) was indifferent to the allocation to goodwill as long as the allocation to tangible assets was at least equal to net regulated book value. The court applied section 68 and concluded that C $140 million was a reasonable allocation to goodwill. Section 68 will apply to an allocation when there is sham or subterfuge. 59 Ideally the parties will include the allocation of the purchase price in the agreement. 57 Subsection 20(24) and para. 20(1)(m) DTC 1241 (TCC), under appeal. 59 The Queen v. Golden et al., [1986] 1 SCR 209. TAX NOTES INTERNATIONAL MARCH 26,