Non-competes, again

Thursday last I tried, once again, to explain the restrictive covenant rules in proposed section 56.4 of the Income Tax Act (Canada) to a seminar hosted by the Hamilton Law Association (please send an email to me if you would like a copy of the PowerPoint presentation). I’m not sure how well I succeeded. I find the rules difficult to work with and impossible to explain because they are so full of apparently random tricks and traps.

For example, assume that A owns all of the shares of Holdco and A is selling the shares. The purchaser requires A to provide a non-compete and the parties allocate an amount to the non-compete. The default rule is that A must include in income all of the amount allocated (see subsection 56.4(2)). The amount can be treated as, in effect, proceeds of disposition of the shares if the exception in paragraph 56.4(3)(c) applies. That exception applies, however, only if the shares being sold constitute an “eligible interest”, and they will constitute an eligible interest only if

• they are shares of a corporation that carries on a business, or
• they are shares of a corporation 90% or more of the fair market value of which is attributable to eligible interests in one other corporation.

It appears that the Holdco shares will not be an eligible interest in the following circumstances (among many others, it seems):

• Holdco owns portfolio securities with a value that is more than 10% of the net value of all of the assets of Holdco. As a result, the Holdco shares would not be an eligible interest of A. But it seems that this problem could be solved by transferring the assets to Opco under section 85 (where they have no business being, in the real world).
• Holdco owns Opco and Realco. Realco owns the real property from which Opco carries on its business, and the Realco shares represent more than 10% of the net value of all of the assets of Holdco. The Holdco shares would not be an eligible interest of A. It seems that this problem could be solved, however, by amalgamating Opco and Realco. The purchaser will likely want to spin the real property out of Amalco into another holding company owned by Holdco immediately after the sale, at some expense, but never mind.
• Opco owes a significant debt to Holdco because, over the years, Opco has paid dividends of its earnings to Holdco, and Holdco has loaned the funds back to Opco and taken back notes secured by the assets of Opco. The notes represent more than 10% of the net value of all of the assets of Holdco. The Holdco shares, then, would not be an eligible interest of A. The problem, however, could be solved simply by converting the notes to shares before the sale.

Frankly, these are the kinds of rules that give tax lawyers a bad name. No wonder that, to some, we appear as priests of some sinister cult that requires a blood sacrifice from time to time to propitiate the angry gods. These rules defy common sense, and the proof is in the easy fixes that are available to solve the problems outlined above, if one only knows that the problems exist in the first place. Can anyone explain to me the policy rationale underlying these rules?