Volume 3, Number 2
The information in Tax Perspectives is prepared for general interest only. Every effort has been made to ensure that the contents are accurate. However, professional advice should always be obtained before acting on the information herein.
Sale of a Business Structuring Non-Compete Arrangements
By W. P. Daye, FCA, TEP
Daye & Company (Edmonton)
A recent decision of the Federal Court of Appeal, Manrell v. The Queen, 2003 FCA 128, March 11, 2003, has confirmed that when a business is being sold, it may be possible to arrange the sale so that a portion of the sale proceeds may escape taxation. This is good news for shareholders who are contemplating the sale of the shares of a company, where they have been active participants in the affairs of the company.
In 1995, Manrell entered into an agreement to sell the shares of three different corporations involved in manufacturing businesses. As part of the Share Purchase Agreement with the purchaser, Manrell was required to enter into a Non-Competition Agreement. Manrell received $3,927,078 for his shares and $979,575 for entering into the Non-Competition Agreement.
When Manrell filed his tax return, he reported the Non-Compete payment as proceeds giving rise to a capital gain. After receiving his notices of assessment, Manrell changed his position, on the basis of the decision of the Tax Court in Fortino, which had held that Non-Compete payments should be non-taxable amounts.
In considering the Manrell matter, the Federal Court of Appeal held that the taxpayer had not disposed of property; consequently, there was no resulting capital gain to be taxed and the position of the Tax Court was reversed.
The findings of the Federal Court of Appeal in Manrell lead us to consider what tax planning opportunities may arise from that decision. Only time will tell the extent to which this decision may be relied upon in structuring various business transactions, but the following possibilities, and cautions, come to mind:
- When a business is being sold, it is generally more beneficial for the vendor to sell shares rather than assets. The capital gains exemption had previously created this bias; now, the possibility of attaching a non-taxable "Non-Compete Agreement" to the share sale arrangement becomes an important planning consideration as it may provide an additional source of tax-free proceeds.
- If a business sale is being structured as an "asset sale", it will be difficult to argue that any "Non-Compete" payments should not be subject to tax, as such amounts are likely to be regarded as being part of the bundle of intangible assets which are being sold as part of the total sale package. While an argument can be made that it is the individual shareholder who is giving up his right to compete, not the corporation which is selling its assets, CCRA may be quicker to challenge the non-taxability of non-compete payments in asset sale transactions.
- Taxpayers entering into Non-Compete Agreements at the time of selling shares are more likely to be successful arguing that the Non-Compete payments are not taxable if they have been actively involved with the business. Shareholders who have not been active will have a difficult time arguing that their Non-Compete undertakings have any real value.
- The allocation of the total sale proceeds between share proceeds and Non-Compete proceeds must be reasonable in the circumstances.
- The Non-Compete Agreement should set out as many undertakings by the vendor as possible. Consider delineating such items as: data, know-how, customer relationships, trade secrets, promises not to recruit employees, as well as promises not to compete directly or indirectly, by way of loan, investment or in any other manner.
- Where shareholders are parties to a Unanimous Shareholders'Agreement, which specifies that all shareholders receive the same price per share, the active shareholders may get additional proceeds by way of Non-Competition proceeds, whereas non-active shareholders would not get such proceeds. Any attempt to equalize the proceeds on a per-share basis would likely weaken any argument that some of the proceeds are anything other than share sale proceeds.
- Some may argue that it may be possible to extend the rationale in Manrell to situations where a key employee possessing special knowledge, customer relationships, etc., is departing and enters into a Non-Compete Agreement with his employer. Unfortunately, the provisions of paragraph 6(3)(e) of the Income Tax Act may serve to deem such amounts to be employment income that would be fully taxable. Accordingly, considerable care must be exercised when trying to apply the rationale in Manrell to such situations.
- The GST consequences attached to the non-compete arrangements are not clear as different commentators have expressed differing views on this question. Hopefully, some clarity will be added to the GST question by way of a CCRA ruling or other pronouncement.
The findings in the Manrell case provide us with an important tax planning opportunity when structuring sale transactions. The early indications are that the Crown will not seek leave to appeal this decision to the Supreme Court of Canada. This may simply signify that the Minister of Finance will introduce amendments that will be designed to block the favourable findings in Manrell. As a result, the tax planning opportunities confirmed by Manrell may be short-lived.