Understanding Restrictive Covenants in Ontario: Insights from GYTD CPA

Restrictive covenants are legal agreements that can significantly impact the sale or acquisition of businesses, corporate shares, or partnership interests. These covenants, which may be in the form of arrangements, undertakings, or waivers, often have a set duration and may be limited to certain geographical areas. 

The Canada Revenue Agency (CRA) has specific views and technical interpretations regarding these covenants. One critical aspect is that any amount received or expected to be received from a restrictive covenant is generally treated as ordinary income under tax laws, particularly under subsection 56.4(2). This broad definition can include non-disclosure, non-solicitation, and non-compete agreements. 

However, there are notable exceptions to this income-inclusion rule: 

• Employment Income Exception: This applies to certain employment-related restrictive covenants. 

• Eligible Capital Property (ECP) Exception: To benefit from this, both the vendor and purchaser must jointly elect and file a specific form. 

• Shares and Partnership Interests Exception: Similar to the ECP exception, this requires a joint election and filing by the involved parties. 

Additionally, the new Section 56.4 introduces further nuances, such as the full income inclusion and the “deemed receipt” rule. A key condition for the deemed receipt rule is that the vendor must not receive any proceeds for granting the restrictive covenant. Even nominal amounts can be considered proceeds, affecting the application of this rule. 

In summary, restrictive covenants in Ontario are complex legal instruments with significant tax implications. Parties involved in such agreements must carefully consider these aspects, especially in terms of income inclusion and the various exceptions provided under tax laws.