Published: June 12, 2026
The Dilemma: Commercial Necessity vs. Harsh Tax Defaults
When a business is sold, whether through a share sale or an asset sale, the purchaser almost invariably demands restrictive covenants—such as a non-competition or non-solicitation agreement—from the selling shareholders or key principals. This is a standard commercial mechanism designed to protect the purchaser’s investment and preserve the goodwill of the acquired enterprise. However, the interaction between corporate commercial practice and Canadian tax law introduces severe, often unexpected, tax complexities.
The central problem boils down to a mismatch in tax treatment: while the sale of shares or capital business assets generally yields capital gains, consideration received for a restrictive covenant is treated by default as fully taxable income. Under section 56.4 of the Income Tax Act (ITA), the definition of a “restrictive covenant” is intentionally broad, sweeping in classic non-compete clauses, customer non-solicitation undertakings, confidentiality agreements, and exclusivity arrangements. Unless a specific statutory exception applies, subsection 56.4(2) includes all amounts received or receivable in respect of a covenant directly into the taxpayer’s income for the year.
This default rule creates a significant trap for the vendors, as it can inadvertently convert what should be tax-favoured capital proceeds into fully taxable ordinary income.
The Silent Risk: The Deeming Power of Section 68
A common misconception is that if the purchase and sale agreement allocates nil consideration to the restrictive covenant, no tax consequences arise under section 56.4. This planning oversight ignores the powerful reallocation mechanism found in section 68 of the ITA, which empowers the Canada Revenue Agency (CRA) to deem a reasonable portion of a lump-sum transaction price to be consideration for the restrictive covenant. To achieve tax certainty, the transaction must qualify for narrow statutory relief that explicitly turns off the operation of section 68.
Venues to Counter Section 68 Deeming Power
To avoid ordinary income recharacterization, vendors must navigate specific technical exceptions under section 56.4. In the context of a legitimate share or business sale, the two primary pathways are the Share Disposition Exception and the Goodwill Exception.
The Share Disposition Exception: Subsection 56.4(3)(c)
When an arm’s-length transaction common shares of a corporation carrying on a business is structured as a share sale, paragraph 56.4(3)(c) serves as a primary gateway. This exception permits an amount to be excluded from ordinary income and added directly to the vendor’s proceeds of disposition for the shares, provided several conditions are met:
- The covenant must directly relate to the vendor’s disposition of an “eligible interest,” which includes common shares of a corporation carrying on a business.
- The covenant must be an undertaking not to compete, and it must be reasonably considered necessary to maintain or preserve the fair market value of the shares sold.
- The parties must jointly execute and file a prescribed election form.
The purchaser is then entitled to add the corresponding amount to the cost base of the acquired shares.
The Goodwill Exception: Subsection 56.4(3)(b)
In a transaction structured as an asset sale rather than a share sale, paragraph 56.4(3)(b) provides a parallel mechanism. Where a business is sold, any consideration allocated to a restrictive covenant can be excluded from income if it would be included in the proceeds of disposition of Class 14.1 cumulative eligible property (goodwill). Similar to the share exception, a joint election between the vendor and the purchaser is mandatory, allowing the purchaser to treat the payment as a capital outlay for goodwill.
The Ultimate Protection: Subsection 56.4(7)
The most robust tool in transaction planning is subsection 56.4(7). While the elections under subsection 56.4(3) deal with scenarios where an explicit dollar amount is paid for a covenant, subsection 56.4(7) addresses the more common reality where a non-compete is demanded, but no distinct proceeds are paid for it.
This provides absolute statutory protection, ensuring the CRA cannot retroactively carve out a portion of the share or asset purchase price to tax it as ordinary income. To secure this protection, the transaction must satisfy a rigorous matrix of conditions:
- The Non-Compete Requirement: The restrictive covenant must be an undertaking not to compete with the arm’s-length purchaser.
- The Integral Link: The covenant must be integral to the written share or asset purchase agreement and granted solely to preserve the fair market value of the underlying property or shares being sold.
- The “No Proceeds” Condition: The vendor must receive no distinct or separate proceeds for granting the covenant.
- The Goodwill Election: If the transaction involves goodwill, the prescribed joint election must be completed and filed with the CRA.
Historically, the CRA maintained a rigid technical stance regarding the “no proceeds” condition. If, for example, a contract utilized standard legal drafting boilerplate stating that the covenant was granted for $1, the CRA would argue that the vendor failed the “no proceeds” test.
Fortunately, administrative policy has softened. The CRA now accepts that standard boilerplate language used solely to ensure legal enforceability—where the $1 is nominal and not a substantive payment—will not by itself invalidate the application of subsection 56.4(7). However, if any real or substantive consideration is paid for the covenant, this protective exception is instantly broken.
Pro Tax Tip – Ensure Precise Statutory Matching and Timely Filing
Because the default tax treatment for restrictive covenants is severe, contracting parties must never leave the application of these exceptions to chance. Commercial agreements must be drafted to explicitly match the exact statutory wording of subsection 56.4(7) or paragraphs 56.4(3)(b) or (c).
Furthermore, satisfying the substantive conditions is only half the battle; the administrative filing requirements are equally strict. Under subsection 56.4(13), any required election must be submitted to the CRA in its prescribed form, accompanied by a full copy of the restrictive covenant itself. For Canadian residents, the filing deadline is the taxpayer’s standard filing-due date for the taxation year in which the covenant was granted. Failure to file on time can lead to the invalidation of the election, exposing the vendor to a recharacterization of their sale proceeds.
Parties to a transaction should always consult an experienced Canadian tax lawyer early in the drafting phase to ensure their restrictive covenants are fully compliant and protected.
FAQ
If a purchase agreement includes both a non-competition clause and a customer non-solicitation clause, do they require separate tax elections?
The CRA has confirmed that where a non-solicitation clause and a non-competition clause are contained within the same agreement, they can be evaluated as a single restrictive covenant. If both undertakings are integral to maintain the value of the shares or assets sold, subsection 56.4(7) can apply to protect both clauses from section 68 recharacterization. However, this is a highly fact-sensitive determination; covenants that go beyond protecting the value of the business sold, such as broad employee non-solicitation, may be considered ancillary and may not automatically qualify.
What happens if an employee is forced to sign a non-compete, but all the sale proceeds are paid to the vendor corporation?
Subsection 56.4(6) provides a specific relieving exception for individual employees who grant a restrictive covenant in connection with a purchaser’s acquisition of the business. If the individual employee deals at arm’s length with the purchaser and the vending corporation, receives no direct proceeds for granting the covenant, and the entire consideration is received exclusively by the vendor corporation, section 68 will not apply to the individual employee. This protects the individual employee from being attributed a personal ordinary income inclusion for a covenant that structurally benefited the selling shareholders.
DISCLAIMER: This article provides broad information regarding tax statutes. It is only accurate as of the posting date and has not been subsequently updated. It does not constitute legal or tax advice and should not be relied upon to make transaction decisions. Every corporate transaction is unique and governed by its specific factual circumstances. If you have specific questions regarding a restrictive covenant, you should seek the advice of a qualified Canadian tax lawyer.
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