Structuring a CCPC Shareholder's Exit with a Non-Compete

Suppose that one of the owner-managers of a CCPC is to exit and sign a non-competition agreement in favour of the CCPC. Option 1 for the buyout is to have the corporation repurchase the shares; this option provides a good result for the remaining shareholders (because the corporation, not the remaining shareholders, pays for the buyout) but a poor tax result for the departing shareholder. Option 2 is to have the remaining shareholders personally buy out the exiting shareholder; this option provides a poor result for the remaining shareholders (because the remaining shareholders have to borrow funds or use tax-paid dollars) but a good tax result for the departing shareholder. The inclusion of the non-compete further complicates the tax analysis.

Option 1

The repurchase of the shares by the corporation will trigger a deemed dividend under subsection 84(3). This option creates a tax cost in itself; in addition, it causes problems with the restrictive covenant rules in section 56.4. These rules provide for an income inclusion for the amount allocated to the non-compete unless the payment falls into one of the categories of exceptions (subsection 56.4(2)). One possible exception is paragraph 56.4(3)(c), which refers to a disposition of property that is an eligible interest in a corporation. However, this ­exception cannot work: one of the tests for this paragraph to apply is subparagraph 56.4(3)(c)(iv), which states that subsection 84(3) does not apply to the disposition. A second possible exception is provided by subsection 56.4(7), but the application of subsection 84(3) invalidates this exception too (paragraph 56.4(7)(e)). Thus, because a subsection 84(3) deemed dividend is associated with the transaction, the restrictive covenant rules apply. Further, the non-compete is valuable, and one cannot simply allocate $1 to it; the rules in section 68 would reallocate proceeds in that case.

The overall effect of these two sets of provisions is to cause a poor tax result for the departing shareholder. For example, if a total of $500,000 is to be paid to the departing shareholder, $100,000 may be ordinary income resulting from that shareholder's signing the non-compete agreement, and $400,000 may be a deemed dividend resulting from the repurchase of shares.

Option 2

If the remaining shareholders purchase the shares, the exiting shareholder will have a capital gain, and that capital gain may qualify for the capital gains exemption.

The exiting shareholder's non-compete could satisfy the wording of clause 56.4(7)(b)(ii)(B), because shares of the capital stock of a corporation are being disposed of. According to the preamble to subsection 56.4(7), subsection 56.4(5) applies, thereby causing the reallocation of proceeds rules under section 68 not to apply. Thus, one can allocate only $1 of the payment by the remaining shareholders to this covenant (where the $1 is for the purpose of making the covenant legally enforceable). (One should not allocate more than $1: see ­"Restrictive Covenants: Some Reminders," Canadian Tax Focus, February 2017.)

To understand the combined effect of this option, assume that the exiting shareholder is to be paid $500,000; a total of $499,999 is proceeds from the sale of the shares, and the resulting tax liability will be zero if all of the gain is eligible for the capital gains exemption. The only tax will be on the $1 of ordinary income resulting from the allocation of $1 to the non-compete. Clearly, this outcome is a much better tax result for the departing shareholder.

Stephen A. Miazga
Felesky Flynn LLP, Saskatoon

Canadian Tax Focus
Volume 7, Number 3, August 2017
©2017, Canadian Tax Foundation