Restrictive covenants are most commonly found in non-competition agreements. However, other types of commercial transactions may also constitute restrictive covenants for tax purposes. The interpretation of the term ‘restrictive covenant’ can be of interest to taxpayers involved in M&A transactions as the rules may result in significant adverse consequences, unbeknownst to the parties.
The Federal Court of Appeal (FCA), in Pangaea One Acquisition Holdings XII S.À.R.L. v. The Queen, recently affirmed the Tax Court of Canada’s (TCC) decision and held that an agreement between two parties pursuant to which an amount was received in consideration for the recipient’s waiver of a veto right was considered to be a restrictive covenant.
Legislative background and brief overview of restrictive covenants
Prior to 2004, the courts had held that non-competition payments were non-taxable receipts. A non-competition agreement is generally used to govern how a contracting party engages in a similar business for an agreed-upon number of years or within an agreed-upon geographical territory.
In 2004, amendments to section 56.4 of the Income Tax Act (Act) were proposed to further define restrictive covenants and to ensure that payments received as consideration for entering into a non-competition agreement would be taxable. The term ‘restrictive covenant’ as defined in subsection 56.4(1) of the Act now includes non-competition agreements and other undertakings and waivers made by a taxpayer.
Generally, a ‘restrictive covenant’ of a taxpayer means an agreement entered into, an undertaking made, or a waiver of an advantage or right by the taxpayer, that affects the acquisition or provision of property or services by the taxpayer. In technical interpretation 2017-0688301I7, the Canada Revenue Agency (CRA) noted that the restrictive covenant rules were broadly drafted to prevent taxpayers from being able to structure transactions that would result in them receiving amounts as non-taxable capital receipts in inappropriate circumstances. CRA therefore considered that a restrictive covenant could, in addition to typical non-competition clauses, include exclusivity clauses, signing bonuses, break fees, supplier loyalty agreements, confidentiality agreements, franchise agreements, and referral fees. The definition of ‘restrictive covenant’ excludes, among other things, an agreement or undertaking that disposes of the taxpayer's property.
Pangaea One Acquisition Holdings XII S.À.R.L. (Pangaea) is a corporation resident in Luxembourg.
In November 2013, Pangaea, Thomvest Seed Capital Inc. (Thomvest), and William T. Dodds (Dodds) sold their shares of Public Mobile Holdings Inc. (Public Mobile) to TELUS Communications Inc. (TELUS).
Prior to the sale, Pangaea, Thomvest, and Dodds were all parties to a Unanimous Shareholders’ Agreement, which restricted a Public Mobile shareholder from transferring its shares without the written consent of the Special Majority Shareholders. Pangaea was one of the Special Majority Shareholders of Public Mobile. In other words, Pangaea had a veto right.
In September 2013, Pangaea and Thomvest entered into an agreement (the Letter Agreement). Pursuant to the Letter Agreement, Thomvest paid $3 million to Pangaea to waive its veto right in the Unanimous Shareholder Agreement and execute the Sale and Purchase Agreement (SPA) for the sale of shares of Public Mobile to TELUS. Thomvest also withheld and remitted $750,000 of the $3 million under Part XIII of the Act.
In January 2014, Pangaea filed an application requesting a refund of the $750,000 on the basis that it was eligible for treaty relief under the Canada-Luxembourg Tax Treaty (Treaty). The Minister denied the refund on the basis that the payment was in respect of a restrictive covenant and subject to Part XIII tax pursuant to subsection 56.4(2) and paragraph 212(1)(i).
The main issue in the Pangaea case was determining whether the $3 million paid by Thomvest to Pangaea was in respect of a restrictive covenant as defined in subsection 56.4(1) of the Act. If the Letter Agreement was a restrictive covenant, the amount received by Pangaea must be included in Pangaea’s income for that taxation year.
TCC’s ruling in respect of a restrictive covenant
At trial, the TCC judge concluded that the Letter Agreement was ‘an agreement’ or ‘a waiver of an advantage or right’ pursuant to subsection 56.4(1). The Letter Agreement did not explicitly mention that Pangaea would block or intend to block the sale of the shares as a Special Majority Shareholder. However, the TCC found that the documentation and testimonial evidence clearly showed that Pangaea was not initially willing to sell its shares of Public Mobile to TELUS. Pangaea was subsequently motivated by the Letter Agreement (and related payment) to execute the SPA and waive its veto right in the sale of its shares of Public Mobile to TELUS.
The TCC also held that the expression “affects or is intended to affect, in any way whatever” in section 56.4 suggests there must be a clear link or nexus between the Letter Agreement and the acquisition or provision of property or services. The TCC found that there was an obvious nexus between the Letter Agreement and the sale of the Public Mobile shares to TELUS because of the commercial reality of the transaction. For example, the $3 million was paid to Pangaea to waive its veto right and execute the SPA. The Letter Agreement therefore affected or was intended to affect the ‘provision of property’, being the sale of the shares of Public Mobile to TELUS.
At trial, Pangaea argued that the veto right could be characterized as property and thus the arrangement should not be considered as a restrictive covenant because there was a disposition of its veto right. In other words, Pangaea claimed that the Letter Agreement resulted in a disposition of its property, being Pangaea’s veto right meaning that the exclusion in the definition of restrictive covenant was satisfied. However, the TCC found that even if the veto right could be characterized as property, there was no evidence that the veto right had been disposed of because there was no actual transfer, conveyance, or event of an assignment of the right to a third party. The veto right was waived by Pangaea. Consequently, that exclusion did not apply and the Letter Agreement was considered to be a restrictive covenant.
FCA affirms the TCC’s decision
The FCA agreed with the TCC’s analysis and held that there was an obvious nexus between the Letter Agreement and the disposition of the shares to TELUS, because the $3 million payment was made under the Letter Agreement for Pangaea to execute the SPA with TELUS. The FCA further confirmed that a restrictive covenant is broadly defined and encompasses much more than non-competition agreements.
Planning and negotiation opportunities
The definition of restrictive covenant is broad and can apply to agreements or covenants other than traditional non-competition agreements. This case raises interesting alternative planning questions. For example, would the tax result in Pangaea have been different if Pangaea had assigned its veto right to Thomvest in consideration for the $3 million?
The assignment of the veto right to Thomvest might have supported the proposition that the veto right had been disposed of by Pangaea thus resulting in sales proceeds to Pangaea rather than income from an amount paid in respect of a restrictive covenant. Sales proceeds from a disposition of capital property would be taxed at capital gains rates and potentially be eligible for Treaty relief.