Monday, February 6, 2006

Taxing In-Action

Imagine if one spouse said to the other: “Honey, you burned lunch again! And it was only a grilled cheese sandwich. I’ll make you a deal: I’ll pay you $1,000 if you agree never to cook again.” Please note this example is by no means a reflection on my ability to make a grilled cheese sandwich. As it turns out, the $1,000 payment received by the culinarily-challenged spouse could be subject to taxation under proposed amendments to the Income Tax Act.

Canada’s income tax scheme is based on the concept of taxation of income received from a source, such as employment or business. Tax is imposed on an amount received as a result of doing something. However, in the case of the proposed legislation, tax is being imposed on an amount paid for NOT doing something.

Proposed section 56.4 of the Income Tax Act is the government’s response to two Federal Court of Appeal cases, Fortino and Manrell, where non-compete payments received by the taxpayers were not taxable. Non-compete payments typically arise during the sale of a business where the buyer pays the seller money in exchange for the seller agreeing not to compete with the business after it is sold. Proposed section 56.4 seeks to tax such a payment. However, the proposal uses the term “restrictive covenant”, which is broader than just non-compete payments. Restrictive covenants are basically agreements where you promise not to do something. The agreement does not even have to relate to the sale of a business.

Section 56.4 would add to the taxpayer’s income all amounts received in respect of a restrictive covenant (including, but not restricted to, a non-compete payment). There are a few limited and complicated exceptions under which only part of the payment is included in income. One exception relates to a sole proprietor selling a business. Another exception relates to the sale of shares of a corporation or an interest in a partnership. In order for these exceptions to apply, both the seller and buyer must file a joint election. The rules are complicated, as usual, but in the end, the government has found a way to tax someone for being paid NOT to do something, including not making grilled cheese sandwiches.

-- Devinder Sidhu

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The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.