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'Non-competition' payments may be tax-free

Everyone likes to own property. I recall a conversation I overheard not long ago as I was sitting in a restaurant in Red Deer, Alta.

A rancher from Red Deer was bragging to the owner of a small farm from near-by Wetaskiwin. "I can get in my car at six in the morning," the rancher said, "drive for six hours, spend an hour eating lunch, drive for another six hours, and I still wouldn't have reached the end of my property."

The rancher sat smiling as the farmer looked at him in apparent amazement. Then the farmer spoke: "Ya, I can sympathize with you," he said. "I had a car like that once."

When you hear the word "property," it's natural to think of real estate. The truth is, Canadian tax law includes a lot more in the definition of property than just real estate. In fact, a recent court decision hinged around the definition of property, and the result was good news for taxpayers. Let me explain.

The rules

If you take the time to read through the definition of "property" in subsection 248(1) of Canadian tax law (and I can't think of many things more enjoyable), you'll find that the definition is pretty broad.

In fact, "property" is defined to mean property of any kind whatsoever, whether real or personal or corporeal or incorporeal and, without restricting the generality of the foregoing, includes -- yada, yada, yada. Even your old hockey equipment is caught under this definition.

Why does it matter if something is considered to be "property" under our tax law? If you ever dispose of property, or are deemed to have disposed of it, you could face tax on a capital gain. You may even have a capital loss (although you won't be able to claim a loss on the sale of your old hockey equipment or most other personal use property -- sorry about that).

Finally, if something is considered to be property, you'll generally face tax on any income you earn from that property while you own it. The bottom line? The definition of property matters a lot.

The decision

On March 11, the Federal Court of Appeal (FCA) rendered a decision in the case of Manrell v. The Queen. The FCA held that a payment received by an individual on the sale of shares of a corporation in exchange for a promise not to compete (a non-competition payment) is not taxable. A tax-free payment? What a rare thing these days.

In this case, Mr. Manrell owned or controlled three operating companies that he agreed to sell in 1995. The agreement he struck with the buyer required the buyer to pay $4-million to the sellers for non-competition agreements. The taxman assessed Mr. Manrell for 1996 and 1997 on the basis that his share of the non-competition payment should be taxable as a capital gain.

You see, the taxman took the position that a right to compete is considered to be property under our tax law. And when Mr. Manrell disposed of that right, this triggered a capital gain. On the surface, this reasoning seemed to make sense because the definition of property in Canadian tax law includes "a right of any kind whatever."

Now for the good news. The FCA decided that a right to compete is not property at all. And because it's not property, there was no disposition of any property when Mr. Manrell gave up the right to compete. If there was no disposition of property, there is no tax to pay on the transaction. That's right. The non-competition payment was tax-free.

The rationale put forth by the FCA was that the right to carry on a business and compete with others is a right that belongs to everyone. This right is not the exclusive property of any one individual.

The result is that Mr. Manrell did not dispose of property within the ordinary meaning of the word when he gave up his right to compete. The taxman was trying to argue that the word "property" has a broader meaning under our tax law than its ordinary meaning, and that "property" should include a non-exclusive, commonly held right to carry on a business. The FCA didn't buy it.

The moral of the story? You may want to build a non-competition payment into a deal if you're thinking of selling shares soon. The Manrell decision may be appealed to the Supreme Court of Canada, so this tax-free treatment may not last forever. By the way, the same tax-free treatment will not extend to employees who receive a non-competition payment on leaving an employer. Those payments will be considered employment income.

Tim Cestnick, CA, CFP, TEP is author of The Tax Freedom Zone and Winning the Tax Game 2003. He is managing director, National Tax Services, at AIC Ltd.

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