Treatment of a restrictive covenant

Assumed facts

Terence and Isabelle each own 50 of 100 common shares of X Ltd., which carries on a business. The adjusted cost base (ACB) of their shares is nil.

• Both Terence and Isabelle receive $900,000 for selling their 50 shares of X Ltd. to Y Ltd. Terence receives $150,000 for his restrictive covenant, and Isabelle grants a restrictive covenant for which she is to receive $50,000.
• The required elections are made and filed on time.

Application of proposed rules

Isabelle

Because Isabelle is to receive $50,000 for her restrictive covenant, she may add part of those proceeds to the $900,000 she is to receive for the sale of her shares of X Ltd. The part of the $50,000 that can be added is the amount by which the value of her share interest would increase if the covenant was provided for no consideration. This covenant includes also all restrictive covenants that may reasonably be considered to relate to a disposition of an interest in the business by any taxpayer.

1. Capital gain equals $950,000

($950,000 proceeds less nil ACB)

Where proceeds of disposition are:

$900,000 in proceeds of disposition for shares of X Ltd.

plus

$50,000 of the covenant proceeds (which can be added to the proceeds of disposition from the sale of the business), determined as follows:

Lesser of:

1. $50,000 (amount receivable)
2. $100,000 (value by which Isabelle's share interest in X Ltd. would increase if covenants provided by her and Terence were provided for no consideration when compared with a sale in which no covenant is granted; that is 50% of $200,000), calculated as follows:

To the extent

$1 million (50% of $2 million if covenants for no consideration)

is more than

$900,000 (50% of $1.8 million, if no covenant granted)

2. Ordinary income equals nil

($50,000 less $50,000 allocated to proceeds of disposition for shares)

Terence

Because Terence is to receive $150,000 for granting a restrictive covenant, he may add a part of those proceeds to the $900,000 he is to receive for the sale of his shares of X Ltd. The part of the $150,000 that can be added is the amount by which the value of his share interest would increase if the covenant was provided for no consideration. This covenant includes all restrictive covenants that may reasonably be considered to relate to a disposition of an interest in the business by any taxpayer.

1. Capital gain equal $1 million
($1 million proceeds less nil ACB)

Where proceeds of disposition are:

$900,000 in proceeds of disposition for shares of X Ltd.

plus

$100,000 of covenant proceeds (which can be added to the proceeds of disposition from the sale of the business), determined as follows:

Lesser of:

1. $150,000 (amount receivable)
2. $100,000 (value by which Terence's share interest in X Ltd. would increase if covenants provided by him and Isabelle were provided for no consideration when compared with a sale in which no covenant is granted; that is, 50% of $200,000), calculated as follows:

To the extent

$1 million (50% of $2 million if covenants for no consideration)

is more than

$900,000 (50% of $1.8 million if no covenant granted).

2. Ordinary income equals $50,000
($150,000 less $100,000 allocated to proceeds of disposition for shares).