The federal government has proposed amendments to the Income Tax Act affecting the income tax treatment of amounts received or receivable by a taxpayer for granting a restrictive covenant.

The proposed amendments respond to recent Federal Court of Appeal decisions, which held that amounts receivable by a vendor on the sale of shares of a corporation, for an agreement not to compete with the business carried on by the corporation, were generally not taxable.

The amendments would alter this result and, subject to an exception described below, would treat any amount receivable in respect of a restrictive covenant as ordinary income for income tax purposes.

The amendments include an exception to ordinary income treatment in circumstances where proceeds are receivable by a taxpayer in respect of an arm’s length disposition of shares in a corporation, and other proceeds are receivable by the taxpayer for a restrictive covenant relating to the business carried on by the corporation.

In these cases, the amount receivable for the covenant may be treated as part of the proceeds for the disposition of the shares, to the extent that the covenant increases the fair market value of the shares. Only the portion of the amount receivable for the covenant that is in excess of that treated as share proceeds will be taxable as ordinary income. This mechanism will also apply to dispositions of partnership interests.

These proposals will apply to amounts received or receivable after today, other than to amounts received before 2005 pursuant to a written agreement made on or before today between parties dealing at arm’s length.