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A recent decision of the Tax Court in Manrell questions the practice in Canada of structuring non-competition payments to obtain tax-free treatment to a vendor.

The Tax Court's 1996 decision in Fortino (upheld by the Federal Court of Appeal) allowed, as a tax-free receipt, a payment by a vendor to a purchaser where the payment was: contained in the purchaser's original letter of intent; made pursuant to a non-competition agreement that was separate from the share purchase agreement; found to be reasonable in light of the purchase price paid for the shares of the target; and paid to a person other than the corporate entity carrying on the business that was being sold.

After Fortino it became common practice to structure an acquisition transaction to include a non-competition payment to enhance the after-tax return to the vendor group, thereby allowing the purchaser and the vendor to agree on an overall price lower than the price would have been without such planning.

In Manrell the Tax Court found that by entering into non-competition agreements with the purchaser and the target, the direct and indirect shareholders of the target disposed of their right to compete with the purchaser. The taxpayer received a payment that was tied inexplicably to the payment for the target's shares thereby giving rise to a capital gain. The Tax Court's decision has been appealed to the Federal Court of Appeal.

Pending the appeal decision, the characterization of non-competition payments in the hands of the recipient is unclear. Parties to an acquisition must take care to follow closely the structure set out in the Fortino case to preserve a filing position that a non-competition payment is not subject to tax as a capital gain.

Catherine Brayley and Nicholas Dietrich

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