After years of contradictory rulings issued by the District Courts, the Supreme Court recently resolved the ambiguity surrounding the classification of compensation in respect of non-competition covenants when employees leave employers. The Supreme Court deliberated the question of whether at issue is a capital gain that is subject to capital gains tax (25%) or earnings that are taxable as employment income (up to 48%).
The Supreme Court examined three district court appeals and ruled that, in most instances, compensation in respect of non-competition covenants being paid upon severance of employment relations shall be classified as employment income, pursuant to section 2 (2) of the Income Tax Ordinance [New Version], 5721 – 1961 (“the Ordinance”). Basically, the court reduced the maneuvering room for classifying “non-competition” receipts.
The Supreme Court clarified the procedure for classifying such income and ruled that the examination of non-competition receipts for tax purposes is a two-stage process. During the first stage, the examination must ascertain whether at issue is truly a non-competition covenant or merely camouflage for other payments (such as wages or a severance bonus). During the second stage, the examination must ascertain whether the presumption of “employment income” can be refuted under the circumstances and proven to be a capital receipt.
The Supreme Court clarified that, in instances whereby both classifications are possible – both capital and revenue, the revenue classification shall prevail. Therefore, in order to classify a receipt as a capital receipt, the taxpayer must convince the tax authorities that the receipt does not involve mixed characteristics; i.e., under no circumstances can the receipt be classified as employment income.
In its ruling, the Supreme Court relied on the principle that compensation that a taxpayer receives is classified according to the loss being compensated. The compensation granted to an employee in respect of the expected decrease in wages resulting from the non-competition covenant is in essence compensating the employee for the loss of career opportunities at competitors of his former employer. Consequently, according to the Court, this receipt shall be classified according to its purpose – and a substitute for wages shall be classified as employment income.
The court also clarified that it makes no difference whether the non-competition payment is paid out as a one-time payment or is paid over the “non-competition” period, and it makes no difference whether the non-competition agreement was signed when the employee was hired or just prior to severance.
We wish to point out that, notwithstanding this Supreme Court ruling, circumstances still exist under which it will be possible to classify non-competition receipts as capital receipts; for example: in instances whereby an employee’s qualifications are not transferable to another branch of the economy (differentiating between a structural engineer who is precluded from engaging in structural engineering and a manager of a real-estate firm, who is precluded from managing real-estate firms but can use his managerial expertise in other sectors). Furthermore, when at issue are qualifications that are liable to become outdated for lack of use thereof, or when at issue is a sweeping covenant of non-competition with no time limit, which basically prevents the employee from engaging in his profession in the future, to the point that he is ejected from the market, these types of circumstances serve as de facto compensation for the personal ability to work; in such cases it is still possible to argue that at issue are capital receipts.