On August 10, 2016, the Israeli Supreme Court published an interesting judgement dealing with the matter of the taxation of a non-compete consideration paid by an employer to his employee after ending the employment relationship. The said judgement finally put an end to the old discussion of whether such a payment should be classified as a capital gain type of income (which is generally subject to a lower tax rate of 25%) or regular working income (up to 50%). The matter of non-compete payments is also part of a more broad discussion regarding the taxation of all types of payments that are paid to an employee upon ceasing his work for the relevant employer.
Before explaining the new court ruling, we should mention that the execution of a non-compete agreement between an employer and an employee also involves other legal aspects in addition to the tax aspect, for example: labor law, antitrust law, contract law and constitutional law. From the labor point of view, the Israeli courts discussed in many different cases the matter of the validity of a non-compete clause included in an employment agreement, in light of the contradiction with the employee's right to freedom of occupation. We can mention, very generally, that the common ruling provides that a non-compete agreement may be valid and legal only in the event that it is designed to protect the legal interests of the employer (in addition to the non-compete itself), and it is also proportional so that it reflects an equilibrium between the legal interests of the employer and the employee's right to freedom of occupation and interest of earning a living based on his expertise.
From tax point of view, the Supreme Court held that there is a presumption under which a non-compete payment – as any other payment paid to an employee – is regular working income which is subject to the ordinary income tax rates. There is no importance for this purpose whether the non-compete was paid exactly in the end of the employment relationship or at a later point of time. However, the employee has the right to try refuting this presumption. The rationale behind this judgement is that a non-compete payment is meant, in fact, to compensate the employee for the expected reduction of his income (in light of the limitation of the possibility to utilize to the fullest the employee's earning capacity) and, therefore, this compensation should be treated as a wage.
Finally, the Supreme Court held that there may be exceptional cases in which the employee can prove that the practical result of a specific non-compete clause is a total reduction of his earning capacity, so that the payment should be classified as a capital gain. An example for such a case can be a commercial pilot who is not allowed to work as a pilot in any other airline company for a long period of time, so that his flight knowledge may be eroded. However, we should bear in mind that most of the circumstances in which non-compete payments are paid are for senior employees and managers whose occupational areas are quite broad and, therefore, there is no cause to argue for the exceptional. As an example, on November 13, 2016, an Israeli district court rejected a similar argument of an engineer and manager in the Ness group who received an amount of $550,000 at the end of this employment under the title of "Non-Competition and Waiver of Intellectual Property Rights", and it was held that it was regular working income (based on the rationale of the Supreme Court judgement).