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Authorisation Number: 1011626349469

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Ruling

Subject: Employment termination payment

Question

Is the payment described as a restrictive covenant termination payment excluded from being an employment termination payment under paragraph 82-135(j) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer: No.

This ruling applies for the following period:

2009-10 income year

The scheme commences on:

1 July 2009

Relevant facts and circumstances

Your employment with the employer commenced several years ago.

You were continuously employed with the employer until a specified date during the 2008-09 income year when your employment contract terminated.

The terms and conditions of employment were contained in various contracts of employment which covered your period of employment with the employer and its successor organisations.

The employment contract in place at the time of separation was dated prior to 10 May 2006 and the conditions of separation were outlined in a 'Deed of Termination and Release' dated after 9 May 2006.

The Deed stated that the parties irrevocably agree that your current employment contract would expire and that the employer would not offer you any further extension.

The Deed also stated that in consideration of the employer agreeing to pay you a severance payment, in an amount agreed, you agreed to forgo a right concerning your employment. You also agreed to enter into a restrictive covenant whereby you agreed not to be employed or contracted in any business in a specific geographical area for a specified period, entitling you to a restrictive covenant payment,

You were paid a specified amount which was nominally paid pursuant to your employment contract relating to the restrictive covenant payment (RCP). The sum represented a specified number of weeks pay at your annual remuneration package rate.

Negotiations between the parties eventually led to acceptance of a payout of a total of a specified number of weeks pay to be made as a consequence of termination. This would be represented as a specified number of weeks' severance and a specified number of weeks RCP and an extension of two months, from the nominal contract expiry date. In total, the specified number of weeks' pay undertaking given by the employer would therefore be met.

A letter during the 2007-08 income year from the employer to you confirmed a number of these facts.

Further in this letter, the employer also set out the terms of its separation offer which stated that subject to accepting a Redundancy payment of a specified number of weeks to extinguish your right it would agree to make a RCP of a specified number of months pay. The composition of the specified number of weeks was subsequently changed by agreement.

The letter also proposed an option to access your services on a consultancy basis for a specified period at your final daily salary rate.

The proposed arrangements were effected on this basis and a payment of a specified number of weeks severance was made during the 2008-09 income year and a payment of a specified number of weeks pay was made during the 2009-10 income year.

You are over 55 years of age.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 995-1

Income Tax Assessment Act 1997 Subsection 82-130(1)

Income Tax Assessment Act 1997 Paragraph 82-130(1)(a)

Income Tax Assessment Act 1997 Paragraph 82-130(1)(b)

Income Tax Assessment Act 1997 Paragraph 82-130(1)(c)

Income Tax Assessment Act 1997 Section 82-135

Income Tax Assessment Act 1997 Section 83-175

Income Tax Assessment Act 1997 Subsection 83-175(1)

Income Tax Assessment Act 1997 Subsection 83-175(2)

Reasons for decision

Summary

The payment described as a restrictive covenant payment is not excluded from being an employment termination payment under paragraph 82-135(j) of the Income Tax Assessment Act 1997 (ITAA 1997). The payment is considered to be an employment termination payment under section 82-130 of the ITAA 1997.

The payment described as a restrictive covenant payment should be included in your income tax return for the 2009-10 income year.

Detailed reasoning

Employment termination payments made on or after 1 July 2007

From 1 July 2007, the taxation treatment of payments made in consequence of the termination of any employment of the taxpayer has changed. These payments were formerly known as eligible termination payments.

Section 995-1 of the Income Tax Assessment Act 1997 (ITAA 1997) states that:

employment termination payment has the meaning given by section 82-130 of the ITAA 1997.

Subsection 82-130(1) of the ITAA 1997 states that:

A payment is an employment termination payment if:

· it is received by you:

· in consequence of the termination of your employment; or

· after another person's death, in consequence of the termination of the other person's employment; and

· it is received no later than 12 months after that termination (but see subsection (4)); and

· it is not a payment mentioned in section 82-135

Section 82-135 of the ITAA 1997 states:

The following payments you receive are not employment termination payments:

…

e. the part of a genuine redundancy payment or an early retirement scheme payment…

j. a capital payment for, or in respect of, a legally enforceable contract in restraint of trade by you so far as the payment is reasonable having regard to the nature and extent of the restraint;

…

Payments made in consequence of the termination of employment

For a payment to be an employment termination payment, the payment must be made in consequence of the termination of employment. The phrase 'in consequence of the termination of your employment' is not defined in the legislation. However, both the Courts and the Commissioner have considered the meaning of this phrase.

In Taxation Ruling TR 2003/13 (TR 2003/13) the Commissioner has considered the meaning of the phrase 'in consequence of'.

In paragraph 5 of TR 2003/13 the Commissioner states:

a payment is made in respect of a taxpayer in consequence of the termination of the employment of the taxpayer if the payment follows as an effect or result of the termination. In other words, but for the termination of employment, the payment would not have been made to the taxpayer.

As further stated by the Commissioner in paragraph 6 of TR 2003/13, there must be:

a causal connection between the termination and the payment, although the termination need not be the dominant cause of the payment. The question of whether a payment is made in consequence of the termination of employment will be determined by the relevant facts and circumstances of each case.

In your case, the Deed provides for the cessation of employment.

From the facts provided, there is a causal connection between the termination of your employment and the payment made under the Deed.

Accordingly, the termination of employment and the payment are all intertwined and connected. You would not have otherwise received the payment except for the termination of your employment. The circumstances in which the payment was made and the terms of the Deed clearly show that the payment was made in consequence of termination of employment. Therefore the first requirement under subparagraph 82-130(1)(a)(i) of the ITAA 1997 has been satisfied.

The payment is received no later than 12 months after termination

The second condition for the payment to meet the criteria as an employment termination payment is stated under paragraph 82-130(1)(b) of the ITAA 1997. The settlement sum must be received within 12 months of an employee's termination of employment, unless he or she is covered by a determination exempting them from the 12 month rule.

You terminated employment with the employer during the 2008-09 income year and the lump sum was paid during the 2009-10 income year. The payment was made within 12 months of the termination of your employment. Therefore the requirement under subparagraph 82-130(1)(b) of the ITAA 1997 has been satisfied.

Exclusions under section 82-135 of the ITAA 1997

As already noted, certain payments made on termination of employment are excluded from being an employment termination payment under section 82-135 of the ITAA 1997. Relevant to this particular case is whether any part of the payment is a genuine redundancy payment under paragraph (e) of section 82-135 of the ITAA 1997 or a capital payment for or in respect of a legally enforceable contract in restraint of trade under paragraph (j) of section 82-135 of the ITAA 1997.

Genuine redundancy payment

A genuine redundancy payment is so much of a payment, received by an employee who is dismissed from employment because the employee's position is genuinely redundant. The payment must exceed the amount that could reasonably be expected to be received by the employee in consequence of the voluntary termination of his or her employment, at the time of the dismissal (subsection 83-175(1) of the ITAA 1997). Section 83-175 of the ITAA 1997 replaces former section 27F of the Income Tax Assessment Act 1936 (ITAA 1936) where the payment was referred to as a bona fide redundancy payment.

To qualify as a genuine redundancy payment all of the conditions under section 83-175(2) of the ITAA  1997 must be met. The conditions include:

The employee is dismissed before the earlier of:

· the day he or she turned 65; or

· if the employee's employment would have terminated when he or she reached a particular age or completed a particular period of service the day he or she would reach the age or complete the period of service (as applicable).

· if the dismissal was not at arms length the payment must not exceed the amount that could reasonable be expected to be made if the dismissal was at arms length.

· at the time of the dismissal, there was no arrangement between employee and the employer, or between the employer and another person, to employ the employee after the dismissal.

However, a genuine redundancy payment does not include any part of a payment that was received by the employee in lieu of superannuation benefits to which the employee may have become entitled at the time of the payment or at a later time.

The first condition is that the taxpayer is dismissed from employment because the taxpayer's position is genuinely redundant.

The terms dismissal and redundancy are not defined in the ITAA 1997. Therefore, it is necessary to consider the ordinary meaning of the terms and the meaning the courts have ascribed to each word.

The Explanatory Memorandum to the Income Tax Assessment Amendment Bill (No.3) 1984, which inserted former section 27F into the ITAA 1936 states, at page 91:

The terms dismissal and redundancy are not defined in the legislation and, therefore, should be given their ordinary meanings. Dismissal carries with it the concept of the involuntary (on the taxpayer's part) termination of employment. Redundancy carries the concept that the requirements of the employer for employees to carry out work of a particular kind, or for employees to carry out work of a particular kind in the place where they were so employed, have ceased or diminished or are expected to cease or diminish. Redundancy, however, would not extend to the dismissal of an employee for personal or disciplinary reasons or for reasons that the employee was inefficient.

The Commissioner has issued Taxation Ruling TR 2009/2 Income Tax: genuine redundancy payments (TR 2009/2). The Ruling provides guidance on the factors to be considered in the interpretation of section 83-175 of the ITAA 1997.

Paragraph 11 of TR 2009/2 states:

There are four necessary components within the basis genuine redundancy requirement:

· The payment being tested must be received in consequence of a termination.

· That termination must involve an employee being dismissed from employment.

· That dismissal must be caused by the redundancy of the employee's position.

· The redundancy payment must be made genuinely because of a redundancy.

Each of the requirements will be discussed individually.

The payment is in consequence of the termination of employment

The issue of whether the payment was made in consequence of your termination of employment was discussed above. It was determined that the payment would be considered to be made in consequence the termination of your employment. Therefore the requirement that the payment must be received in consequence of a termination is met.

Dismissal from employment

Dismissal requires a termination of employment at the initiative of the employer without the consent of the employee.

In this case you were dismissed from employment by the employer on during the 2008-09 income year.

As you were dismissed from employment by the employer, the second requirement of a genuine redundancy has been met.

Dismissal caused by redundancy

Section 83-175 of the ITAA 1997 requires that the dismissal be caused by redundancy of the employee's position, and not for some other reason. Redundancy must be the reason for termination of employment by way of dismissal.

At paragraphs 25 to 29 of TR 2009/2, the Commissioner makes the following comments regarding dismissal and redundancy:

25. An employee's position is redundant when an employer determines that it is superfluous to the employer's needs and the employer does not want the position to be occupied by anyone. Accordingly, it is fundamentally the employer's decision that a position is redundant. On occasion the decision may be unavoidable due to the circumstances of the employer's operations.

26. In some circumstances, an employer may reallocate the duties and functions attached to a particular position to another position within the employer's organisational structure. In such cases, the former position is redundant. However, if the employee who had been working in that position is still employed by the employer following the reallocation of duties and functions, there will not be a dismissal.

27. On the other hand, if an employer decides after a structural reorganisation to terminate an employee, the former position of the employee is effectively redundant as long as the reorganisation is the prevailing or most influential cause of the termination.

28. A dismissal is not caused by redundancy where personal acts or default are the prevailing or most influential cause for the termination. For example, a person may be dismissed due to unsatisfactory performance or behaviour.

29. In some cases, an employer may decide to reorganise or restructure their organisation at the same time as identifying underperformance of particular members of staff or areas within the existing organisational structure. In the event that employees are dismissed in these circumstances, careful consideration will need to be given to what was the prevailing or most influential cause of dismissal.

Further, at paragraph 284 of TR 2009/2, the situation of a person's employment terminating at the end of a contracted period is addressed:

284. It would normally be the case that someone employed on a contract for a set period could not be dismissed at the end of that period. Their employment would simply terminate because the arrangement stipulated that the employment would cease at that time.

In this case, the position with the employer is not redundant as there is no evidence that the position has been abolished. Your employment was terminated on during the 2008-09 income year at the expiration of the contracted period of employment. Also, as part of the negotiations concerning the Deed the employer offered, and you agreed, that you would be available to provide consultancy services to the employer during the restrictive covenant period from the termination of employment.

As it is considered that the dismissal was not caused by the redundancy of your position, the third requirement of a genuine redundancy has not been satisfied.

The redundancy payment must be made genuinely because of a redundancy

It should be noted that whether a redundancy is genuine is determined on an objective basis.

In this case, from the facts provided, it is not evident that there has been a redundancy as discussed above. Therefore the fourth requirement of a genuine redundancy payment has not been satisfied.

All the conditions under section 83-175 of the ITAA 1997 must be met before the payment is considered a genuine redundancy payment. As two conditions have not been met, the payment will not be a genuine redundancy payment under section 83-175 of the ITAA 1997. No part of the payment will be tax-free under section 83-170 of the ITAA 1997.

We will now discuss whether the payment is capital payment for or in respect of a legally enforceable contract in restraint of trade under paragraph (j) of section 82-135 of the ITAA 1997.

Restraint of Trade exclusion

The payment will be an employment termination payment unless the exclusion in paragraph 82-135(j) of the of the ITAA 1997 (paragraph (j) ) applies. The exclusion in paragraph (j) states:

a capital payment for, or in respect of, a legally enforceable contract in restraint of trade by you so far as the payment is reasonable having regard to the nature and extent of the restraint;

For the exclusion under paragraph (j) to apply there must be:

· a capital payment

· for, or in respect of, a legally enforceable contract in restraint of trade; and

· the payment is reasonable having regard to the nature and extent of the restraint.

A capital payment

Numerous tests have been defined by the courts in determining whether an amount is income rather than capital. Generally, it has been held that a lump sum payment for entering into a restrictive covenant is of a capital nature.

In Hepples v. Commissioner of Taxation [No. 2] (1991) 65 ALJR 650; (1991) 91 ATC 4808; (1991) 22 ATR 465; (1991) 102 ALR 497; Justice Deane stated:

Traditionally, a genuine payment to an individual employee as consideration for covenants in restraint of his or her freedom to compete or to use or divulge certain information during a specified number of years after the termination of employment has not been seen as income in the ordinary sense…

The issue of whether a payment received for entering into a restrictive covenant on termination of employment was income or capital was considered in Paykel v. Commissioner of Taxation (1994) 126 ALR 248; (1994) 28 ATR 92; (1994) 94 ATC 4176. Justice Heery, in finding that the payment was capital in nature, stated:

Here the covenant was in no way incident to Mr Paykel carrying on the income earning activity of managing the Paykel companies. It was predicated on the assumption, indeed his covenant, that he would cease such activity. It was a one-off lump sum paid for a restraint for a substantial period. There was no suggestion that a similar payment would be repeated at the end of that period…

…….It does not follow in my opinion that where the taxpayer has no asset at all (a right to work not being an asset for these purposes) a payment received in consideration for some negative promise must be income.

In this case, the payment under the Deed does not demonstrate the characteristics of being income in nature. It is accepted that the payment under the Deed is capital.

For, or in respect of, a legally enforceable contract in restraint of trade

The issue for consideration is whether the provisions of the Deed amount to a legally enforceable contract in restraint of trade. It is not the role of the Commissioner to determine the validity of a contract, however, the terms of the agreement can be examined to see if it is likely that the restraint is legally enforceable.

The Deed demonstrates the essential elements of a contract, that is, there was an offer, acceptance, consideration and an intention of the parties to be legally bound. There is also nothing to suggest either of the parties did not have the legal capacity to enter into the agreement.

It is clear from the Deed that the payments are for entering into the restraints of trade. Accordingly, it is accepted the payments are for, or in respect of, a legally enforceable contract in restraint of trade.

The extent to which the amount of the consideration is reasonable

The Commissioner has no published guidelines on how to determine the amount that is reasonable for the purposes of the exclusion under subsection 82-135(j) of the ITAA 1997. Each case needs to be determined on its own merits.

In the majority judgement in Commissioner of Taxation v. Scully [2000] HCA 6; (2000) 169 ALR 459; 2000 ATC 4111; (2000) 201 CLR 148; (2000) 43 ATR 718; (2000) 74 ALJR 504 (Scully) it was stated that the purpose of including the reasonableness provision was to allow the Commissioner to disallow an excessive or fraudulent claim.

While the reasonableness provision referred to in Scully was in respect of personal injury, that is, whether the payment is 'reasonable having regard to the nature and extent of the' injury, the principle in Scully can also be applied to this case to determine whether the payment is 'reasonable having regard to the nature and extent of the' restraint of trade.

In Scully, Acting Chief Justice Gaudron and Justices McHugh, Gummow and Callinan stated that:

In our opinion, the fact that the payment must be "reasonable having regard to the nature of the personal injury and its likely effect on the capacity of the taxpayer to derive income from personal exertion" envisages that the payment has been calculated by reference to the injury. Furthermore, no support for the Full Court's conclusion is given by the reference in pars (m) and (n) to "amount or value" and to reasonableness. Those terms are used for the entirely different purpose of permitting the Commissioner to disallow an excessive or fraudulent claim for an exclusion by a taxpayer.

...

In our opinion, the words "in respect of" are principally concerned with payments such as those for loss of earnings consequent on personal injury. That that is the effect of that phrase appears from the words of par (n) itself - the consideration must be "reasonable having regard to the nature of the personal injury and its likely effect on the capacity of the taxpayer to derive income from personal exertion" (emphasis added). That meaning is also confirmed by the Explanatory Memorandum which stated that: "[p]ayments being excluded from the definition by paragraphs (k), (m) and (n) are sums paid as loans or under covenants in restraint of trade or by way of compensation for loss of income through personal injury." In their context, the words "in respect of" do not cut down the requirement that the payment must be a payment to compensate for the injury.

In our opinion, the payment in this case cannot be characterised as "consideration... in respect of, personal injury". The fact that the payment is not calculated by reference to the nature and extent of the injury or likely loss to the respondent and the fact that the other benefits are similar to that for total and permanent disablement point inevitably to the conclusion that the payment was "consideration... for, or in respect of" the respondent's termination of employment and her rights under the Trust Deed and was not "consideration... for, or in respect of" her injury.

In this respect, it should be noted that the 'paragraph (m)' referred to in this decision relates to the former provision concerning whether payments made before 1 July 2007 for restraint of trade are eligible termination payments in accordance with subsection 27A(1) of the ITAA 1936.

In this case, the restraints of the settlement and the related payments are both set out in the Deed.

Under the Deed, the employee will not, during the restricted period, do any of the following:

· engage in any similar business or activity, or be in competition with the employer;

· solicit, canvass, approach or accept any approach from a customer or client of the employer;

· interfere with the relationship between the employer and its customers, employees or suppliers; and

· induce or assist in the inducement of any employee of the employer to leave that employment.

The restrictions are for a specified period and within a specific area.

From the facts of the case, considering that the restriction of the settlement only applies to the specific area and the employer is the only entity that is able to legally conduct such a business in that area, the restraints of the Deed will have no significant effect on the business and competition the employer. Therefore the payment under the Deed for restraints of trade is not considered to be reasonable.

Further, following the decision in Scully, to be 'reasonable having regard to the nature and extent of' requires that such a payment must also be calculated with reference to the reason the payment is being made to the taxpayer, in this case the restraint of trade.

The payment for restraint of trade is referable to the term of the restraint, the specified number of week's remuneration for a restraint lasting a specified number of months. However, the actual loss to the taxpayer as a result of the restraint is, at most minimal. This is especially so when, as part of the termination payment negotiations, the employer offers the taxpayer consultancy work at their current salary for the period of the restraint.

Consequently, it is not considered that the payment relates to any loss you would suffer as a result of the restraint being imposed.

Consequently, the Commissioner considers that in this case, the third condition of the exclusion under paragraph (j) of the definition of an employment termination payment is not met

It has been determined from the facts of the case that the amount of the payment is not a payment mentioned in section 82-135 of the ITAA 1997. Therefore, the requirement under paragraph 82-130(1)(c) of the ITAA 1997 is met.

The payment is an employment termination payment as it has met all the conditions under section 82-130(1) of the ITAA 1997. The payment is made in consequence of the termination of employment, the payment is made within 12 months of the termination of employment and the payment is not excluded from being an employment termination payment under section 82-135 of the ITAA 1997.

Therefore, the payment under the Deed for the restraint of trade is considered to be an employment termination payment in accordance with section 82-130(1) of the ITAA 1997.

Tax Treatment of the employment termination payment

An employment termination payment made after 1 July 2007 will be comprised of the following components:

Tax free component this includes the pre-July 83 segment (if any) and/or the invalidity segment (if any); and

Taxable component the amount remaining after deducting the tax free component from the total payment.

The tax free component is not assessable income and is not exempt income.

The taxable component is included, in full, as assessable income.

Given the date you commenced employment with the employer, there will not be any pre-July 83 segment within the meaning of section 82-155 of the ITAA 1997.

As the payment is not made because you ceased being gainfully employed as a result of suffering from ill-health, there is no invalidity segment for the purposes of section 82-150 of the ITAA 1997.

As the employment termination payment of contains neither a pre-July 83 segment nor an invalidity segment, there is no tax free component as defined in section 82-140 of the ITAA 1997. Rather the entire employment termination payment is a taxable component as defined in section 82-145 of the ITAA 1997.

The taxable component is subject to tax, depending on the person's age when the payment is received.

For recipients below preservation age, the taxable component of an employment termination payment is taxed at 30 percent for amounts below the employment termination payments cap of $150,000 for the 2009-10 income year, and at the top marginal rate for amounts above the cap.

For recipients over preservation age on the last day of the income year in which the payment was made, the amount of the payment up to $150,000 is taxed at a maximum rate of 15 percent. The amount over $150,000 is taxed at the top marginal tax rate plus Medicare levy.

Preservation age is the age at which retirees can access their superannuation benefits. This will be 55 for persons born before 1 July 1960 and between 55 and 60 for persons born after 30 June 1960.

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