Edited version of private advice

Authorisation Number: 1052229756798

Date of advice: 8 April 2024

Ruling

Subject:Lump sum payment - restraint of employment

Question

Is the restraint of trade payment to you by your former employer assessable as a capital gain?

Answer

Yes.

Question

Is the resulting capital gain from the receipt of the payment a discount capital?

Answer

No.

This private ruling applies for the following periods:

Year ending 30 June 20XX

The scheme commenced on:

X XX 20XX

Relevant facts and circumstances

Position Details

•           Previous position - chairperson reporting to the managing director.

•           Term Ongoing

•           Annual Base Salary $XXX,XXX-00 inclusive of superannuation contributions of X.X% of annual base salary.

•           Additional Benefits:

•     Long Term Incentive Plan (LTIP) as set out in Schedule X;

•     Director and officers' insurance

•     Personal accident insurance cover provided by a work insurance provider;

•     Travel Insurance whilst on company business;

•     Laptop computer

Core Working Hours

•     Average of X day/s per week over X month to be work between the hours of X am to X pm Monday to Friday in each week wither at the office, home or on project sites.

•     Location in the State

•     Term - X Years

Your employment with the employer commenced on XX X 20XX. The terms and conditions of employment were contained in executive services agreement dated XX X 20XX (employment agreement).

You were continuously employed with the employer until XX X 20XX, when your employment was terminated.

The employment agreement contained in Clause XX, restraint provisions effective from the date of your termination of employment.

The restraint provisions in the employment agreement were expressed to limit your post- employment activities in respect of certain geographical areas, but the duration of the restraint was expressed as 'N/A'.

In the income year ending 30 June 20XX your employer was acquired by the purchasing company.

You have not been offered any continuing employment with the employer or the purchaser.

Restraint of employment contract

Parties

•           The Company - your previous employer

•           The Restrained Beneficiary- you

•           The Buyer - the new company/owner

Background

A.  The Buyer is proposing to enter into the share sale and purchase agreement in order to acquire the Company, your former employer.

B.  The Restrained Beneficiary is currently employed as deputy chairperson for the company and the business.

C.  The restraint beneficiary is not a current shareholder in the company but is a key member of management of the company.

D.  The terms of restrained beneficiary's employment are currently set out in an existing executive service contract dated XX X 20XX between the Restrained Beneficiary and the Company (executive service contract).

E.  The Restrained Beneficiary's employment will terminate on XX X 20XX (termination date) in accordance with the terms of the document.

F.  Accordingly, the Restrained Beneficiary has agreed to enter into this document to give effect to the termination of his employment and in order to assure to the Buyer the full benefit and value of the goodwill in the purchased company and the business that it is acquiring pursuant to the terms of the share sale and purchase agreement.

Restraint agreement

•           Completion date means X XX 20XX or date otherwise agreed Buyers and Sellers

•           Completion payment means $X,XXX,000.

•           Date of signing X XX 20XX.

Restraint Area - Any of the following Areas

(a) Australia

(b) State A and State B

(c) State A; and

(d) State B.

Restraint Period - Any of the following periods commencing on the completion date:

(a) XX months;

(b) XX months;

(c) XX months;

(d) XX months;

(e) XX months; and

(f)  XX months.

Restricted business - Any business which is the same or substantially similar to, or which likely to be competitive with any material part of the Business.

Employment group company means each of involved businesses and each of their subsidiaries, and a reference to the employment group includes all of them.

Completion Payment - Payment obligation

The Buyer or the Company must on the completion date pay to the Restrained Beneficiary the completion payment.

Restraint

You will be prohibited from:

•     Carrying on or preparing to carry on, in any capacity, similar business to the employer or purchaser or being in competition to the employer or purchaser;

•     Enticing or inducing away any material customer, supplier vendor, employee, contractor or consultant of the employer or purchaser;

•     Taking action that is likely to cause detriment to or interfere with the relationship with material customer, supplier, vendor employee, contractor or consultant of the employer or purchaser;

•     Doing or saying anything which is prejudicial to the interests of the employer or purchaser;

•     Using the trademarks or names of the employer; or

•     Counselling, procuring or otherwise assisting any person to do any of the aforementioned acts,

Within Australia for a period of X years.

On the X XX 20XX, you, your employer and the purchaser signed a deed titled 'restraint deed'(restraint deed).

The restraint deed provided, by clause X, that your employment would terminate on X XX 20XX, and the employer would pay-out any unpaid salary arising in respect to your employment up till his termination and any accrued, but undertaken, statutory annual leave or long service leave entitlements.

The restraint deed provided, by clause X and paragraph X of the background, that the employer or the purchaser would pay you a 'completion payment' (defined in clause X of the restraint deed as the amount of $X,XXX,000) following the termination of your employment, and subject to the you entering into the terms of the restraint deed (restraint payment).

The restraint deed contained restraint provisions to the benefit of both the employer and the purchaser in clause X. The restraint of trade in respect of you was intended to last for X years in respect of a geographical area covering Australia.

The Company paid the restraint payment to you on and withheld from the restraint payment on the basis that it was ordinary income.

The restraint payment of $X,XXX,000 was paid on X XX 20XX.

Relevant legislative provisions

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

Income Tax Assessment Act 1997 paragraph 82-135(j)

Income Tax Assessment Act 1997 section 104-25

Income Tax Assessment Act 1997 subsection 104-35(1)

Income Tax Assessment Act 1997 section 108-5

Income Tax Assessment Act 1997 section 115-15

Income Tax Assessment Act 1997 section 115-25

Reasons for decision

Question 1

Is the restraint of trade payment to you by your former employer assessable as a capital gain?

Answer

Yes.

Summary

Section 82-135 of the Income Tax Assessment Act 1997 (ITAA 1997) specifically excludes from the definition of an employment termination payment a capital payment in respect of a legally enforceable contract in restraint of trade so far as the payment is reasonable having regard to the nature and extent of the restraint.

Restraint of trade payments can be made on signing an employment contract as well as on the termination of a contract. Payments made on signing a contract have the character of income. Those that are made on termination have the character of capital.

This is outlined in paragraphs 128 - 130 of the Taxation Ruling TR 95/3 Income tax and capital gains: application of subsections 160M(6) and 160M(7) to restrictive covenants and trade ties.

Your restraint deed payment will therefore be assessed as a capital gain.

Detailed reasoning

Employment termination payment

An employment termination payment is a payment received in consequence of the termination of employment of a person.

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

A payment is an employment termination payment if:

(a) it is received by you:

i. in consequence of the termination of your employment; or

ii. after another person's death, in consequence of the termination of the other person's employment;

and

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

(c) it is not a payment mentioned in section 82-135.

Section 82-135 of the ITAA 1997 specifically excludes from the definition of an employment termination payment a capital payment in respect of a legally enforceable contract in restraint of trade so far as the payment is reasonable having regard to the nature and extent of the restraint.

A payment for the restraint deed therefore may be examined to determine whether it is an employment termination payment or a capital payment, in accordance with the above definition.

In order to determine this, the Commissioner considers whether:

•                the consideration is of a capital nature,

•                the consideration is for, or in respect of, restraint of trade,

•                the contract in restraint of trade is legally enforceable, and

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

The Commissioner has no published guidelines on determining whether a payment is reasonable under this paragraph. Each case must be considered on its own merits.

Where the Commissioner decides that an amount is not an employment termination payment, the payment (or part of it) may be assessable as a capital gain.

Capital in nature

Restraint of trade payments can be made on signing an employment contract as well as on the termination of a contract. Payments made on signing a contract have the character of income. Those that are made on termination have the character of capital.

This is outlined in paragraphs 128 - 130 of the Taxation Ruling TR 95/3 Income tax and capital gains: application of subsections 160M(6) and 160M(7) to restrictive covenants and trade ties.

Your restraint deed payment will therefore be assessed as a capital gain.

The nature and CGT implications of restrictive covenants were most thoroughly explained in the Explanatory Memorandum ('EM') to the Taxation Laws Amendment Act (No. 4) 1992, where it was stated that rights under a contract of personal services are CGT assets.

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. FC of T (1991) 173 CLR 492; 91 ATC 4808; 22 ATR 465 Deane J 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. FCT (1994) 126 ALR 248; 28 ATR 92; 94 ATC 4176. Heery J 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.

In your case you received a $X,XXX,000 payment in return for entering into a X-year restraint deed with your employer and the purchaser on the X XX 20XX. The payment does not relate to you carrying on an income earning activity and there is nothing to suggest that similar payments will be made to you after the X year period ends. For these reasons the payments are considered to be capital in nature.

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

The first issue for consideration is whether the provisions of the agreement amount to a legally enforceable contract, restraint deed. 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.

In your case, the agreement between you and your employer and the purchaser 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.

Queensland does not have specific laws governing restraints of trade, but case law and the Competition and Consumer Act 2010 (Cth) (the Act) determine the principles of such clauses.

It is clear from the agreement that the payment for entering into the restraint deed is part of the purchase agreement and separate from your employment. Accordingly, it is accepted the payment are for, or in respect of, a legally enforceable contract in the restraint deed.

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 section 82-135 of the ITAA 1997. Each case needs to be determined on its own merits.

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

In your case, the payment to be made in accordance with the agreement are calculated by reference to the following:

•           Your existing part-time salary - $XXX,000 (standard hours for X day/s per week).

•           The term of restraint - X Years.

•           The scope- the restraint applies Australia wide.

•           Your position in the company at the time - chairperson.

•     The value of the restraint to purchaser as goodwill.

On face value, given your position as chairperson, the value of the restraint to the purchaser, the nature and scope of the restraint, the amount of consideration would appear reasonable. Therefore, because the payment is of a capital nature, it is for a restraint of trade that is legally enforceable and it is reasonable having regard to the nature and extent of the restraint, the payment is not an employment termination payment.

Capital gains tax consequences

CGT event D1

Section 104-35 of the ITAA 1997 states that CGT event D1 happens if there is a transaction involving an amount being received for entering into a restrictive covenant.

The time of CGT event D1 is when the taxpayer enters into the contract. You signed the restraint deed on X X, 20XX. While we acknowledge a taxpayer makes a capital gain from CGT event D1 if the capital proceeds from creating the right are more than the incidental costs incurred in creating it. If the capital proceeds are less than the incidental costs, a capital loss is made. A capital gain from CGT event D1 cannot be a discount capital gain.

In your case, CGT event D1 happened when you entered into the agreement on X XX 20XX, with term to commence effective of the completion on X XX 20XX. This agreement created rights for you to receive a payment in the future. These rights are intangible assets. The cost base in this instance includes the costs incurred in entering into the agreement.

The capital proceeds are the value of the assets, that is, the value of the rights to receive a future payment.

Any capital gain made as a result of entering into the restrictive covenant with Company and the Purchaser would be assessable in the 20XX financial year.

CGT event C2

Section 104-25 of the ITAA 1997 states that CGT event C2 happens if a taxpayer's ownership of an intangible CGT asset ends because the asset expires or is redeemed, cancelled, released, discharged, satisfied, abandoned, surrendered or forfeited.

A capital gain is made if the capital proceeds from the ending are more than the asset's cost base. A capital loss is made if those capital proceeds are less than the asset's reduced cost base. The capital gain or loss is the difference between the amounts.

The time of the event (and so the time when a capital gain or loss is made) is:

•                when the taxpayer enters into the contract that results in the asset ending, or

•                if there is no contract - when the asset ends.

CGT event C2 will happen when you receive a payment from the Company in relation to your agreement, because the receipt of that payment means that your right to receive it (i.e. the asset) has been extinguished.

Question 2

Is the resulting capital gain from the receipt of the payment a discount capital?

Answer

No.

Summary

Section 115-25(3) of ITAA 1997 excludes the CGT general discount from applying to capital gains arising from a number of CGT events including, (a) CGT event D1-creating contractual or other rights.

Conceptually, the CGT general discount could not apply to the CGT events listed in ss 115-25(3)(a) to 115-25(3)(f) of ITAA 1997 even without their specific mention therein. This is because the CGT asset involved comes into existence when the CGT event occurs so that the 12-month holding rule never could be satisfied. Furthermore, the fact the execution and completion of the restraint deed happens within less than 12 months means the discount for CGT would not be available in your circumstance.

Discount capital gains

A discount capital gain is a capital gain that satisfies the requirements of Subdivision 115-A of the ITAA 1997.

To be a discount capital gain, a capital gain must:

•                Be made by an individual, a complying superannuation entity, a trust, or by a life insurance company from a CGT event in respect of a CGT asset that is a complying superannuation asset.

•                Result from a CGT event happening after 11:45am EST on 21 September 1999.

•                Be worked out without the cost base being indexed, and

•                Result from a CGT even happening to a CGT asset owned by the taxpayer for at least 12 months.

Timing

While it is clear the initial executive services agreement contained retractations around conduct after employment ceased, it is still considered separate from the restraint deed. This is because, the terms, the parties involved, and consideration and time-line indicate that it is separate. The completion date for example highlighted under clause X of the restraint deed states, the restraint deed was executed X XX 20XX and the completion date is defined as X XX 20XX or date otherwise agreed by the Buyers and Sellers. This makes it clear, the restraint deed and payment in question commenced after the execution of on X XX 20XX and ended with the receipt of the payment on the X XX XX.

Creation of a new asset

The CGT discount is not available for a CGT event that creates a new asset and a capital gain. This might happen, for example, with a restrictive covenant, where you receive payment for agreeing not to do something or granting a lease.

Section 115-25(3) of the ITAA 1997 excludes the CGT general discount from applying to capital gains arising from a number of CGT events including, (a) CGT event D1-creating contractual or other rights.

Capital gains from the CGT events mentioned in paragraphs (3)(a) to (f) are not discount capital gains because the CGT asset involved in the CGT event comes into existence at the time of the event, so it is impossible to meet the requirement in this section that the asset have been acquired at least 12 months before the event.

Conclusion

Conceptually, the CGT general discount could not apply to the CGT events listed in subsections 115-25(3)(a) to 115-25(3)(f) of the ITAA 1997 even without their specific mention therein. This is because the CGT asset involved comes into existence when the CGT event occurs so that the 12-month holding rule never could be satisfied. Furthermore, the fact the execution and completion of the restraint deed happens within less than 12 months means the discount for CGT would not be available in your circumstance even if section 115-25(3) did not apply.

Copyright notice

© Australian Taxation Office for the Commonwealth of Australia

You are free to copy, adapt, modify, transmit and distribute material on this website as you wish (but not in any way that suggests the ATO or the Commonwealth endorses you or any of your services or products).