Edited version of private ruling

Authorisation Number: 1011761976400

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Ruling

Subject: Restraint of trade payment

Questions and answers:

Will the payments made to you by your employer after your retirement be treated as employment termination payments for tax purposes?

No.

Will the payments made to you by your employer after your retirement be treated as ordinary income for tax purposes?

No.

Will the payments made to you by your employer after your retirement be subject to capital gains tax?

Yes.

This ruling applies for the following periods:

Income year ending 30 June 2011

Income year ending 30 June 2012

Income year ending 30 June 2013

The scheme commenced on:

1 July 2010

Relevant facts and circumstances

You retired in the income year ended 30 June 2011.

In the income year ended 30 June 2009 you entered into an agreement with your employer regarding the transfer of certain clients you presently service following your retirement.

You and your employer agreed that your employer would pay you periodical payments for X years.

These payments would represent consideration paid for passing across to your employer the clients presently serviced by you, in recognition of your proprietary interest in the clients and the fact that you were responsible for introducing them to your employer.

The proposed payments were agreed to in return for you agreeing to a restraint of trade period of X years following your retirement.

The clients transferred are expected to generate future revenue for your employer.

The payments have been calculated in reference to the revenue generated by the clients. In particular, the payment amounts made have been calculated at a defined percentage of the respective client revenue generated.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 82-135.

Income Tax Assessment Act 1997 Section 104-25.

Income Tax Assessment Act 1997 Section 104-35.

Reasons for decision

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

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.

A payment for restraint of trade must therefore 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

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 will be receiving monthly payments in return for entering into a X year restraint of trade agreement with your employer and in recognition of you passing across your client base to your employer following your retirement. These payments do 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 of trade

The first issue for consideration is whether the provisions of the agreement 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.

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

The Restraints of Trade Act 1976 applies to restraints of trade in NSW. Section 4 of this act makes a restraint of trade invalid where it is against public policy. There is nothing the clause of the agreement which appears to be against public policy. Therefore the restraint of trade appears to be legally enforceable under this act.

The Trade Practices Act 1974 also applies to restraints of trade. Sections 45 and 45B make unenforceable, contracts and covenants for restraint of trade where the effect of the contract or covenant is a substantial lessening of competition in the market. It is difficult to see how a restraint of trade applying to one person engaging in the business activities specified for 3 years would result in a substantial lessening of competition in the market. Therefore the restraint of trade appears to be legally enforceable under this act.

It is clear from the agreement that the payments are for entering into the restraints and for passing across your client base. 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 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 payments to be made in accordance with the agreement are calculated by reference to the period of the restraint and the income you would have received had you not retired. On face value, given your previous employment position, and the nature of the restraint, this 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.

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 with your employer. This agreement created rights for you to receive payments 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 future payments.

Any capital gain made as a result of entering into the restrictive covenant 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 each time you receive a payment from your former employer 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.

When CGT event C2 occurs the cost base will include the value of the asset, and the capital proceeds will be the monetary amount received.