Edited version of private ruling

Authorisation Number: 1011812629378

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Ruling

Subject: Assessibility of payment received after signing deed of release

Question 1:

Is the payment to you by your former employer, subject to the agreement of the 'Deed of Release' upon termination of your employment, assessable as an Employment Termination Payment?

Answer:

No.

Question 2:

Is the payment to you by your former employer, subject to the agreement of the 'Deed of Release' upon termination of your employment, subject to capital gains tax?

Answer:

Yes.

This ruling applies for the following period:

Year ended 30 June 2010

The scheme commences on:

1 July 2009

Relevant facts and circumstances:

You resigned from a managerial post with an Australian private company in early 2010.

The circumstances behind your resignation stemmed from a workplace issue.

You believe that you were obliged by law to report some of the Occupational Health and Safety (OH&S) related practices of the company to a government authority.

In addition, you believe that you were personally liable given that you had knowledge of the potential dangers your employer was exposing the workers and the general public to.

You have provided copies of your email and resignation letter to your former employer detailing these issues and the lack of support you have received from the company to address these concerns.

You have also provided the 'acceptance of resignation' and 'offer of settlement' letters from your employer with the details of proposed termination payments.

Your employer has emphasised that your position within the company was not made redundant; therefore you are not entitled to a redundancy payment.

As per the evidence you have provided you received two different payments from your employer upon termination.

You would like us to determine the characteristics of the second payment that basically represents a promise to pay an amount of money in return for signing the Deed.

By signing the Deed you have legally agreed not to take up any business or activity, which is in competition with the business of the company, for a specific period after the termination of your employment.

You have stated that you are unable to determine whether this payment is taxable due to the following:

· the payment is related to your resignation

· your resignation was a 'no option other than resign' situation

· your resignation was also classed as 'constructive dismissal'

· your resignation took place in the context of the 'general duty of care provision' of the OH&S Act

· no superannuation contributions were made in relation to this payment

· the payment was subject to signing of a Deed that contained a 'no compete' clause; this clause effectively cancels any compensation benefits

· the overall nature of the payment taking into account the content of your resignation letter, your former employer's offer and the conditions imposed on this offer.

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 received a lump sum amounts in return for entering into a restraint of trade agreement with your former employer. 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 in future.

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 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.

In your case, the agreement between you and your former 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. 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 payment to you was made in accordance with the agreement of the Deed of Release, by which you are obliged to restrain from competing with your employer company for a definite period from the date of termination of your employment.

You were offered a lump sum payment to cover your salary and wages for a period that is almost as long as the period of restraint, in lieu of full and final settlement of the matter, as outlined in the Offer of Settlement letter from your employer.

It is apparent that the payment was calculated by reference to the period of the restraint. On face value, given your position in the company 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 former employer. This agreement created a right for you to receive the payment. This right is an intangible asset. The cost base in this instance includes the costs incurred in entering into the agreement. The capital proceeds are the value of the asset, that is, the right you have received.

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 happened when you received a payment from your former employer in accordance to the 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.

Therefore the payment in question is capital in nature and subject to capital gains tax in your 2009-10 tax return.