Edited version of private advice

Authorisation Number: 1052246900943

Date of advice: 14 May 2024

Ruling

Subject: CGT - restraint of trade payment

Question 1

Is the lump sum payment received under the restraint of trade clause in your original employment contract assessable as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Is the lump sum payment received under the restraint of trade clause in your original employment contract an employment termination payment (ETP)?

Answer

No.

Question 3

Did CGT event C2 happen when you received the restraint of trade payment?

Answer

Yes.

Question 4

Are you eligible for the 50% CGT discount in relation to the assessable capital gain resulting from CGT event C2, which happened when you received the restraint of trade payment?

Answer

No.

This ruling applies for the following periods:

Year ended 30 June 20XX

Year ended 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

You entered into a Fixed Term Employment agreement (the original employment contract) with your employer in late 20XX (several years ago) in relation to a managerial position.

A specific clause of the original employment contract imposes various restraint terms on you during a specified restraint period (one year following the termination of your employment).

Another clause of the original employment contract states that subject to you being employed for at least a certain set period of time, upon termination of your employment you will receive a payment (restraint of trade payment).

In late 20XX (a couple of years after you commenced the employment), you then signed an offer of permanent part time employment (subsequent employment contract) with your employer.

The subsequent employment contract stipulated that many of the terms would be on the same terms as the original employment contract (including all of the various restraint terms set out in relevant clause).

You resigned from your employment in late 20XX (several years after you commenced the employment), with your final day of employment being a few days later.

Your employer issued a severance letter to you which refers to the restraint of trade payment as per the relevant clause of your original employment contract.

You signed acknowledgement of the severance letter in late 20XX.

You received the restraint of trade payment a day after you signed acknowledgment of the severance letter.

Relevant legislative provisions

Income Tax Assessment Act 1936 Section 170

Income Tax Assessment Act 1997 Section 6-5

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

Income Tax Assessment Act 1997 Section 102-25

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Section 104-35

Income Tax Assessment Act 1997 Section 115-5

Income Tax Assessment Act 1997 Section 115-10

Income Tax Assessment Act 1997 Section 115-15

Income Tax Assessment Act 1997 Section 115-20

Income Tax Assessment Act 1997 Section 115-25

Reasons for decision

Question 1

Summary

The lump sum payment received under the restraint of trade clause in your original employment contract is not assessable as ordinary income, as it is a one-off lump sum payment that does not meet the characteristics of ordinary income.

Detailed reasoning

Section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of a taxpayer includes income according to ordinary concepts (ordinary income).

Ordinary income has generally been held to include three categories, namely income from rendering personal services, income from property and income from carrying on a business.

Other characteristics of income that have evolved from case law include receipts that:

• are earned
• are expected
• are relied upon; and
• have an element of periodicity, recurrence, or regularity.

In your case you received a restraint of trade payment that is not income from rendering personal services, income from property or income from carrying on a business.

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 have received a lump sum payment in return for entering into a restraint of trade agreement with your former employer. This payment does not relate to you carrying on an income earning activity. For this reason, the payment is considered to be capital in nature.

Accordingly, the lump sum payment is not ordinary income and is therefore not assessable under section 6-5 of the ITAA 1997.

Question 2

Summary

The lump sum payment received under the restraint of trade clause in your original employment contract meets the criteria for being excluded from the definition of an employment termination payment (ETP), as set out in paragraph 82-135(j) of the ITAA 1997. As such this payment is not classed as an ETP.

Detailed reasoning

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

You have received a lump sum payment in return for entering into a restraint of trade agreement with your former employer. For the reasons noted above in the explanation of the decision to question 1, the payment is considered to be capital in nature.

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

The next issue for consideration is whether the relevant clause of the original employment contract amounts 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.

At common law, a restraint of trade is not enforceable if it is unreasonable in relation to the interests of either the parties to the restraint or the public. A restraint of trade applying to one person for one year which was agreed to by that person for consideration of a significant sum, does not seem to be unreasonable in relation to the interests of either the parties involved or the public. Consequently, the restraint of trade appears to be legally enforceable.

It is clear from the original employment contract that the payment is for entering into the restraints set out in the relevant clause of your employment contract. Accordingly, it is accepted the payment is 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 is for the equivalent of six months' salary at your total cost remuneration rate prevailing at the time of the payment. Given your position in your previous employment, 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.

Question 3

Summary

CGT event C2 happened upon you receiving the restraint of trade payment in late 20XX as this was when your ownership of your intangible CGT asset ended. This intangible CGT asset was your right to receive the payment, which you only held upon termination of your employment in late 20XX as per the relevant clause of your original employment contract.

Although CGT event D1 may apply in relation to a restrictive covenant, section 102-25 of the ITAA 1997 provides that D1 will not apply if another CGT event happens in your situation. As C2 happens in your case, D1 will not apply.

Detailed reasoning

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 the restraint of trade payment from your former employer in late 20XX, because the receipt of that payment meant that your right to receive it (that is, the asset) had been extinguished.

The relevant CGT asset in your case is the right to receive the payment, which you only held upon termination of your employment in late 20XX as per the relevant clause of your original employment contract.

The cost base in this instance would include any costs incurred in entering into the agreement, and the capital proceeds is the restraint of trade payment you received after your employment was terminated.

Any capital gain which arises from the CGT C2 event should be declared in your 20XX income year tax return.

It is noted that CGT event D1 may apply in relation to a restrictive covenant. However, under section 102-25 of the ITAA 1997, D1 will not apply if another CGT happens in your situation. As C2 has happened in your case, D1 will not apply.

Question 4

Summary

You are not eligible for a discount capital gain in relation to the assessable capital gain resulting from CGT event C2 happening upon you receiving the restraint of trade payment, as you have not held the relevant CGT asset for 12 months or more.

Detailed reasoning

Section 115-5 of the ITAA 1997 details that a discount capital gain is a gain that meets the requirements of sections 115-10, 115-15, 115-20 and 115-25 of the ITAA 1997. The basic requirements for a discount capital gain are:

• capital gains made by an individual
• made after 21 September 1999
• not have an indexed cost base
• on an asset held for at least 12 months.

In your case, you have met the first three of the abovementioned requirements. However, you have not met the last requirement, which is you holding the CGT asset for at least 12 months before the CGT event occurs.

As noted above, CGT event C2 happened when you received the restraint of trade payment as this was when your intangible asset ended.

The relevant CGT asset in your case was the right to receive the payment, which you only held upon termination of your employment. This is because under the relevant clause of the original employment agreement which you signed in late 20XX (several years ago), the restraint of trade payment was only available to you upon termination of employment, which in your case occurred in late 20XX (several years after you commenced the employment).

As such, given you only received the restraint of trade payment a short time (and less than 12 months) after you first held the right to demand that payment, you are not eligible for the CGT discount in relation to the assessable capital gain from CGT event C2.

Note that paragraph 115-25(3)(a) of the ITAA 1997 specifically provides that a capital gain from CGT event D1 is not eligible for the 50% CGT discount. Therefore, even if CGT event D1 applied instead of C2 in your case, you would still not be eligible for the 50% CGT discount.