In an increasingly competitive market, and with the need to keep new innovations and techniques as secure as possible, a question often askedis what are the tax consequences of imposing a restraint of trade on an employee.
Perhaps the place to start in answering this question is to define the term. A restraint of trade is an agreement in terms of which one of the parties undertakes not to exercise his or her trade or profession in the field of the other party for a defined period of time. In return the person agreeing to the undertaking is paid an amount of money that is designed to reflect the price which the restraining party is prepared to pay to ensure that the person being restrained will not damage its business.
So, for example, if you work in the pharmaceutical industry and have been exposed to the development of certain drugs and you resign, your employer may feel that you could damage its business if you go to a competitor. So it may offer to pay you a specified amount of money not to join a competitor in the areas in which it operates for a specified period of time.
Alternatively, you may be in management and may be privy to certain strategic plans which your employer would not like its competitors to be able to adopt. Again the employer may pay you an amount to secure an undertaking from you that you will not work for a competitor within the area in which it operates for a certain period of time.
As the restraint payment is made to ensure that you are not able to exercise your skills it is a capital receipt and therefore not taxable in your hands. Similarly, because your employer has paid the restraint to you to protect its income earning structure the payment will not be taxable in its hands.
It is important, if the South African Revenue Services (SARS) is to accept that the receipt is not taxable, that the restraint is genuine. (You are obliged to reflect the receipt of your tax return in the section for non taxable receipts).
For the restraint agreement to be genuine it must demonstrate that the payment will protect your employer's business. The restraint must therefore be enforceable. It is not sufficient that you merely agree not to compete. It is also important that you are able to demonstrate that you were in a position to be able to damage your employer's business.
The SARS is sensitive to the fact that taxpayers may try to treat lump sums that would have been taxable in their hands, for example leave pay accrued on termination of employment, as a restraint amount, albeit that the amount would cease to be deductible in the employer's hands. SARS often asks detailed questions about the restraint and other amounts that the taxpayer has received on resignation. Therefore it is important that any restraint paid is genuine and enforceable.
You need to be aware of this if you agree to accept a restraint of trade payment since, if it is enforceable, the restraint contract will limit your ability to earn income. It is important that the amount paid to you sufficiently compensates you for this fact.