Be careful if you structure a restraint of trade agreement with your employer to avoid paying income tax. The taxman is prepared to wallop you if it is not a genuine restraint.
Recently Bryan Hopkins, who left as chief investment officer of Old Mutual to join Harvest Securities, a subsidiary of financial services company PSG, said in court documents that he had been paid a restraint of trade to reduce his tax commitment.
He argued that the restraint of trade he signed with Old Mutual for R2 million did not stop him from leaving Old Mutual and setting up with a new business while the agreement was still in force as it was an employment incentive.
Hopkins said in an affidavit dated January 18, 1999 in the matter between Old Mutual and Bryan Hopkins and 15 others: "I say the restraint of trade agreement was not a bona fide restraint of trade agreement and was not in fact intended to protect Old Mutual Asset Management's proprietary interest. The true purpose of the restraint of trade agreement was to provide me (and other selected staff of OMAM who concluded such agreements) with a tax-free capital sum as an employment incentive."
Hopkins and some of the people who left Old Mutual Asset Management at the same time are likely to face some tough questions from the taxman as a result.
Most restraints of trade are structured to pay a lump sum to an employee which effectively prevents that employee leaving and working in the same category of job somewhere else for a limited period of time.
Restraints of trade have become increasingly popular to lock in key personnel. They are also being used extensively to tie up rugby players for particular provinces.
The South African Revenue Services (SARS) says that capital gains are not taxable in terms of the Income Tax Act. In other words any genuine restraint of trade is seen as a capital gain and not as income and therefore is tax free.
However, in reply to questions sent by Personal Finance, W P Coetzee of SARS, said that the taxman also has "the power to ignore transactions or schemes entered into in order to derive a tax benefit only".
Coetzee said that when you complete a form you have to sign that it is "true and correct". Should you make an incorrect statement that will result in you paying less tax "severe penalties will be imposed".
And if any person assists any other person to evade "assessment or taxation" the taxman can also take action. So if an employer deliberately entered into a scheme such as a restraint of trade, to allow it to be used only to avoid tax, then the employer would also face tough penalties.
Coetzee said the taxman's view on restraint of trade payments in general was that "an employee cannot be restrained during the period he is still in his employer's employ.
"Restraint payments, by their very nature are intended to protect the former employer against unfair competition. Therefore regard must be had to the real reasons that give rise to restraint.
"Regard should also be had of the substance of the transaction and not its form only."
Coetzee declined to comment directly on the Hopkins affidavit "because of secrecy provisions in section 4 of the Income Tax Act".
However, he said "should this type of statement be made, this will not go unnoticed and will definitely receive the Commissioner's close attention".