Manage your Practice: Restraint of trade

Disputes relating to restraint of trade agreements often come before the labour courts. However, the tax consequences of consideration received for a restraint of trade imposed on a person were recently before the Tax Court.1 The taxpayer took the view that the receipt of the restraint was capital in nature. SARS did not agree and accordingly adjusted it as an ‘income’ and included it in the gross income of the recipient.

HISTORICAL DEVELOPMENT
Historically the Income Tax Act (the Act) did not specifically deal with restraint payments. According to Judge Farlam, ‘payments made to an employee in exchange for an undertaking not to compete with his employer, i.e. payments for agreeing to a restraint of trade, have been held in a series of cases to be of a capital nature’.2 Such amounts consequently ‘did not fall within’ a taxpayer’s ‘gross income’. However, where the agreements did not ‘contain genuine restraint of trade covenants’ and the consideration received by the employee represented ‘disguised remuneration for services rendered or to be rendered’, the amount received would have constituted gross income.
The Act was amended to specifically include certain amounts that accrued in respect of a restraint of trade, in gross income and to allow the person paying the amount a deduction3 of the amount so incurred. As a result of this amendment, with effect 23 February 2000, any amount received by or accrued to any natural person as a restraint of trade imposed on the person was included in the gross income4 of the recipient. This amendment resulted in such receipts being included in gross income for all natural persons, and not only those linked to an employment relationship.
An amendment, effective from 1 March 2015, ensured ‘that only those individuals who have received the payment as a result of any past, present, or future employment with the entity making the payment will have the receipt included in gross income’.5

WHAT IS A RESTRAINT OF TRADE?

A restraint of trade imposed on an employee
According to Judge Musi, in the Labour Appeal Court:6

• A contract in restraint of trade is one that prevents an employee from exercising his or her trade, profession or calling, or engaging in the same business venture as the employer for a specified period, and within a specified area after leaving employment.
• Employers restrain employees in their service contracts to the extent that an employee who leaves the employ undertakes not to compete with his/her former employer, either independently or in the employ of another.
• The legitimate object of a restraint is to protect the employer’s goodwill and customer connections (or trade secrets) for a specified period after the employment relationship has come to an end.

When will an amount have to be included in the gross income of the recipient?

The income tax consequences
In order to give context, the facts of the tax case mentioned earlier will be used:

• The taxpayer, together with another person, formed a successful business of processing mining by-products containing gold, silver and other metals. Both of them were appointed as directors of the business (company).
• The letter of appointment of the taxpayer, as an employee, provided for a restraint of trade covenant for twelve months after termination of employment.
• The long-term relationship between the two directors broke down, resulting in various disputes and conflicts between the parties. The main dispute concerned the value of the share held by a trust in the company. This dispute was finally resolved and the parties entered into a share-buy repurchase agreement in terms of which the shares of the trust were sold to the company. Two separate settlement agreements were concluded between the parties.
  o A share-buy purchase agreement, which the taxpayer was not a party to, which was subject to a suspensive condition which, amongst others, required the conclusion of a restraint of trade agreement with the taxpayer.
  o In terms of a second agreement the taxpayer was entitled to the payment of R60 million.

The company and the taxpayer were parties to the second agreement, and the following detail appear in clauses therein:

• The taxpayer is an erstwhile director and key employee of the company and various other subsidiaries thereof. The taxpayer ceased to be
  (i) an employee of such companies on or about October 2010 and
  (ii) a director of such companies on or about June 2011.
• An undertaking by the taxpayer not to compete with companies which are subsidiaries of the company for a period of five years.
• An acknowledgement that as a director and key employee of the company and various subsidiaries thereof, he has been exposed and has had access to, and has learnt of certain confidential information.

The taxpayer approached SARS, about the sale of the interest by the trust and legal expenses incurred by him in respect of the dispute, and purportedly obtained a document that the amount received should be capital in nature. The taxpayer’s advisor, a chartered accountant registered as a tax consultant with twenty-seven years of experience, during cross-examination admitted that this document ‘did not refer to the restraint of trade agreement’ and ‘indicated during cross-examination that he could not tell whether the amount received constituted a capital gain’.
It is reasonable to assume that the employer also erred in this respect and did not withhold any employees’ tax when the amount was paid to the employee.

Must the amount be included in the taxpayer’s gross income?

Paragraph (cB) of the definition of gross income
In terms of this paragraph, and for purposes of the Act, ‘gross income’ includes an amount (whether of a capital nature or not) received by or accrued to any natural person as consideration for any restraint of trade imposed on that person in respect or by virtue of −
(i) employment or the holding of any office; or
(ii) any past or future employment or the holding of an office …

The paragraph specifically refers to employment and it was undisputed that the taxpayer, apart from being a director of the company, was also in a contract of employment with the company.

Factually, the restraint of trade agreement came into being consequent to the suspensive condition in the purchase and sale of the shares agreement. The purchase and sale agreement, however, was between the employer company and the trust, and the restraint of trade agreement, on the other hand, was between the employer and the taxpayer.

The question is whether the amount accrued to the taxpayer, a natural person, in respect or by virtue of employment (or past employment). This phrase was previously also found in paragraph (c) of the definition of gross income. Judge Howie said7 that ‘there is no material difference between the expressions “in respect of” and “by virtue of” in paragraph (c)’ and that ‘they connote a causal relationship between the amount received and the taxpayer’s services or employment’. With respect to the ‘causal relationship’, the judge said that the ‘question which requires answering is not: what was the factor or event which prompted the board to decide to make the ex gratia payment?’, but that the ‘question to answer is rather: why was the payment made to those who received it?’ And also that as ‘long as the motivation was to give the recipients a benefit in recognition of their service in’ their employer’s ‘employment then there was an unbroken causal relationship between the employment on the one hand and the receipt on the other’.

Does the evidence show that there was an unbroken causal relationship between the taxpayer’s employment and the payment of the R60 million?

The taxpayer was of the view that there was no direct causal connection between his employment with, or appointment as a director of, the company and the restraint of the trade agreement. On his behalf it was contended that the restraint was not imposed as a result of his employment but rather to protect the shares in the company.

Judge Molahlehi said that it was not disputed that the purchase and sale agreement was between the company and the trust, and that the restraint of trade agreement was between the employer and the taxpayer. It was the employer that, in terms of the second agreement, paid the consideration to the taxpayer. In the judge’s view,

• It was clear from the proper reading of two clauses of the restraint of trade agreement that the restraint has a direct link with the employment contract and the position of the individual as a director of the company,
• The taxpayer ‘acquired knowledge and confidential information by virtue of having been a key employee and director of Holdings’,
• That the contention of the taxpayer that the payment he received was ‘by virtue of the share purchase agreement’ is unsustainable, as he was not a party to that agreement.

The judge concluded that ‘the restraint of trade was imposed on him by virtue of his employment, thus bringing the restraint of trade within the sphere of’ paragraph (cB) of the definition of gross income in section 1(1) of the Act (employment or past employment).
An amount referred to in paragraph (cB) of the definition of ‘gross income’ is ‘remuneration’8 and consequently subject to the withholding of employees’ tax.

CONCLUSION
The parties negotiating a restraint of trade agreement must take care and it is advisable to record exactly why the consideration for the imposition of the restraint was payable. Where there is no causal link to employment, a capital gain would arise and the person making the payment thereof would then not be entitled to make a deduction of the amount incurred.

Where the amount accrues as consideration for a restraint of trade imposed on a natural person in respect of or by virtue of his or her employment, the amount would constitute gross income and it would also be remuneration subject to the withholding of employees’ tax. The employer would be entitled to make a deduction, albeit over a period, of the amount incurred in respect of such a restraint payment.

NOTES
1 Tax case IT 45628, judgment delivered on 17 August 2022, https://www.sars.gov.za/legal-drj-tc-2022-09-sarstc-it-45628-it-2022-zatc-jhb-17-august-2022/.
2 Maguire v The Commissioner for the South African Revenue Service (731/07) [2008] ZASCA 156, 27 November 2008.
3 In terms of section 11(cA) of the Income Tax Act and the deduction is spread over a period.
4 In terms of paragraph (cA) of the definition of gross income in section 1(1) of the Act.
5 This was achieved by adding paragraph (cB) to the definition of gross income.
6 In Bonfigioli South Africa (Pty) Ltd v Panaino (CA 19/13) [2014] ZALAC 59; (2015) 36 ILJ 947 (LAC), 23 October 2014.
7 Stevens v CSARS [2006] SCA 145 (RSA).
8 In terms of paragraph (a), of the definition of ‘remuneration’ in paragraph 1 of the Fourth Schedule to the Act.

Author
PJ Nel CA (SA), Project Director: Tax at SAICA