Supreme Court: Compensation for Non-Compete Undertakings Should Be Taxed as "Ordinary Income"
21/08/2016
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Dear clients and friends,

A recent decision handed down by Israel’s Supreme Court (the Hon. Yitzchak Amit, J.), clarifies an area of the law regarding the taxation of compensation received by an employee as consideration for a non-compete obligation, and further clarifies the test applicable for distinguishing between “ordinary Income”, and “capital gains”, for the purposes of taxation.

Background
In order for a non-compete obligation undertaken by an employee to be effective, Israeli employment law requires (among other things) that the employee be amply compensated for assuming that obligation.

The question that arose in three appeals recently decided by the Supreme Court was whether such compensation should be deemed “ordinary income” or “capital gains”, for tax purposes. Previously, this question has been the subject of conflicting rulings of the District Courts. Three rulings in particular gave rise to the appeals brought before the Supreme Court (Joined Civil Claims 5083/13, 7060/13 and 3051/14; Income Tax Assessor (Kfar Saba) v Yosef Barnea, Income Tax Assessor (Haifa) v Meir Avidan, and Abraham Kringel v Income Tax Assessor (Tikvah)).

Distinguishing between Ordinary Income and Capital Gains in the context of Employer–Employee payments

The Supreme Court ruled that in the absence of a specific legislative provision to the contrary, there is a presumption (which may be refuted by the taxpayer – here the employee) that compensation paid by an employer to an employee constitutes ordinary income, which is taxable at such employee’s prevailing marginal rate of income tax.
The Supreme Court clarified that payments made as compensation for a non-competition undertaking are also subject to this presumption, even where such payments were made after termination of the employer-employee relationship.

Classifying Payments made for under Non-Competition Undertaking for the Purposes of Taxation

In its decision, the Supreme Court created a two-stage test for determining the classification of amounts received for a non- competition undertaking. The first stage is to determine whether the non-compete undertaking is genuine, or whether it constitutes an attempt to mitigate tax exposure for amounts received upon the termination of employment. The second stage is to evaluate the non-competition undertaking, and the payments made therefor, and determine whether or not it refutes the presumption that the compensation is ordinary income. The Supreme Court noted with respect to the second stage that compensation provided for abstaining from employment is in fact paid in lieu of salary, and therefore amounts to salary provided for work and is thus classified for tax purposes as “ordinary income”.
Additionally, while the Supreme Court did not rule out the possibility that exceptional cases might arise in which compensation for a non-competition undertaking would constitute “capital gains”, the Supreme Court noted that these circumstances are rare, insofar as non-competition undertakings generally only limit an employee’s ability to work in their chosen field for a number of years, and do not require them to forfeit their ability to work in that field on a permanent basis.

This publication provides general information and should not be used or taken as legal advice for specific situations, which depend on the evaluation of precise factual circumstances.

 

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