After years of contradictory rulings issued by the District
Courts, the Supreme Court recently resolved the ambiguity
surrounding the classification of compensation in respect of
non-competition covenants when employees leave employers. The
Supreme Court deliberated the question of whether at issue is a
capital gain that is subject to capital gains tax (25%) or earnings
that are taxable as employment income (up to 48%).
The Supreme Court examined three district court appeals and
ruled that, in most instances, compensation in respect of
non-competition covenants being paid upon severance of employment
relations shall be classified as employment income, pursuant to
section 2 (2) of the Income Tax Ordinance [New Version],
5721 – 1961 ("the Ordinance"). Basically,
the court reduced the maneuvering room for classifying
The Supreme Court clarified the procedure for classifying such
income and ruled that the examination of non-competition receipts
for tax purposes is a two-stage process. During the first stage,
the examination must ascertain whether at issue is truly a
non-competition covenant or merely camouflage for other payments
(such as wages or a severance bonus). During the second stage, the
examination must ascertain whether the presumption of
"employment income" can be refuted under the
circumstances and proven to be a capital receipt.
The Supreme Court clarified that, in instances whereby both
classifications are possible – both capital and revenue, the
revenue classification shall prevail. Therefore, in order to
classify a receipt as a capital receipt, the taxpayer must convince
the tax authorities that the receipt does not involve mixed
characteristics; i.e., under no circumstances can the receipt be
classified as employment income.
In its ruling, the Supreme Court relied on the principle that
compensation that a taxpayer receives is classified according to
the loss being compensated. The compensation granted to an employee
in respect of the expected decrease in wages resulting from the
non-competition covenant is in essence compensating the employee
for the loss of career opportunities at competitors of his former
employer. Consequently, according to the Court, this receipt shall
be classified according to its purpose – and a substitute for
wages shall be classified as employment income.
The court also clarified that it makes no difference whether the
non-competition payment is paid out as a one-time payment or is
paid over the "non-competition" period, and it makes no
difference whether the non-competition agreement was signed when
the employee was hired or just prior to severance.
We wish to point out that, notwithstanding this Supreme Court
ruling, circumstances still exist under which it will be possible
to classify non-competition receipts as capital receipts; for
example: in instances whereby an employee's qualifications are
not transferable to another branch of the economy (differentiating
between a structural engineer who is precluded from engaging in
structural engineering and a manager of a real-estate firm, who is
precluded from managing real-estate firms but can use his
managerial expertise in other sectors). Furthermore, when at issue
are qualifications that are liable to become outdated for lack of
use thereof, or when at issue is a sweeping covenant of
non-competition with no time limit, which basically prevents the
employee from engaging in his profession in the future, to the
point that he is ejected from the market, these types of
circumstances serve as de facto compensation for the
personal ability to work; in such cases it is still possible to
argue that at issue are capital receipts.
Originally published August 25, 2016
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Nigeria is a federal constitutional republic located on the west coast of Africa. Modern Nigeria has its origins as a British colony through the 19th and 20th century until it achieved independence in 1960.
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