Taxation of payment for a non-compete obligation

June 4, 2018
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The article was published in Afik News 258 06.06.2018

In the framework of a merger transaction, the manager of a company or a shareholder signs a non-competition agreement and receives monetary compensation in consideration thereof. A few years later, during an audit by the Tax Authority, the Authority suddenly contends that the compensation is considered labor income and must be taxed accordingly (a tax significantly higher than capital income). Is that so?
In today’s business world many companies choose to purchase other companies or companies merge into others, and officers or shareholders in those companies that do not continue with the company sign non-competition and confidentiality agreements that limit them in the continuation of their business in the field. Sometimes this is limited to a short period of time and to a limited area of activity, and sometimes the non-competition obligation is very broad. Especially when it comes to the broad application of these non-compete obligation, they are generally accompanies by significant monetary compensation for the officer in respect of the limitations agreed to be undertaken. However, from the tax point of view, the Tax Authority may subject this compensation to a labor (and not capital) tax regime under certain circumstances, and one should be aware of this in advance and be prepared accordingly as this classification has a far-reaching impact on the tax rate applicable to the compensation.
There are two approaches as to how to tax a non-competition obligation – as the sale of a right, in which case the tax rate is 25% or as labor income for which the tax rate is marginal and can reach 50% plus National Insurance and Health Tax
Labor income is any recurring payoff on a regular basis. For example, it can be determined that the expected income from a fixed source, such as a wage, or from a business owner who operates his business and for that purpose repeats the same activities or services, is a labor income. It is like a tree owner who picks fruit and sells it. In contrast, “capital” income is a one-time event, which is not the normal course of business, and deals with the creation of income from an exceptional event (in most cases). In this case, it is possible to simulate the creation of the income to cutting and selling the tree.
Israeli case law sets that in order to determine how the compensation awarded for non-competition will be taxed, a series of tests should be applied. Among other, the Court will examine the wording of the agreement and whether this is a real non-competition agreement or whether it is a cover for payment of another kind. Moreover, the more vague the construction of the agreement, the greater the risk of seeing it as a labor income and the higher the tax risk. Thus, negligence of the parties in drafting the agreement may result in a Court viewing the one-time compensation as labor income rather than capital, even where the entire tree is cut. In a verdict given March 2018, the Supreme Court of Israel discussed a case in which a company acquired another company and a number of its officers retired and executed a non-competition undertaking against receipt of large amounts for it. In that case, the Court held that this is a labor income, inter alia because the restriction of non-competition was limited and did not prevent the managers from working altogether.
Therefore, in order to avoid a tax accident and to be aware of the implications of these conditions in advance, it is recommended that one consult with a lawyer knowledgeable in the field before executing an agreement that includes a one-time compensation for non-competition and to examine the agreement also with a tax advisor.