Non-Competition Payment Taxed as Income rather than Capital Gain
In Kfar Saba Tax Assessor V. Yosef Barnea the Supreme Court recently ruled that non-competition clause intakes between employer and employee should generally be taxed as regular income and not as capital gains.
The lawsuit deals with the question how should payments of non-competition clause be taxed when given by retirement or termination of employment. The appellees (three in the matter at hand), upon their retirement or termination of employment, received an amount that has been determined in advance in the non-compete clause by them and their employer. In the tax declaration they reported the payment as a capital gain (which for high salaried employees is usually subject to lower tax rates). The tax assessment officer did not agree, and the court was required to classify the payment on the tax level.
Judge Yitzhak Amit of the Supreme Court (with the consent of the honorable President Judge Naor and others in an extended 5-judge panel) accepted the appeal of the tax assessor regarding the question of taxation. The process of examining non-competition payments for tax purposes is two-staged: In the first stage – factual clarification, it is necessary to examine whether this is a real condition of non-competition or a disguise for a different payment; if the employee succeeds in proving the first stage then by moving on to the second stage – legal clarification, one must examine whether the employee succeeded in contradicting the presumption of income and show that it was a capital intake.
Wages of non-work are as wages of work. Meaning, there is no difference between yields arising from activation of human capital & yields of non-activation of it. Both shall be taxed as income tax. ‘Fruity labor income’: by the metaphor of ‘The Tree & The Fruits’, non-competition clause is not equivalent, in most cases, to ‘chopping of the tree’, but to temporary autumn-fall (the falling of some fruit) or temporary or partial pruning of a branch of the tree branches in a manner that does not negate the possibility of growing fruit in other ways. That is, it is not uprooting the tree or causing permanent sterilization of it. In some cases, though rarely, there may be exceptions to non-competition stipulations that will be considered as ‘chopping of the tree’ – the employee will not be able to return to work at the end of the non-competition period or ‘cutting of the main branch to a state of no more-growth’ – permanently sterilizing the ability of the employee to gain income.
In cases that both classifications are possible – Income-Fruit & Capital-Tree, the ‘fruity’ will gain the upper hand. In-order for the employee to convince that the payment shall be classified as capital intake he must prove that under the circumstances there is no way that you can see the payment as a fruity income. As for an example for a possible situation to classify the payment as ‘tree-capital’, a Pilot that is forbidden to fly plains for 7 years according to non-compete clause. In this case, his flying skills will be eroded. If that was his only skill in the aerodynamics industry then such a situation can be considered as cutting of the tree or its main branch. The Pilot must show that this brings him to a state of destruction of ability. Meaning, his professional skills are inherently related to a narrow field of flying jets, so he will lose his main & only financial income/intake potential. Each case will be examined according to its circumstances.
In our case above, the appellees were senior employees with bargaining power and got large retirement or termination of employment grants. Their skills were not sterilized and they could easily find financial income/intake by their skills elsewhere (use of other branches of their tree). Additionally, the non-compete clause was for a short period of time and they were unable to prove their claims in contrast to the presumption mentioned above.
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