Taxwise: Acting to stop 'unfair' deals eating at base

The Inland Revenue is trying to eliminate the tax-free status of payments made to media stars, sports players and senior executives persuaded to quit their contracts early.

These restrictive covenant and exit inducement payments are often treated for income tax purposes as being "capital" for the recipient and the payer.

This means the recipient does not have to pay income tax, and the payer cannot claim a deduction.

But mismatches often arise, with the recipient not being taxed but the payment being deductible because it is on revenue account.

Restrictive covenant payments are made when a person agrees to restrict, for example, the type of services he or she performs or the geographic area in which the services are performed for an agreed period.

Exit inducement payments are made by a prospective employer, not to induce people to accept a job - such a payment would be taxable - but to induce them to leave their existing one.

Inland Revenue, in an Issues Paper on these payments, sees the tax base being eroded by mismatches in the way these payments are taxed.

For example, an exit inducement payment is usually capital in the hands of the recipient.

Whether such a payment is deductible for the payer is less clear. The issue has not been addressed by the courts or in any public statement by Inland Revenue.

If the payer can claim a deduction for the payment but the recipient is non-assessable, Inland Revenue sees an obvious outflow from the tax base.

And now that the top personal tax rate of 39 per cent is higher than the company tax rate of 33 per cent, it sees a potential for loss to the tax base even where there is no mismatch.

For example, say a company pays somebody on the top rate $10,000 for a restrictive covenant and this is on capital account for both.

The payer effectively forgoes $3300 in income tax because the payment is not deductible.

The recipient pays no income tax as opposed to the $3900 he or she would have paid had money been regarded as revenue.

So Inland Revenue sees itself as getting $600 less in tax than it would had the payment been on revenue account to both parties.

Of course, if the payer is a tax loss or tax exempt entity, the apparent loss to the tax base is greater. To address this, the Government plans to change the tax law so restrictive covenant and exit inducement payments are on revenue account to both parties.

It proposes that these payments be brought within the "source deduction payment" definition - the PAYE rules - to ensure withholding at source, thereby taxing the recipient.

Under the proposal, restrictive covenant payments linked to the sale of a business are likely to be caught as being on revenue account. As with most tax, it does not matter whether the payment is in cash or in kind - for example, shares.

It appears the proposed changes are driven by the Government's perception that it is "unfair" that only certain people (eg. sportspeople, executives, media personalities) are able to command payment to restrict their activities or to be induced to leave their job.

The Government sees this ability - which would be on capital account if the established income tax principles that distinguish between capital and revenue were applied - as disguised personal services income (eg. wages).

As the tax system taxes income, not capital (except in a few cases), this legislative redefining of a capital item as income indicates the Government's intention to systematically broaden the tax base (and to ignore the basis of the capital revenue dichotomy).

The Issues Paper envisages that the proposed changes will take effect from the date the relevant legislation is enacted. The bill is not expected before next month.

*Denham Martin is the principal of Denham Martin and Associates, lawyers specialising in advice on taxation and related matters.