The tax treatment of restrictive covenants


Written by Ray Coman


Restrictive covenantsPayment received in return for adhering to a restrictive convent is taxable.  Restrictive covenants are a common clause within an employment contract.  Compensation to an employee for a restrictive covenant is taxed via PAYE.  Where no specific value is assigned to the restriction there is nothing to tax.  The tax system does not try to conjure a value.  A restrictive covenant is only taxable where it has been ascribed a specific value.


Types of restrictive covenant

Tax on restrictive covenants

Compromise agreement

Tax treatment of non-compete clauses as part of a business transfer


Types of restrictive covenant


A restrictive covenant is an agreement not to do something.  Usually for instance a former employee is restricted from:


  • Setting up in competition within a certain period of leaving and/or
  • Having left, competing within a certain geographic radius, and/or
  • Poaching other employees for a competing business and/or
  • Keeping trade secrets and other privileged information confidential.


Tax on restrictive covenants


Most employment pay is in return for doing something.  However, in this strange sense, a payment in return for not doing something is also treated as taxable employment earnings.  The payment is taxed in the tax year of receipt.  This applies, even if paid well after leaving the employment.


If the worker is not an employee, the pay is taxable income.  Where a payment is made in a non-cash form, the value of the asset is taxed.  The legislation defining restrictive covenant payments as taxable can be found in Section 225 of ITEPA 2003.


Often the covenant would be included as a clause with the employment contract.  To the extent that recompense for compliance with the covenant is considered part of salary, it is in that sense being taxed.


Termination agreements often include restrictive covenants.  Shortly after leaving the employee is at greatest risk to the employer of becoming a competitor.  HMRC have specifically stated that provided no consideration is received in return for keeping to the restriction, the restrictive convent does not create taxable pay.


Compromise agreement


A compromise agreement often requires that the employee gives up any claim against their former work.  This is therefore a restriction not to take the former employer to the Tribunal.  HMRC has accepted that there is no taxable value to this undertaking.  However, if the agreement has attributed a value, then that value would be taxable.


It is usually a legal requirement that a payment has to be made for the restriction in order for it to have legal weight.  The consideration which could be a nominal amount is nonetheless taxable.


Damages paid by the employee in compensation for breaching the restriction are not a tax-deductible expense.


Tax treatment of non-compete clauses as part of a business transfer


Following a takeover, a payment in return for a non-compete agreement by the directors of an acquired company will be taxable.  This is because the pay is related to the employment of that director and must therefore be run through PAYE.


Usually, where the previous owners sell their business completely the non-compete clause can be treated as part of the capital sum received.  Restrictive covenants in this situation are subject to capital gains tax regime.  The payment is related to the sale of goodwill which is an asset.


#2 Ray Coman, FCCA 2023-09-23 16:23

The national insurance treatment broadly follows the tax treatment. To the extent that the pay is taxable as employment earnings, it will be subject to NI.

Compensation that is not taxable will not be subject to national insurance liability either
#1 Tom 2023-09-22 10:31
Would national insurance be incurred in addition to tax?

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