Termination payments for a non-compete clause

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1 Termination payments for a non-compete clause Laura Turcan Institute for Austrian and International Tax Law, WU, Vienna 17th October 2015 Case Study Workshop on Practical Problems of Tax Treaty Interpretation and Application" Institute for Austrian and International Tax Law 1

2 Facts of the case (I) Mr A works as a lawyer in State P and he is employed by a law firm in State P. He is a resident of state R. When he gets 65 years old, the law firm terminates the employment contract. Under the contract he is entitled to get an extra payment (an additional one year s salary) if he agrees not to work for a competitor for one year. Institute for Austrian and International Tax Law 2

3 Facts of the case (II) State R employment income extra payment A State P law firm 1. How is the extra payment taxed? 2. How is the extra payment taxed if he were a partner of the law firm and he is entitled to the payment under the partner agreement? Institute for Austrian and International Tax Law 3

4 1. Applicable allocation rule 1. Is the remuneration connected to an employment? If NO Art 21 (Other income applies) (exclusive) taxing rights for the residence state If YES Question 2 2. Is it received for current or previous employment? If current employment Art 15 applies If previous employment Art 18 applies Institute for Austrian and International Tax Law 4

5 1. Art 15 OECD-MC salaries, wages and other similar remuneration - not defined in OECD Model or Commentary Reason and nature of payment essential for classification Timing and type of payment (lump sum/annuity) irrelevant Principle of causality payments must be linked to specific services performed Determination of scope of Art 15 Allocation of taxing rights Place of work principle taxation in the state where work was carried out First rule taxation in residence state Second rule taxation in activity state Institute for Austrian and International Tax Law 5

6 1. Art 18 OECD MC lex specialis in relation to Art 15 pension and other similar remuneration not defined in OECD Model or Commentary exclusive taxing rights for state of residence Three-pronged test for pensions: 1. Care financial support for the recipient best suited for classification of temrination payments, since these are mostly one-off payments 2. Reasonableness 3. Termination of employment must already have occured Institute for Austrian and International Tax Law 6

7 1. Treatment of Termination Payments - General principles 1. Functional causality link with employment? (ie can Art 15 applicable?) 2. Temporal causality timing differences between exercise of employment and receipt of income 3. Geographical causality connection with an employment exercised in a particular state? allocation of taxing rights under Art 15 Can inactivity constitute an exercise of employment? Concept of qualified passivity Possible places of exercise: a) Physical presence of employee direct allocation b) Where employment would have been exercised (if it had continued) replacement of income approach c) Where employment was exercised in the past accrual approach Institute for Austrian and International Tax Law 7

8 1. Treatment of Termination Payments (II) Views before the newest OECD-MC Update: Netherlands: income from employment The US: Art 21 Technical Explanation 2006 Germany: income from employment; inactivity alternative form of action; exercise where competitive activities would have been exercised, unless failure to honour agreement could occur anywhere phyiscal presence If non-compete merely ancillary where services where previously performed Hungary; Switzerland: Art 21 Austria: in a mutual agreement with Germany Art 15 BUT taxation in the previous working state Institute for Austrian and International Tax Law 8

9 1. OECD Update on Termination Payments (I) Type of payment Article Sourcing rule Remuneration for previous work 15 State(s) where previous employment was exercised Payments for unused holiday or sick leave 15 Rebuttable presumption: State(s) of Employment during last year Payment in lieu of notice 15 State(s) where notice period should have been respected Severance payment 15 Rebuttable presumption: State(s) where employment was exercised during the last 12 months of employment Payment of damages for unlawful dismissal 15 State(s) where notice period/services should have been respected Punitive damages 21 Residence state Non-competition payment 15 State(s) where the employee is physically present to honour his/her commitments Institute for Austrian and International Tax Law 9

10 1. OECD Update on Termination Payments (II) Type of payment Article Sourcing rule Pensions rights 15/18 Residence state Deferred compensation/incentive compensation 15 State(s) where employment was exercised with relief for prior taxes Fringe benefits post-employment 15 Rebuttable presumption: State(s) where employment was exercised at the moment of termination Compensation for loss of earnings 15/18/19/ Source state/residence state, depending on the legal context following injury or disability 21 Compensation for loss of future commissions 15 Employment state when the sales were made that gave rise to the payment Partial retirement payments 15 State of physical presence (if stand-by is required) or state where services should have been performed (if no actual work is required) Institute for Austrian and International Tax Law 10

11 1. OECD Update on Termination Payments (III) generally Art 15 is applicable Allocation of taxing rights: principle of causality payment must be broken down if the services were rendered in 2 or more states in general pro-rata basis (temporal basis) of splitting problems when no direct allocation possible OECD came up with sourcing rules Para 2.9. non-compete clause directly related to employment Art 15 BUT not derived from activities performed BEFORE the termination of employment residence state at the time the payment is received Exception if the clause is not the main reason for the payment remuneration received for previous activities place of work Institute for Austrian and International Tax Law 11

12 1. Unsolved questions 1. What if payment is received in multiple installments and the employee moves in the meantime? 2. How important should the agreement be? Should (only) the countries mentioned count? Remuneration is received primarily for activities performed Hybrid forms of non-compete 3. How can abuse be countered? 4. Remaining differences in approach between countries Institute for Austrian and International Tax Law 12

13 2. Question 2 State R employment income extra payment A State P law firm 1. How is the extra payment taxed? 2. How is the extra payment taxed if he were a partner of the law firm and he is entitled to the payment under the partner agreement? Institute for Austrian and International Tax Law 13

14 2. Solution 1. Possible allocation rules: Art 15 if partner is considered an employee Art 7 if he is considered independent Art Allocation of taxing rights: Is the income still attributable to the PE? source state Otherwise residence state Institute for Austrian and International Tax Law 14

15 INSTITUTE FOR AUSTRIAN AND INTERNATIONAL TAX LAW Welthandelsplatz 1, Building D3, 1020 Vienna, Austria Laura Turcan, LL.M (WU) T F laura.turcan@wu.ac.at Institute for Austrian and International Tax Law 15

International Tax and Tax Treaty Conflicts

International Tax and Tax Treaty Conflicts Prof. Dr. Dr. h.c. Michael Lang Institute for Austrian and International Tax Law, WU Vienna (Austria) Institute for Austrian and International Tax Law www.wu.ac.at/taxlaw