31 March 2009

Termination of employment

In our present economic climate where many employees are faced with the threat of retrenchment, the definition of 'gross income' in Section 1 of the Income Tax Act 58 of 1962 (the Act) together with it's special inclusions becomes an important consideration, should employees accept compensation for early termination of their employment contracts. Although receipts and accruals that are capital in nature are not included in the general 'gross income' definition, they may be subject to tax if they are included in terms of the special inclusions to the definition.

Para (d) of the definition of 'gross income' requires the inclusion in gross income of: 'Any amount, including a voluntary award received of accrued in a year or period of assessment in respect of the relinquishment, termination, loss, repudiation, cancellation or variation of an office or employment or of any appointment or right or claim to be appointed to an office or employment.'

Thus in a situation where an employer prematurely terminates a contract of employment and pays an amount for the early termination of the contract in order to compensate the employee for the loss of his right, that amount would be included in the employee's gross income despite it being a lump sum and capital in nature. This applies irrespective of whether the payment is contractual (ie. in respect of breach or termination of the employee's employment contract) or voluntary (ie. in order to maintain a 'happy and contented staff' – Provider v COT [1950 SR] 17 SATC 40).

Likewise, where for example a director appointed for life loses his directorship, the payment of compensation for loss of office/ directorship, would be caught by para (d) of the 'gross income' definition, thereby being taxed as gross income in the hands of the director.

The above-mentioned taxpayers may find some relief in the application of section 10 (1) (x), provided that the requirements of the section are met. If so, an exemption of up to R30 000 would apply to the income in terms of para (d).

Would the same rights apply to compensation a partner receives, should the right he holds in a partnership agreement be terminated early?

The recent judgment of Hartzenberg ADJP in the appeal case of BC Bos v CSARS 70 SATC 187 offers a good illustration of the position.

The TPD had to consider whether a compensation payment made by an accounting firm to its partner, for the early termination of a partnership agreement was of a capital or revenue nature.

After careful consideration of the circumstances, the court whilst reaffirming that the categorizing as capital and income had to be decided on the facts of each particular case, found that the partner's rights in terms of the partnership agreement formed the very foundation of his income-producing structure, it followed that the compensation for his termination thereof was an accrual of a capital nature and thus did not fall within the general of the definition of 'gross income' in section 1 of the Act.

The next question to ask is why the amount failed to fall within the ambit of para (d) to the 'gross income' definition since it applies to amounts of a capital or revenue nature.

The answer to this question lies in the fact that partners are neither the holders of office nor employees of the partnership, therefore para (d) cannot apply as it is restricted to employees and holders of office.

In light of the above, it seems that partners are thus in a better position compared to employees, as the compensation will not be considered as gross income.

A point worth noting is that, should a partnership incorporate to form a section 53 (1) (b) company in terms of the Companies Act 61 of 1973, para (d) may then apply to employees or holders of office in that company.

However, where an independent contractor agrees to render IT services or training to a company for a certain period and such agreement is prematurely cancelled by the company for which the independent contractor receives an amount as compensation, the amount cannot fall within para (d) as the independent contractor does not qualify as an employee or a holder of office.

The amount received by the independent contractor would be included in his gross income if it qualifies as revenue and not capital in nature. Again our courts have reiterated that there is no general principle, since in each case the question comes to be one of circumstances and degree. An important consideration in determining the nature of the amount is whether the contract itself represented a substantial part of the independent contractor's income-producing structure (ITC 1259 – 39 SATC 65).

Patrick McGurk, National Practice Head: Tax

Zakiya Shaik, Candidate Attorney

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