NIM02320 | Class 1 NICs: Earnings of employees and office holders: Restrictive covenants

Section 4(4) of the Social Security Contributions and Benefits Act 1992

Section 313 Income and Corporation Taxes Act 1988

Sections 225 & 226 Income Tax (Earnings and Pensions) Act 2003

An employee may receive a payment in connection with an employment in return for agreeing to restrict their future conduct or activities. Such an agreement is known as a restrictive covenant or undertaking. It is usually (though not invariably) made between employee and employer in order to restrict the employee’s activities if the employment is terminated.

Since 21 July 1989 section 4(4) of the SSCBA 1992 has treated as earnings any payments made to or for the benefit of the employee in return for their having become party to such an undertaking which is chargeable to tax by virtue of section 313 of the ICTA 1988. In April 2003 section 4(4) was changed to reflect that section 313 ICTA 1988 became sections 225 and 226 of the ITEPA 2003.

Until 10 July 1997, section 4(4) did not treat as earnings for NICs purposes any amounts chargeable to tax by virtue of section 313(4) ICTA 1988. Section 313(4) relates to payments for restrictive undertakings which are made in a form other than money. Therefore, between 21 July 1989 and 9 July 1997 only monetary sums paid in return forgiving restrictive undertakings were treated as earnings.

The NICs position was fully aligned with the tax position from 10 July 1997 so that NICs became due not only on cash sums paid in connection with a restrictive covenant but also on payments made in a non-cash form.

This means, for example, that where an employer transfers unit trusts to an employee inconsideration for his agreement to a restrictive covenant then the unit trusts are to betreated as earnings for NICs purposes. A Class 1 NICs liability will arise on the value of the units.

See EIM03600 for further guidance on sections 225 and 226 of ITEPA 2003.

A High Court decision was given in December 2003 in the case of RCI Europe v Woods, which concerned NICs on payments made under a restrictive covenant agreed as part of a severance agreement. The case challenged both the application of section 313 ICTA 1988 and our interpretation of section 6(1) SSCBA 1992.See NIM02015 for more information.