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How to tax a restraint-of-trade payment to an employee
How should an employer tax a restraint-of-trade payment to an employee?
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Direct answer
An employer should treat a restraint-of-trade payment to a natural person as remuneration for PAYE where it relates to that person's employment, holding of office, or past or future employment or office. SARS describes the payment as consideration for sterilising a person's income-earning capacity. The current SARS employer guide says it must be included in remuneration and reflected under IRP5 or IT3(a) source code 3613.
The PAYE treatment does not decide whether a restraint agreement is enforceable under labour law. It also does not mean every payment connected with a departure is necessarily a restraint-of-trade payment. The wording of the agreement, the recipient, the reason for payment and the legal facts must be reviewed before the company pays.
What this means in practice
Restraint payments are often made when an employee leaves, a director resigns, a business is sold or a key person agrees not to compete. The commercial label used in a settlement agreement can be misleading. Payroll needs to know whether the amount is paid to a natural person in respect of past, present or future employment or office and whether it is truly consideration for the restraint.
SARS's PAYE guide expressly includes this type of payment in remuneration. That means it should not be paid from an accounts-payable process as though it were an untaxed invoice. The company should route the signed agreement and calculation to payroll before authorising the payment.
The payment may be substantial and once-off. That is not a reason to omit PAYE. It does mean the employee will need a clear payslip, certificate treatment and a copy of the agreement to understand the withholding. The business should also avoid splitting one agreed payment into unexplained instalments merely to reduce the apparent payroll impact.
Step-by-step
- Obtain the signed agreement before payment. Keep the restraint clause, settlement agreement, termination terms, payment schedule and any board approval together. Do not rely on an email summary or a verbal instruction from a manager.
- Identify the recipient. The rule in SARS's current guide refers to payment to a natural person. Record whether the recipient is the employee, former employee, director or another person. If a company, trust or other entity is involved, get a specific review rather than assuming the same treatment.
- Identify the employment connection. Confirm whether the payment is in respect of employment or holding office, including past or future employment or office. The agreement should describe the restraint period, territory, activity restricted and consideration clearly enough for the business to support the payroll classification.
- Separate other amounts. A termination package can include unpaid salary, leave pay, notice pay, a severance benefit, damages or legal-cost provisions. Do not combine these mechanically with the restraint amount. Each category may need its own PAYE treatment and evidence.
- Process PAYE through payroll. Once the payment is classified as a restraint-of-trade amount within the rule, include it in remuneration and deduct employees' tax in the correct payroll period. SARS identifies source code 3613 for IRP5 or IT3(a) reporting. Check the current software specification before submission.
- Reconcile and explain. Keep the payment authorisation, payslip, withholding calculation and certificate record. Reconcile the payment to the EMP201 and EMP501. Give the recipient a clear explanation of the gross amount, PAYE withheld and certificate treatment, without offering legal or personal tax advice beyond the documents.
Documents and records to keep
Keep the executed restraint agreement, settlement correspondence, termination or resignation documents, board approval and proof of the recipient's identity. Retain the payment instruction, payroll calculation, payslip, EMP201 support and IRP5 or IT3(a) record. Include documents that explain the commercial context, but protect confidential information appropriately.
Employer records generally need to be retained for five years under SARS's PAYE guidance, and for longer if they are relevant to an audit, objection or appeal. A complete file is important because the payment may be reviewed long after the employee has left.
Important limits and exceptions
This article addresses the narrow PAYE rule stated in SARS's guide. It is not a labour-law guide to whether a restraint can be enforced, and it does not classify every exit payment. A payment for unpaid salary or leave, for example, should not be re-labelled as restraint consideration just because the agreement also contains a restraint.
The natural-person condition is material. Do not automatically use code 3613 where the payment is made to a company, trust or partnership, or where the employment link is unclear. If the agreement involves an overseas recipient, equity, a sale of shares or multiple legal entities, specialist advice is necessary.
When to get tailored advice
Seek payroll, tax and employment-law advice before paying a large restraint amount, negotiating a mixed settlement, paying a director, or making payment to any entity other than the individual concerned. Get a review if the payment is connected to a business sale, a foreign jurisdiction, a dispute or a court order.
TaxProof can help organise the agreement, payment record and payroll reconciliation evidence. We cannot decide legal enforceability, draft the restraint or substitute for tailored tax advice on a complex exit package.