No competition agreement and its taxation

15 February 2018

In the current constantly changing business environment it has become an elementary interest of employers to be able to keep their business secrets in order to remain competitive. The confidentiality obligation of employees (Section 8(1)) defined in the Labour Code (hereinafter LC) is a tool to achieve that goal. More and more companies take the opportunity stated in the LC and enter into a no competition agreement with their employees.

             Under such an agreement the employee undertakes not to take any position in the job and/or at a company stated in the agreement for maximum 2 years from the termination of employment. In exchange, the employee is eligible for some compensation the minimum rate of which is defined by law. Pursuant to the law, the amount of compensation may not be less than one-third of the base wage due for the same period. The agreement is most often concluded simultaneously with the employment contract but it also may to be signed during or at the termination of the employment. In terms of enforceability it is very important to define exactly the activity and the geographic unit governed by the agreement. If it entails excessive grievance, it may be annulled in a potential lawsuit. E.g., an engineer working in a motor manufacturing plant cannot be banned from working as an engineer but they may be prevented from taking employment in a competitor plant.

            The parties may also specify the frequency of the payment in the agreement. There are a number of options based on their choice. The no competition compensation may also be paid monthly with the monthly wages (separated from them), or in a lump sum at the time of cessation of the legal relationship, or in instalments, in predefined periods, after the termination of the legal relationship.

            The Labour Code allows an employee to exercise the right of cancellation if they terminate their employment with immediate effect. The employer may also cancel the agreement but only when the employee has not yet performed their share of the agreement. Consequently, an employee may not exercise the right of cancellation following the cessation of employment. It is important to stress that when the legal relationship is terminated with a mutual consent, the effect of the agreement does not cease automatically. If the parties also intend to repeal that, it must be stated separately in the document prepared for the termination.

            In terms of taxation of the compensation under the agreement, the time of payment is an important factor. When the payment is made during or simultaneously with the cessation of the employment, it functions as wages and must be considered income from employment as defined in the Act on Personal Income Tax (hereinafter PIT Act). If the payment is made after the termination of employment, then Section 28 of the PIT Act shall be applied, i.e., it constitutes other income which is part of the aggregated tax base. In both vases the private individual must pay 15% personal income tax.

In addition to the taxation issues, the employee may also be obliged to pay social insurance contribution. Any contribution payment obligation is defined based on whether the payment is made during or after the cessation of the legal relationship constituting the basis of social insurance. If the payment is made during the employment or any other legal relationship covered by social insurance, then contribution is also payable. In the case of employment, pension contribution (10%), health insurance contribution (4 and 3%) as well as labour market contribution (1.5%) is payable just like in relation to wages and wage type remuneration.

If the payment is not made during the term of the legal relationship, no contribution is payable from the gross amount.

The employer has to pay any other taxes in relation to such compensation depending on whether the payment is made during or after the termination of employment. If the payment is made during or at the time of termination of the insurance relationship, the employer must pay 22% social contribution tax and 1.5% vocational training contribution tax in line with the taxation on employment. If the amount is not paid out during the insurance period, the payer must pay 22% health contribution tax.

Marianna Gönczi |