Introduction: Why Restrictive Covenant Payments Cross Two Tax Systems
Restrictive covenant payments are the one part of a City exit package that both Britain and America tax in full, and neither country offers the reliefs executives expect. Furthermore, the American treatment turns on a rule almost no adviser applies: where you promised not to compete, rather than where you worked.
That single distinction decides whether your UK tax produces a usable credit. Consequently, an identical payment can attract 47 per cent or 62 per cent of total tax depending on wording your lawyer drafted for commercial reasons.
Most departing executives never see the analysis. Additionally, employment counsel negotiates the covenant, the UK payroll team applies PAYE, and nobody asks how the American return will treat it. Therefore, the damage is locked in at signature.
What Restrictive Covenant Payments Actually Are
Restrictive covenant payments buy your agreement to limit your future conduct. Specifically, they compensate you for accepting non-compete, non-solicitation, non-dealing or confidentiality obligations, usually for a defined period after you leave.
They are not payments for work performed. Rather, they are payments for refraining from work, and that difference drives almost every conclusion in this guide. Notably, both tax systems recognise the distinction, yet they draw opposite consequences from it.
Who This Guide Is Written For
We wrote this for American citizens and green card holders leaving senior roles in Britain. Specifically, that means managing directors, partners, portfolio managers and founders whose exit documents carry a separately priced covenant.
The sums involved justify the analysis. Moreover, covenant consideration in the City routinely reaches six figures, and the tax swing on it frequently exceeds £30,000. Therefore, the planning window before signature is worth protecting.
How Britain Taxes Restrictive Covenant Payments
Britain treats restrictive covenant payments as employment income. Additionally, it does so through a specific statutory route rather than the general termination rules, which produces a harsher outcome than most people assume.
Section 225 and Restrictive Covenant Payments
Section 225 of the Income Tax (Earnings and Pensions) Act 2003 brings covenant consideration into charge as general earnings. Specifically, HMRC confirms in EIM03602 that such consideration is taxable as general earnings, and the employee is taxed on the whole amount received.
Timing follows receipt rather than the period covered. Therefore, a payment for a two-year covenant lands entirely in the tax year you receive it, even where you receive it long after employment ended.
The connection to employment is broad. Furthermore, the undertaking need only relate to a current, future or former office or employment. Additionally, it does not matter to whom the payment is made, so directing it to a company or family member changes nothing.
Why the £30,000 Exemption Does Not Apply
Here the mainstream commentary gets it wrong. Several widely read pages state that restrictive covenant payments can shelter within the £30,000 termination exemption. However, that exemption sits in sections 401 to 416 and applies only to payments that are not otherwise earnings.
A genuine section 225 payment is earnings by statute. Consequently, it falls outside the termination code entirely, and no part of it is exempt. Therefore, the first pound is taxable at your marginal rate.
Confusion arises because settlement agreements bundle several payments together. Specifically, HMRC guidance on compromise agreements works through how a single sum splits between covenant consideration and genuine termination compensation. Ultimately, the label in the document does not bind HMRC, but a considered allocation does help. Guidance from the ICAEW on employment taxes and the Chartered Institute of Taxation tracks these boundaries closely.
PAYE, National Insurance and Non-Cash Consideration
Employers must operate PAYE on the payment. Moreover, employer obligations apply in the normal way, so the tax leaves at source before you see the money.
National Insurance follows the same path. Specifically, NIM02320 confirms Class 1 contributions arise on restrictive covenant consideration, including where the consideration takes a non-cash form. Consequently, both employee and employer contributions apply without any exempt slice.
That NIC point matters for Americans particularly. Furthermore, National Insurance is not a creditable tax for US purposes, so it is simply a cost with no offsetting relief.
Where the American Rules Diverge
America agrees restrictive covenant payments are taxable. However, it disagrees about almost everything else, and the differences all reduce the reliefs available to you.
Restrictive Covenant Payments Are Ordinary Income
Restrictive covenant payments are ordinary income in the United States. Critically, courts have consistently refused to treat them as proceeds from the sale of goodwill, because you are paid for a promise rather than for property.
The rate consequence is immediate. Therefore, the money is taxed at rates reaching 37 per cent rather than the long-term capital gains rates, and no basis offsets it. Additionally, the IRS guidance on taxable income treats it as fully includible.
Where the payment connects to employment, it usually reaches you through payroll. Consequently, it appears in wages, and withholding applies on the American side too where a US payroll is involved.
Why the Foreign Earned Income Exclusion Cannot Reach It
This is the trap that costs the most. Specifically, section 911 excludes only foreign *earned* income, defined as amounts attributable to services performed by the individual.
Restrictive covenant payments compensate you for not performing services. Therefore, they fall outside the definition, and the exclusion cannot shelter them. The regulations determining foreign earned income reinforce the point by tying the exclusion to services actually rendered.
Executives routinely assume otherwise. Moreover, because their salary qualified for the exclusion, they expect the exit payment to qualify as well. Consequently, they discover the shortfall only when the return is prepared, long after the planning window closed. The IRS foreign earned income exclusion guidance and the Form 2555 instructions both confine relief to services income.
Self-Employment Tax and the Payroll Question
One rule on restrictive covenant payments works in your favour. Specifically, covenant consideration is generally not subject to self-employment tax, because you are not carrying on a trade or business by refraining from competing.
That relief is narrow but real. Therefore, a former partner receiving covenant consideration usually avoids the 15.3 per cent charge that would apply to genuine partnership earnings. Additionally, where UK National Insurance has already applied, a certificate of coverage prevents duplicate social security cost on other elements of the package.
The Sourcing Rule Behind Restrictive Covenant Payments
Sourcing determines whether the UK tax on restrictive covenant payments becomes a usable credit. Furthermore, for restrictive covenant payments the rule is unlike anything applying to salary or bonus.
Korfund and the Place of Forbearance
American law sources a covenant payment to the place where you gave up the right to act. Specifically, the principle established in *Korfund Co. v. Commissioner* treats the income as arising where the promisor forfeited the freedom to compete, and Revenue Ruling 74-108 applies the same logic.
So geography of restriction governs, not geography of work. Consequently, a London banker who promises not to compete in the United States generates US-source income, despite never working there during the covenant period.
That result surprises people. However, it follows logically from what the payment buys. Ultimately, you are selling access to a market, and the market determines the source.
Apportioning a Multi-Territory Covenant
Most City restrictive covenant payments cover several territories. Therefore, the payment must be apportioned between US-source and foreign-source amounts on a reasonable basis reflecting the facts.
Reasonable methods vary. For example, relative market size, revenue opportunity or the employer commercial footprint can each support an allocation. Additionally, the source rules in section 861 frame the wider analysis.
Documentation carries the argument. Consequently, an allocation agreed contemporaneously and supported by commercial evidence withstands examination far better than one reconstructed years later.
When Part of the Payment Becomes US-Source
Global institutions drafting restrictive covenant payments almost always include the United States. Specifically, a covenant protecting a worldwide franchise names America expressly, because that is where much of the competitive threat sits.
The moment it does, part of the payment turns US-source. Therefore, that slice cannot carry a foreign tax credit, regardless of how much UK tax you paid on it.
The Foreign Tax Credit Consequence
With restrictive covenant payments, this is where the money actually leaks. Moreover, the leak is invisible in the UK computation, which shows a perfectly ordinary PAYE deduction.
Why a US-Source Slice Strands Your UK Tax
For restrictive covenant payments the credit works only against foreign-source income. Specifically, Form 1116 computes a limitation by reference to foreign-source taxable income in each basket.
Britain, meanwhile, taxes the entire payment. Consequently, UK tax attributable to the US-source portion has nothing to offset, and it becomes an absolute cost rather than a credit. Publication 514 and the IRS foreign tax credit guidance set out the limitation mechanics.
Excess credits rarely rescue the position. Furthermore, carryovers only help where you later generate foreign-source general basket income with spare capacity, which many executives never do after leaving Britain.
Treaty Re-Sourcing and Its Limits
The treaty offers partial relief. Specifically, the relief from double taxation article permits re-sourcing certain income so that a US citizen can claim a credit, but it applies only to the extent the United Kingdom holds a taxing right under the treaty.
Re-sourcing demands its own computation. Therefore, you file a separate Form 1116 for the re-sourced category rather than folding the amount into the general basket. Additionally, the claim requires disclosure, and it does not convert every stranded pound into a credit.
We treat re-sourcing as a repair rather than a plan. Ultimately, drafting the covenant correctly beats litigating the source afterwards, which is why our tax treaty optimisation service engages before signature wherever possible.
Timing Across Two Tax Years
The tax years do not align. Specifically, Britain taxes on receipt in a year ending 5 April, while America taxes on a calendar year basis.
A payment made in February therefore lands in different years in each country. Consequently, the UK tax and the American income can fall in periods that do not match, which distorts the credit calculation unless you elect carefully. Similar timing questions arise with garden leave and notice pay.
Structuring Restrictive Covenant Payments Before You Sign
Almost all of the damage from restrictive covenant payments is fixable in the drafting. Moreover, none of the steps below require aggressive positions or unusual structures.
Define the Restricted Territory Precisely
Limit the covenant to the territories that genuinely matter commercially. Specifically, if the real competitive risk sits in London and Europe, say so, and do not extend the restriction to America out of habit.
Narrowing the territory narrows the US-source slice. Therefore, more of the payment stays foreign-source, and more of your UK tax becomes creditable. Notably, employers rarely object where the commercial protection is unaffected.
Allocate the Consideration in the Agreement
Split the package explicitly. Furthermore, separate covenant consideration from termination compensation, notice pay and any bonus element, and record the reasoning.
Allocation helps both sides of the Atlantic. Consequently, HMRC can see which sums fall inside section 225, while the IRS can see the basis for your sourcing position. Additionally, an unallocated lump sum invites the worst assumption in both jurisdictions. Practitioner material from the AICPA and HMRC is worth reading before you agree the split.
Watch the Year of Receipt
Receipt drives the UK charge on restrictive covenant payments. Therefore, moving a payment across 5 April can change the rate applied, particularly where you leave Britain part way through a year.
Residence status compounds this. Moreover, if you have already left the United Kingdom, the interaction between the covenant charge and your residence position needs checking before the money moves.
A Worked Example: The Departing Managing Director
Numbers show the scale of the restrictive covenant payments problem. Accordingly, the following case reflects a pattern we see regularly in City exits.
The Facts
An American citizen resident in London leaves a global bank in January 2027. Her settlement agreement allocates £250,000 specifically to a twelve-month covenant. Meanwhile, the covenant restricts her from competing in the United Kingdom, the European Union and the United States.
A reasonable commercial allocation attributes forty per cent of the restriction value to the American market. Therefore, £100,000 is US-source and £150,000 is foreign-source.
The British Position
Section 225 charges the whole £250,000 as general earnings. Consequently, income tax at 45 per cent produces £112,500, and employee National Insurance at 2 per cent adds £5,000.
No exemption applies. Therefore, the UK cost is £117,500, and the £30,000 termination exemption plays no part whatever.
The American Position
America taxes the same £250,000 as ordinary income at 37 per cent, giving £92,500. Critically, the foreign earned income exclusion is unavailable, because the payment rewards forbearance rather than services.
The credit then hits its limit. Specifically, only the £150,000 foreign-source portion supports a credit, capping relief at roughly £55,500. Consequently, around £37,000 of American tax remains payable, and the UK tax sitting on the US-source slice is stranded.
Total tax reaches approximately £154,500 on £250,000, an effective rate near 62 per cent. However, had the covenant been confined to Britain and Europe, the whole payment would have been foreign-source, the credit would have covered the American charge entirely, and the cost would have stopped at £117,500. Ultimately, three words of drafting were worth £37,000.
How TaxYork Can Help
TaxYork reviews exit documentation before you sign it. Furthermore, we model the covenant allocation across both systems, quantify the credit position, and tell you precisely which drafting changes are worth negotiating.
We also repair completed deals. Specifically, where restrictive covenant payments have already been taxed, we test the sourcing position, apply treaty re-sourcing where it genuinely applies, and correct returns that claimed an exclusion the law never permitted.
Our clients are senior professionals with substantial cross-border exposure. Therefore, we work to the standard such packages demand, from a single covenant review through to full historic correction on your US tax returns.
Conclusion
Restrictive covenant payments are taxed harshly and symmetrically. Specifically, Britain charges the whole sum as earnings with no exemption, while America charges it as ordinary income with no exclusion.
The variable across restrictive covenant payments is sourcing. Because the American rule follows the territory of the restriction rather than the place of work, a covenant naming the United States converts part of your payment into US-source income and strands the UK tax paid on it. Consequently, the effective rate can climb from 47 per cent to well beyond 60.
Negotiate the wording, not the aftermath. Ultimately, the cheapest hour you will spend on an exit package is the one before signature.
Contact Us
Speak to our specialists while your exit terms are still in draft. Furthermore, we can review completed settlements where restrictive covenant payments were taxed without any cross-border analysis.
Email hello@taxyork.com or call 020 3488 8606. Alternatively, book a consultation and we will assess your position within one working day.
Disclaimer
This article provides general information about restrictive covenant payments and their treatment in the United Kingdom and the United States. It does not constitute tax advice for any specific person or transaction. Tax rules change frequently, and their application depends entirely on individual circumstances. Therefore, you should obtain professional advice before acting. TaxYork accepts no liability for decisions taken solely on the basis of this article.