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Tax Appeals Tribunal

State of New York

*1 IN THE MATTER OF THE PETITION OF NICHOLAS PENCHUK

for Redetermination of a Deficiency or for Refund of Personal Income Tax under

Article 22 of the Tax Law and the New York City Administrative Code for the

Years 1989, 1990 and 1991.

DTA No. 812646

TSB-D-97(31)I

April 24, 1997

Opinion

In her determination, the Administrative Law Judge concluded that the income received as a result of the covenant not to compete was not derived from or connected with a New York source. The payments received by petitioner were in lieu of future employment which was unconnected to employment with Duncanson & Holt. Petitioner gave up his right in the future to be self-employed or to be employed by a competitor of Duncanson & Holt and, given the national and international nature of the business of Duncanson & Holt, the Administrative Law reasoned that there was no basis to assume that a business competitive to Duncanson & Holt would be located in New York.

The Administrative Law Judge also concluded that since the covenant not to compete would have applied to petitioner if he had engaged in a competitive business located outside New York State, the amount received by petitioner in exchange for the covenant not to compete was not connected with, or derived from, New York sources on the mere speculation that petitioner could have located a competitive business in New York State as well as outside New York State.

Additionally, she concluded that there was no evidence in this record to support a conclusion that the consideration received was a pension or retirement benefit to petitioner. Therefore, the Administrative Law Judge determined that there was no basis for applying 20 NYCRR former 131.4(d) to petitioner's situation.

*5 The Division argues that the Administrative Law Judge erred in concluding that there is no basis on which to assume that a business competitive to Duncanson & Holt would be located in New York. It argues that at least in part, the covenant not to compete was intended to protect the New York business of Duncanson & Holt since that company continued to maintain its headquarters there. Further, petitioner continued to work in New York City throughout the years at issue herein. Therefore, the Division asserts that the situs of the right which petitioner gave up (to compete with Duncanson & Holt for a specified period of time) was New York.

Relying on the decision of the United States Tax Court in Korfund Co. v. Commissioner (1 T.C. 1180), the Division argues that payments received for a covenant not to compete are sourced to the jurisdiction in which the promisor agrees not to compete. The market in which petitioner may have competed with Duncanson & Holt should be limited to the market in which petitioner has actually worked. While the covenant might have been intended to cover additional territories, since petitioner conducted most of his business in New York, at least in part the covenant was intended to prevent petitioner from competing with Duncanson & Holt in New York. The Division also argues that petitioner did, in fact, retire from Duncanson & Holt and the consideration received as a result of the covenant not to compete was a retirement or pension benefit. Pursuant to 20 NYCRR 131.4(d), the consideration at issue should be treated as compensation for personal services attributable to services performed in New York State. Contrary to petitioner's position, the Division argues that monies received pursuant to a covenant not to compete are taxable as compensation for personal services and not as income derived from an intangible.

Petitioner, in opposition, argues that the Administrative Law Judge correctly concluded that the consideration received for the covenant not to compete was not New York source income. Tax Law § 631(b)(2) provides that income received by a nonresident from intangible personal property is income derived from New York sources only to the extent that the income is from property employed in a business, trade, profession or occupation carried on in New York. To the extent petitioner "employed" the covenant not to compete, he employed it to facilitate his sale of stock to Duncanson & Holt. Neither the isolated sale of stock nor the observance of a covenant not to compete constitutes the conduct of a business, trade, profession or occupation. The fact that Duncanson & Holt had its headquarters in New York and petitioner performed services for Duncanson & Holt after the reorganization do not affect the source of the consideration paid for the covenant not to compete.

Petitioner also argues that 20 NYCRR former 131.4(d) applies only to pension or retirement benefits attributable to a person's prior services to his employer. Petitioner argues that there is no basis on which to conclude that the amounts received pursuant to the covenant not to compete were attributable to petitioner's services to Duncanson & Holt prior to the reorganization. Therefore, section 131.4(d) does not apply and these payments are not compensation for personal services attributable to services performed in New York State.

*6 In Matter of Haas (Tax Appeals Tribunal, April 17, 1997), we considered issues similar to those involved in this proceeding. In that decision we stated:

"[t]he Division argues that Korfund Co. v. Commissioner (supra) requires that we consider the source of this income to be New York because petitioner had a right to compete with MLSI in New York and that is where he gave up that right. In Korfund, the Tax Court considered whether the taxpayer, a New York corporation, was liable for withholding tax on amounts paid to certain nonresident aliens pursuant to an agreement not to compete with the taxpayer. The Tax Court found that the rights of the nonresident aliens to do business in the United States were interests in property in this country. Since the situs of their right to income from this property was in the United States, the income derived from foregoing the use of these rights for a specified period of time was earned and produced in the United States and subject to withholding taxes.

"We do not find Korfund to be dispositive of the issues in the present case. The Legislature has specified what it considers to be income derived from or connected with New York sources in Tax Law § 631. There is no indication that the Legislature intended that the provisions of the Internal Revenue Code concerning the source of income for nonresident aliens would apply to a determination of taxable income pursuant to Tax Law § 631. Section 861 of the Internal Revenue Code defines those items of gross income which are treated as income from sources within the United States. Such items of income include, among others, all items of interest and dividends of domestic corporations, rents and royalties from any interest in property within the United States and all social security benefits. In sum, the items included in source income from within the United States form a much broader category than those which are included in the income of a nonresident pursuant to Tax Law § 631 and have little applicability in determining the issue at hand" (Matter of Haas, supra).

Similarly, we do not agree with the Division's argument in the present matter that Korfund requires that the payments made pursuant to the agreement not to compete must be sourced to New York State.

As we concluded in Haas, a payment made pursuant to a covenant not to compete is ordinary income to the petitioner. Tax Law § 631(a) provides that the New York source income of a nonresident individual is the sum of the net amount of items of income, gain, loss and deduction included in the individual's Federal adjusted gross income which are "derived from or connected with New York sources." Relevant to this proceeding, items of income, gain, loss and deduction "derived from or connected with New York sources" are those items which are either: (a) attributable to a business, trade, profession or occupation carried on in New York; or (b) income from intangible personal property only to the extent that such income is from property employed in a business, trade, profession or occupation carried on in New York (Tax Law § § 631[b][1][B] and 631 [b][2]). If there were no covenant not to compete, petitioner might have exercised his skill and ability in competition with Duncanson & Holt in New York. If such competing services were rendered in New York, tax on the earnings therefrom would have been payable to New York. However, the contractual payment was made for the observance of the covenant not to perform competing services in New York and elsewhere. Therefore, the taxpayer could only comply with the terms of the contract and be entitled to compensation pursuant to the agreement by refraining from performing competing services in New York and elsewhere. If petitioner did perform competing services in New York, he would have been in breach of his agreement and not have earned the compensation which is now sought to be taxed. If he is taxed by the jurisdiction where he would have performed services but for the covenant, then he is being taxed on a business, trade, profession or occupation not carried on in New York, clearly a situation not embraced by Tax Law § 631(b)(1)(B).

*7 As to the argument by the Division that the consideration received as a result of the covenant not to compete was a retirement or pension benefit and, therefore, taxable pursuant to 20 NYCRR 131.4(d), we agree with the Administrative Law Judge that petitioner did not retire from Duncanson & Holt and the funds at issue were not paid as part of a retirement package.

As a result, we affirm the determination of the Administrative Law Judge.

Accordingly, it is ORDERED, ADJUDGED and DECREED that:

1. The exception of the Division of Taxation is denied;

2. The determination of the Administrative Law Judge is affirmed;

3. The petition of Nicholas Penchuk is granted; and

4. The Notice of Deficiency, dated August 9, 1993, is cancelled.