Clawback provisions have become a buzz word for bonus and share plans over recent years, particularly for quoted companies.
However, the ability of employees to reclaim the income tax and National Insurance contributions (“NICs”) they have paid on amounts which are subsequently clawed back has been difficult, which has meant most employers only provide for the net amount to be recoverable. Due to a recent Tax Tribunal decision, however, employers may now be able to recover the gross amount from their employees.
If an employee has received a bonus of £100,000, he will (this year) probably have paid income tax and NICs of £52,000 and his employer will also have paid employer’s NICs. If the employee is required to repay the gross amount of his bonus, ie £100,000, he would make an overall loss of £52,000 because HMRC has not traditionally allowed the employee to reclaim the income tax and NICs previously paid. (The employer will also have made a loss of £13,800 unless it can also reclaim its employer’s NICs.)
In practice, therefore, clawback provisions have been typically drafted so that the employee is only required to repay the net amount of his bonus (in the above example, £48,000). Whilst this means the employee is effectively put back in the position he would have been in had the bonus not been paid, the employer remains out of pocket.
In any event, rather than seeking recovery of amounts previously paid, the employer often reduces the amount it is due to pay to the employee under future awards. For example, if a bonus paid in 2010 is to be clawed back, the company could do this by reducing the amount of any bonus paid in 2013 but this only works if the employee is still in employment.
HMRC’s position has been the subject of much debate. However, the First Tier Tax Tribunal (FTT) has recently ruled in favour the taxpayer and held that an employee can claim relief for income tax paid on a bonus which has subsequently been subject to clawback.
During the 2005/06 tax year, an employee received a £250,000 signing on bonus. The bonus was received at the time he joined but was subject to clawback of a relevant proportion if he left employment within five years. In that event, the contract provided for the relevant gross amount of his bonus to be repaid.
The employee left employment before the end of five years and was required to repay £162,500 of his bonus. HMRC refused a claim for relief for the income tax paid on the amount clawed back. The employee challenged this on three grounds:
- He had made an error when submitting his tax return for 2005/06. This signing-on bonus was not taxable until it could not be clawed back and so he should be allowed to adjust that return to reflect the lower amount of his bonus ultimately received;
- The bonus was a loan, ultimately part of which was repaid and part of which was waived; or
- The repayment of the bonus was “negative earnings” and, to the extent it exceeded taxable earnings from the same employment when the bonus was repaid, relief was available against other income, meaning, in effect, through a process of netting off, the relevant tax could be reclaimed.
Decision of the FTT
The FTT held that:
- The employee had not made an error in his 2005/06 tax return. The bonus was properly received when it was paid and the fact that it may have to be repaid in certain circumstances did not prevent the payment from being “earnings” in the first place. The tax return did not contain an error simply because the earnings received may have to be repaid at a future date.
- The bonus was not a loan. Although the FTT held that the parties could have structured the bonus as a loan, on the facts, the payment had not been structured that way.
- The employee should win on his last point. The repayment of the bonus was “negative taxable earnings” for the year in which the bonus was repaid. There was some debate between the employee and HMRC as to what constitutes negative taxable earnings and the FTT commented on a lack of guidance or relevant case law in this area. However, the FTT held that the repayment of the bonus was an obvious example of negative taxable earnings. Accordingly, the amount of the bonus repaid (£162,500) should be applied as follows: First, it should be set off against other income from the same employment in the same tax year. The employee had already received £140,000 from his employer in 2006/07 and so, as £162,500 was greater than this, the amount of taxable earnings from that employment for the 2006/07 tax year was reduced to zero (and any PAYE already paid would be recovered by the employee); Second, any excess (in this case £22,500, ie £162,500 minus £140,000) would be negative taxable earnings and so could be set off against other income received in the same tax year and/or offset against income received in the previous tax year, and relevant overpaid tax reclaimed.
The FTT did not opine on whether NICs could also be recovered because HMRC had already agreed that, if the FTT ruled in the employee’s favour, it would make corresponding adjustments to the NICs paid.
This is a helpful ruling on the ability of employees to recover tax (and possibly NICs) on cash awards which have been clawed back and supports the view by many outside HMRC that the tax on such payments should be recoverable. However, several points should be noted:
- This is a decision of the FTT, the lowest of the tax tribunals, and may be appealed by HMRC. HMRC has so far not commented on whether it intends to change its approach going forward;
- There does not seem any difference in principle why the same tax rules should not apply where poor results etc require clawback to align with the FSA’s Remuneration Code or the Association of British Insurers’ best practice;
- The decision relies on the employee being able to claim an additional relief where the amount of the bonus repaid exceeds earnings from the same employment in that tax year. Any relief here, together with any other reliefs, will now be capped at £50,000 (or 25% of the individual’s income if greater) from 6 April 2013. Any claim must also be made within 12 months of the date by which self-assessment returns must be filed for the relevant tax year;
- Although HMRC agreed in this case to adjust any NICs previously paid, this appears to be on a non-statutory basis and so it is possible that going forward HMRC may reject any claim for repayment of NICs, even it allows income tax relief; and
- The case related to the clawback of cash bonuses and it remains to be seen whether a similar approach would be applied to a clawback of shares previously awarded to an employee
As stated above, companies have traditionally only drafted for recovery of net bonuses, but now companies should start considering whether they should recover the gross amount or at least provide for the ability to ask for it.
For a copy of the case, please click here.