– relief is available against general income under s128 ITA 2007
A recent First-tier Tribunal judgement has thrown the spotlight on the tax treatment of earnings paid in one tax year and which are later ‘clawed-back’ pursuant to the operation of a provision in the contract of employment. If HMRC accept the analysis in the judgement, it could pave the way for those employees, whose annual bonuses are awarded subject to the potential operation of a so-called ‘malus’ clause, to obtain relief against general income for income tax paid on an amount ‘clawed-back’.
A clawback provision will typically provide that the employee shall be required to forfeit all or part of a bonus which has been paid if conditions relating to the conduct and performance of the company, business or individual concerned are not met. Typically, these relate to circumstances involving not only the discovery that the facts on the basis of which the bonus was quantified and paidwere incorrect, but also to a subsequent failure to achieve anticipated levels of minimum performance or conduct.
The mechanisms by which such a recovery of paid bonus can be effectedare normally based on the terms of the employment contract or of the arrangement under which the bonus is paid, such as a cash or share-based incentive plan. (An example of such a clawback provision is set out at Clause 11 of the precedent Form of Senior Executive Deferred Share Bonus Plan in Appendix A of Vol 2 of our book “Employee Share Schemes”.) In practice it may, particularly in the case of an employee who has left employment, prove difficult to enforce. One difficulty for the (ex-) employee who is called upon to repay a bonus has been the fact that, at least in the view of HMRC, it has not been possible for the individual to recover from HMRC the income tax and NICs on that part of the bonus which is repaid pursuant to the operation of such a provision.
In the case of Julian Martin vs HMRC [2013] UK FTTT 40 (TC)], the employee had been paid a bonus in the tax year 2005/06 of £250,000, subject to deduction of income tax and NICs under PAYE, in consideration of his agreement to remain with the employer for a further 5 years. Under the employment contract, as amended, he was liable to repay a proportion of that sum if, inter alia, he gave notice at any time to terminate his employment before the end of that period. In the event he did give early notice and it was agreed that his employment terminated in the following tax year, 2006/07. In consequence, and under the terms of the employment contract, he became liable to repay £162,500, which he duly did. In that year he had earnings of approximately £140,000.
The appellant argued that (a) he was entitled to make an “error or mistake” claim to reduce his taxable earnings in 2005/06; or (b) the arrangement fell to be taxed as a beneficial loanwhich was partly repaid and partly released; and (c) that he was entitled to ‘employment loss relief’ against general income, in 2006/07, under s128 Income Tax Act . The contentions in (a) and (b) were dismissed : the bonus fell to be taxed as earnings actually received in 2005/06, per s18 ITEPA 2003; and on the facts it simply was not a ‘loan’.
However, the Tribunal determined that s11 ITEPA 2003 expressly recognises the concept of negative taxable earnings (“negative TE”), and here was an example of a situation in which the concept is relevant. In 2006/07 the appellant had earnings of £140,000 and was required as a term of his contract of employment to pay back to his employer £162,500. This resulted in ‘negative TE’ of approximately £22,500 for which the appellant was entitled to relief against general earnings in 2006/07 under s128 Income Tax Act 2007 (HMRC having conceded that, in the circumstances they would allow such a claim to be made ‘out of time’, there being a 1-year limit on the making of claims under s128). That section is headed “Losses in an employment or office”.
The appellant argued that he suffered a loss in an employment or office by repaying part of the bonus. HMRC argued for a more restricted scope to the section. It was, however, agreed between the parties that a “loss in the employment” as mentioned in s128 does refer back to the concept of negative TE mentioned in s11 ITEPA 2003. So, if in a year the employee has earnings paid of 100 and is required to payback 110, he will pay no tax on the earnings received and have negative TE of 10 for which relief is available by way of a deduction in calculating net income (and, to the extent that it cannot be fully utilised as mentioned in s129 ITA2007, by way of an allowable capital loss – see s130). If, by contrast, he has earnings of 100 and is required to payback 20, then he will have net taxable earnings of 80.
The Tribunal commented that, whilst s11 ITEPA was unclear and could only be ascribed a sensible meaning by reference to s128 ITA, it clearly envisaged a situation in which such negative TE would be recognised. As to what exactly would count as such negative TE, the Tribunal held that the phrase must mean a contractual reversal, under the terms of employment, of what had constituted taxable earnings. By contrast, damages sought from an employee on termination of employment would not, for example, rank as negative TE.Likewise, if an employee is awarded shares under a share-bonus arrangement, and the shares fall in value, such loss in value cannot rank as negative TE.
Contrary to HMRC’s contention, there is no requirement that such negative TE has to have arisen in the period of the employment. In the present case it arose after the employment had ended.
HMRC had, until now, asserted that the application of relief under s128 is restricted to circumstances in which an employee, in effect, shares in a loss of the employer, for example, by a cashier being required to make good a shortfall in the till. (The examples given in HMRC’s Employment Income Manual are not correct – they appear to refer to situations in which it is doubtful if the individual is even an employee !). The Tribunal declined to comment on the NICs implications of the decision.
It would now appear that an employee who is required to, and does in fact, pay back an amount of bonus pursuant to such a ‘clawback’ provision in the employment contract, may claim relief under s128 ITA 2007 for the amount by which the amount repaid exceeds the amount of positive taxable income in the relevant year. HMRC’s view that s128 is more restrictive in its application is incorrect. It remains to be seen if HMRC will, in such circumstances, refund the employee’s and employers’ NICs on the amount repaid.
Share-based bonuses
If shares awarded subject to such a ‘clawback’ arrangement have increased, or fallen, in value at the time when some or all such shares are transferred back (typically to an employees’ trust), what is to be taken as the amount or value to be deducted in determining the taxable earnings of that year and, if it be the case, what is the amount of ‘negative TE’ for which loss relief would be available ? Notwithstanding the comments of the Tribunal mentioned above, it is unclear what would be the amount concerned. Is it :
a) The value at the time they were first received as earnings of the employee; or
b) The value at the time of transfer back of such number of those shares as are later forfeited or transferred back.
If, as the judgement suggests, it is a ‘reversal of what had constituted earnings’, the correct answer might be (a). In fairness, the Tribunal did not consider the application of the principle to such share-based awards. In any event, care is needed as HMRC might contend that s128 relief is inapplicable where such an award is made under a plan which, by its terms, is expressed to be outside the scope of, and in addition to, the employee’s entitlements under his employment contract.