Clawback provisions in bonus and share plans have generally been adopted on the basis that the employee will not get any tax credit for any amount clawed back. Sometimes, the clawback provisions expressly reflect this understanding by requiring a repayment of only the net amount, thereby accepting that the tax originally paid is lost.
However, the recent decision in Julian Martin v HMRC indicates that this reluctant admission may no longer be necessary. The Tribunal allowed an amount which had been clawed back by an employer to be deducted from earnings received that year and possibly carried back to an earlier year. This is all to do with the concept of negative taxable earnings in Section 11 ITEPA 2003.
Mr Martin entered an employment contract which provided for a £250k "signing on bonus" but, if he were to leave the employment within five years, a proportion of the bonus was to be repaid by Mr Martin (gross). He left the employment within five years and had to repay £162,500. HMRC acknowledged that this could well have the result that Mr Martin was worse off than if he had never had the bonus at all - but said it was nothing to do with them. They just had to apply the law.
The Tribunal observed that there was, "astonishingly", no guidance in the legislation about negative taxable earnings in Section 11 ITEPA 2003 – what they are and how you calculate them. However, the Tribunal could "barely think of a more obvious example" of negative taxable earnings than that presented by Mr Martin and his payment to his employer of £162k. Although the amount repaid was not itself a loss, it could be deducted from his other income of £140k in the same tax year and this meant:
- there was no income tax for the year of the repayment because the deduction reduced the income to nil; and
- there were surplus negative taxable earnings, entitling him to a claim for relief of £22,500.
Subject to a possible appeal, it may be that HMRC will address the issue of clawback and how the tax position should be revised.
This decision gives rise to an interesting position where the deduction from income in the year of the clawback shelters income which would otherwise be taxed at a higher rate than originally payable on the bonus.
For example, let's say that in January 2011 a bonus of £25k is paid on top of a salary of £120k. The marginal rate of tax would have been 40%, so the tax on the bonus would be £10k. If in 2014, the full amount of the bonus is clawed back pursuant to a contractual requirement when the base salary is £170k. Without the relief for the clawed back amount, the employee’s top rate of tax (post April 2013) would be 45% - on £25,000 of the base salary. However, taking the clawed back amount into account as negative taxable earnings, there will be no income charged at 45% (because the 45% threshold is no longer achieved). As a result, the ability to take into account the repayment when computing the tax liability means a tax bill that is £11k lighter (which is also £1k more than the tax bill originally levied on the bonus…).
The draft Finance Bill 2013 introduces a cap on the relief that this kind of loss. Accordingly, from April 2013, the relief is limited to £50,000 or 25% of income, whichever is the greater. Unless the employee has non-employment income in the year that the clawback is operated, presumably the £50k cap will apply as the clawback would reduce the taxable income to below zero.