Over the last few years, quoted companies and companies in the financial sector have come under pressure from investors and regulators to introduce provisions requiring senior executives to lose or repay bonuses where there has been misconduct, risk failings or exceptionally poor financial performance.
A related question is whether a repayment by the employee entitles the employee to get tax back which he will have paid on a bonus he has not ultimately kept.
These points were considered in the Martin case in 2014. There, an employee received a signing-on bonus, but left and had to repay some of it back to his employer.
In that case, the analysis was that the employee could reduce his overall earnings for the year in which he made the repayment. The repayment fell within the previously little-discussed category of “negative earnings” for tax purposes. This could be set off against other earnings from the same employment for that tax year, with only the net result being taxable. So, if an executive’s overall salary for a year was 200 but he paid 50 to his employer in that year (it does not matter which year the relevant bonus related back to), tax for the year would end up only being due on 150. As the tax that would have been paid under PAYE on 200 throughout the year would have been too much, the tax paid on 50 would be repaid. Click here to a link to our Law-Now on this case.
HMRC were at pains to specify this case was very fact specific and a considered HMRC response addressing clawback scenarios in general has been awaited for some time. This has now been published.
HMRC address a number of questions in their guidance, but many still remain:
What are negative earnings?
HMRC examples only refer to a bonus being repaid because of resignation. The current concern for many quoted companies and/or companies in the financial sector is whether cash bonuses (or share award gains) which are repayable because of misconduct or poor financial results would also be treated as negative earnings. The manual gives examples of what are not negative earnings. These include repayment of money obtained by theft and for breach of a restrictive covenant. Clawback because of misconduct or poor financial results seems different, however, in that is repayable under an inherent term of an award in the first place and so it is more akin to the sign-on bonus being repayable in the Martin case, where the repayment was negative earnings. Accordingly, most clawback payments should be allowable as negative earnings, but it is unfortunate that the HMRC examples do not expressly deal with these clawback situations.
What if someone is no longer an employee when clawback is made?
Again, the HMRC examples do not directly address this, but the clawback payment should be netted off against the earnings of the last year of employment, and, if tax has been overpaid on the overall net amount in that year, tax would be repaid. It should be noted though that clawback payments can only be netted off against earnings of the same employment. An employee who changes jobs cannot net off negative earnings of one employment against positive earnings of another.
Does it matter if the amounts being repaid relate to share as opposed to cash awards?
The amount paid back is normally a cash payment and so whether the source of the gain is a cash bonus or share award should not matter, though HMRC examples do not address this specifically. However, the amount paid back can probably only be netted off against cash payments in the tax year in question, not share option gains or vestings of share awards. This may severely limit the ability for full set off in certain cases.
What if the clawback payment exceeds cash earnings for the year?
This may not be an unusual problem when clawback arises. Imagine an ex-employee has to make a repayment of 50, representing 3 years bonuses and share vestings, but his salary for the last year in which he was employed (no bonus was paid to him that year) was 10. In this case, 40 would go unrelieved. The HMRC manuals do not address this scenario (in all their examples the clawback payment is lower than the earnings for the year), and the fear is the balance will normally go unrelieved.
There is often a debate with clawback clauses whether the repayment should be the actual payment made by the employer (say 100) or the net payment received by the employee (60 assuming 40% tax). Given the continuing uncertainties, the fairest way forward seems to be to draft to give the employer the discretion to clawback the gross amount (ie 100). If a clawback does occur, that discretion should be exercised in the light of the facts and possibly updated HMRC guidance at the time as to whether the employee can recover the relevant tax. Only where he can, would the employer pursuing him for 100 seem appropriate.
Click here to read the HMRC guidance: https://www.gov.uk/hmrc-internal-manuals/employment-income-manual/eim00805