Income tax paid on a bonus payment which is later clawed back by an employer can be reclaimed by the taxpayer, but only in certain circumstances.

In HMRC v Martin [2014] UKUT 429 (TCC), Mr Martin entered into an employment contract with JLT Risk Solutions which included a £250,000 "signing bonus" in return for Mr Martin's commitment to remain employed for five years. The bonus was repayable on a time-apportioned basis if the employment relationship ended before the five years.

Mr Martin received the bonus together with his first salary payment, both of which were treated as "emoluments" subject to income tax and NICs. This resulted in Mr Martin receiving a net bonus of £147,500. One year later, Mr Martin gave JLT formal notice of his intention to resign and, as a result, he became liable to repay £162,500 of the bonus. Mr Martin then brought a claim against HMRC for tax relief on the basis that he was entitled to a repayment of tax.

The dispute centred on whether the signing bonus ceased to be "earnings" when repaid or whether it became "negative taxable earnings". HMRC tried to argue that the repayment was liquidated damages for breach of an implied provision that the employee would not leave before the fifth anniversary of the contract and therefore not earnings at all.

The First Tier Tribunal accepted that the clawed-back proportion of the bonus should be treated as negative taxable earnings, but disagreed with Mr Martin's argument that this could be offset against the tax liability in the year that the bonus was paid (2005/06). Instead, it must be recognised in the tax year in which repayment was made.

The Upper Tribunal upheld the First Tier Tribunal's decision, agreeing that:

  • The full amount of the bonus was taxable when Mr Martin received it on 25 November 2005;
  • Mr Martin's earnings in 2005/06 could not be reduced by the payments made to JLT in a subsequent tax year.
  • Negative earnings should be deductible from any positive earnings in the tax year in which repayment is made. If this results in a negative figure for taxable earnings, relief may be available under s.128 Income Tax Act 2007.

The Upper Tribunal ruled that a payment from an employee to his employer or certain third parties would fall within the category of negative taxable earnings if the payment had "attributes of positive taxable earning" with suitable adjustments to reflect the fact that payment is flowing in the opposite direction. Very broadly, if a payment would be considered taxable earnings, its repayment would be considered negative taxable earnings.

The UT’s decision relied heavily on the contractual arrangement between Mr Martin and JLT:

  • The initial payment of £250,000 had been made as consideration for Mr Martin agreeing to enter into the new contract of employment – it was fully taxable in the year that it was originally paid to him and could not be seen as a contingent payment on account;
  • The terms of the contract were clear – if Mr Martin left before the fifth anniversary of the entry into the new contract, then he would be liable to repay a proportion of the bonus, the repayment could not be seen as compensation for a repudiatory breach of contract because it was being made in accordance with the explicit terms of the contract.

The tribunal emphasised that the decision was based on the particular contractual terms at issue and a different set of facts could produce a radically different conclusion.

If there had been proper planning when the contract was first put in place, Mr Martin would not have had this argument at all. It is worth employers thinking at the outset about situations in which employees might be asked to make repayments. If the drafting is correct when the contract is first signed there will be no need to rely on a highly fact-specific situation when the repayment actually happens.