The First Tier Tax Tribunal (Julian Martin v The Commissioners for HMRC [2013] UKFTT 040) has allowed an employee to set-off the amount of a bonus that he was required to repay against his taxable earnings for the year. This allowed the employee to reduce his income tax liability to nil and to claim further tax relief.

This decision creates the opportunity of using a claw-back in relation to bonus or share awards to recover all of the excess value that a company has paid, without prejudicing the employee's tax position - HMRC has previously been unwilling to accept that this is possible. There may, however, be practical difficulties in taking this approach, which we discuss below.

Companies should now consider amending claw-back provisions to allow claw-back to be operated on this basis, as well as reviewing any recent claw-backs. If claw-back has to be operated in the future, companies should consider whether this case can be applied to enable the amount subject to claw-back to be recovered in full on a tax efficient basis.

This is a timely decision because claw-back provisions are becoming ever more common in share and bonus plans, and shareholders generally expect UK quoted companies to operate such provisions. There have been a number of legal concerns in respect of claw-backs, but these are being eroded, not only by this decision in respect of tax, but also by the case of the £1.7m lunch (read our briefing here), which went a long way towards relieving concerns as to the contractual enforceability of forfeiture and, as a consequence, claw-back provisions.

The Julian Martin decision

To date, HMRC has been unwilling to accept that a participant in a share or bonus plan is entitled to reclaim income tax if an award on which income tax had already been paid is subsequently subject to a "claw-back".

However in the Julian Martin case, the Tribunal accepted that the employee was entitled to set-off the amount that was repaid against his income in the year of repayment, thereby reducing the participant's tax liability in that year (in the case, to nil). Further, where the amount of the repayment exceeds the amount of taxable income in that year, the excess will constitute an employment loss, which allows the employee to make a claim for tax relief against any general income in the year of repayment or the previous tax year. If the amount repaid exceeds the income from those two years, any further excess will constitute a capital loss that the participant can carry forward.

The Tribunal did agree with HMRC that the actual income tax that arose at the time of the payment of the bonus could not be reclaimed retrospectively, limiting the claim to the time of repayment. However, allowing the amount of the repayment to be set-off against taxable income in the year of the claw-back ensures that, in most cases, employees should be able to recover a significant proportion, if not all, of the value they initally lost to tax.

The decision is subject to the possibility of appeal by HMRC, particularly as it is based on a legislative provision on which no guidance has previously been issued (either by the Government or HMRC), and which has never before been considered by a court. The decision does, however, derive from a logical reading of the legislation which HMRC appeared to have accepted during the course of the case, and so HMRC may ultimately accept what is a very sensible commercial decision.

The decision should allow claw-back to be operated on a tax efficient basis

The decision in the Julian Martin case does seem to be wide enough to apply to a standard claw-back provision in a share or bonus plan, although the case did not consider this directly and the position is not entirely clear.

The case concerned a bonus that was paid upfront on a conditional basis, such that it was repayable in part if the participant left within 5 years, and the Tribunal found this to be the clearest type of payment to which the principle would apply.

The position is less clear for a claw-back in a share or bonus plan, because in those plans the conditions (such as remaining in employment) have to be met before payment is made. The repayment, or claw-back, is then generally only triggered if a misstatement of results or misconduct is subsequently discovered.

However, the Tribunal did not restrict the principle to conditional payments, and its description of the payments to which the principle would apply, as "a contractual reversal, under the terms of employment, of what had constituted taxable earnings", does seem wide enough to encompass a claw-back of a share or bonus award. Indeed, from a commercial perspective, there is little difference, as in both cases the participant repays to his employer (or former employer) an amount that was originally subject to tax.

This decision should mean that companies can use claw-back to recover all of the excess value that has been paid

Until now, a claw-back would normally have been expected to operate in one of two ways: by lapsing, in whole or part, other bonus or share awards held by the participant; and/or by requiring the participant to repay an amount, often based only on the net, after-tax, value which the participant received.

The first of these approaches remains an effective means of operating claw-back, as the company can enforce the claw-back unilaterally, and without any tax issues arising (because the other bonus or award is lapsed before tax becomes payable).

The second approach, a "net claw-back", has generally been accepted, because although the company did not recover the full value (and HMRC was left with a windfall), it did achieve the objective of ensuring that the participant would not benefit from the misstatement or misconduct.

However, the Julian Martin decision creates the possibility of companies being able to operate claw-back in respect of the full, gross, amount. This would enable the company to recover all of the excess value it paid out, whilst the participant may not be prejudiced from a tax perspective, where he is able to set-off the repaid amount against his income tax liability. These advantages come at HMRC's expense.

Practical difficulties in operating claw-back on a gross basis

There will be practical issues in operating a claw-back on a gross basis, because there will be a time delay before the tax relief is available during which the participant will be out of pocket.

This arises because the participant would need to claim credit for the amount of the claw-back through his self-assessment tax return, whilst having had to repay the claw-back amount upfront. Further, the employer would have to continue operating PAYE during the year on amounts received by the participant, irrespective of the potential full rebate on the tax liability (the employee would subsequently reclaim this over-deducted tax through self-assessment).

These issues mean that companies should retain discretion as to how claw-back is to be applied in a particular case.

In context

Hopefully, the recent examples of courts taking practical and commercially appropriate decisions in respect of claw-back (and similar) arrangements will continue, particularly given the clear policy driver in favour of allowing companies the ability to ensure employees do not receive unjustified remuneration.

Companies should now consider how they may be able to use the opportunities that these cases create, both by amending plan rules to allow claw-back on a gross-basis, if ever needed, and, as highlighted in our other recent briefing, considering how share and bonus awards are treated on terminations where the participant is subject to post-termination covenants.