Since the financial crisis of 2008 / 2009, swathes of new regulations have been introduced governing various aspects of remuneration in the financial services sector. A key feature of these rules is the compulsory clawback of variable remuneration (typically bonuses) in certain situations.

Until relatively recently there was significant uncertainty about how the clawback of remuneration should be treated for tax purposes. Historically, HM Revenue & Customs (HMRC) took the view that the clawback of remuneration was not eligible for tax relief but, in 2014, the tax tribunal decided that a bonus repayable by a taxpayer to his employer under a clawback provision in his employment contract constituted “negative taxable earnings” subject to income tax relief (HMRC v Julian Martin).

HMRC recently published new guidance on negative taxable earnings and the availability of tax relief following a clawback of remuneration. The guidance generally reaffirms the tax tribunal decision in the Julian Martin case and provides additional clarity on certain other scenarios.

What are negative taxable earnings?

Taxable earnings generally arise from payments from an employer to an employee by reason of the employment. In the Julian Martin case, the tax tribunal explained that the reverse situation, where payments are made by the employee to the employer, may, depending on the specific circumstances, be negative taxable earnings.

In determining whether an amount paid by an employee to their employer (or in some cases, a third party) constitutes negative taxable earnings, careful consideration must be given to identifying all the relevant facts. HMRC’s new guidance makes clear that not every payment by an employee to their employer will constitute negative taxable earnings.

To constitute negative taxable earnings a payment must be made for a reason relating directly to the relevant employment. For example, payments on account of damages for breach of an employment contract (such as breach of a restrictive covenant) will not be treated as negative taxable earnings. Consequently, no tax relief will be available in respect of such payments.

How do negative taxable earnings lead to tax relief?

General earnings are taxable in the year they are “for” (i.e. earned). Similarly, negative taxable earnings are normally “for” the year in which they are paid, rather than the year in which the original sums being repaid were earned. This distinction is critical to the availability of tax relief as it means the original taxable earnings (being the bonus) and the negative taxable earnings arising from the clawback of such bonus will not generally arise in the same tax year and so will often not be capable of set-off against each other (unless clawback happens to occur in the same tax year as the relevant remuneration was paid).

If negative taxable earnings are paid after the relevant employment has ceased they will be “for” the last tax year in which the employment was held.

Tax relief for negative taxable earnings is given through the employee’s self-assessment tax return. Negative taxable earnings provide relief in the following order:

  1. Negative taxable earnings are first set against the employee’s positive taxable earnings from the same employment in the same tax year. This may allow the employee to reclaim tax previously deducted from employment income by way of PAYE.
  2. Any excess negative taxable earnings are then set against the taxpayer’s general income (i.e. such as other employment income, interest and dividend income) for the tax year of clawback or the previous tax year (which may include the original bonus itself if paid in the previous tax year). This may reduce the tax payable in respect of such income in the current year and may generate a repayment of tax in respect of the prior year.
  3. Any remaining excess can then be taken as relief against any capital gains in either the tax year of clawback or the previous tax year.

Excess negative taxable earnings may not be carried forward. Consequently, if negative taxable earnings exceed taxable income in the tax year of clawback and the previous tax year, full relief will not be obtained.

Practical Considerations

Although HMRC’s guidance provides helpful clarification of the tax treatment of clawback payments, the rules remain complex and present uncertainty for both employers and employees.

By way of example, employers will naturally want to ensure that they have the right to clawback remuneration on a gross of tax basis, so as to put the employer in substantially the same position they would have been in had the payment never been made (aside from the sunk employers’ NIC cost). However, the ability of employees to obtain full tax relief in respect of the clawback of remuneration relies upon the payment being respected as negative taxable earnings (which will ultimately depend upon the specific circumstances) and the employee having sufficient taxable income in the relevant tax years. As such, employees may be expected to resist gross clawback obligations and to push for net of tax clawback obligations which will not leave the employee out of pocket in the event full tax relief is not obtained.

In addition, under current law, no tax relief or repayment of employee or employer NICs is available in the event of a clawback of remuneration and no tax relief is available in relation to shares which were the subject of an income tax charge by reason of the employment related security rules and which are subsequently forfeited under a clawback provision. This may have practical consequences for the design of share based deferred remuneration plans.

As regulatory requirements and market practice increasingly require employers to apply clawback, it is to be hoped that HMRC will apply its guidance pragmatically and that the government will ultimately provide greater certainty by introducing specific legislation to govern the position of negative taxable earnings.