In Martin, the First-tier Tribunal held that the amount of a bonus that an employee was required to repay constituted ‘negative taxable earnings’, that could first be set off against (positive) taxable earnings, with any excess constituting a loss in respect of which the employee could claim relief. This is a timely decision, given the increasing importance of ‘claw-back’ provisions in many bonus and share plans. A claw-back of a cash bonus should give rise to negative taxable earnings, and therefore relief. However, the position is less clear in respect of a claw-back of a share-based award, and so the usefulness of this decision in that case may be limited.
In Julian Martin v HMRC ([2013] UKFTT 040), Mr Martin (the appellant) entered into a new employment contract committing him to work for a period of at least five years. Mr Martin was paid a signing bonus, but the contract provided that the bonus was repayable in part if he gave notice to terminate his employment within the five-year period. Mr Martin did give early notice, and repaid part of the bonus accordingly.
Having done so, Mr Martin argued that he was entitled to relief against the income tax paid on the bonus, which had been subject to income tax and NICs in full at the time of payment.
The appellant ran three alternative arguments as to why he was entitled to relief. Firstly, it was argued that the signing bonus had only been taxed in full upon payment due to error or mistake. The First-tier Tribunal rejected this contention, holding that the fact that the appellant had entered into a contract pursuant to which he may have to repay a specified sum did not affect the character of the initial payment as earnings, which was therefore correctly taxed (subject to PAYE and NICs) at the time it was received.
The second contention, that the signing bonus had in fact constituted a loan, was not supported by the facts, so was quickly rejected by the tribunal.
The third argument was that the amount of the repayment constituted ‘negative taxable earnings’.
You would not be remiss if you have not come across this concept before, as there is but a solitary reference in the tax statutes to taxable earnings being negative. ITEPA 2003 s 11(3)(a) provides that:
‘Relief may be available under [ITA 2007 s 128]
(a) where [the total amount of taxable earnings from the employment in the tax year are] negative’; or
(b) in certain exceptional cases where [the total amount of deductions from taxable earnings in a tax year exceeds the total amount of taxable earnings for that year].’
This provision therefore envisages that taxable earnings can be negative, and the tribunal continued to consider how this can arise. In doing so, the tribunal noted with surprise that that there has been no guidance published on the meaning of negative taxable earnings, and that the concept had never before been considered by a court. In the absence of any guidance, the tribunal sought to give the phrase its most natural meaning, which it formulated as ‘a contractual reversal, under the terms of employment, of what had constituted taxable earnings’.
What, then, is the effect of taxable earnings being negative? If an employee’s salary for a year is 100, and the employee makes a repayment that constitutes ‘negative taxable earnings’ of 110, then net taxable earnings (ITEPA 2003 s 11) are minus 10. This means that no income tax arises for that year (without the need to claim relief), and relief under ITA 2007 s 128 is available in respect of the excess 10.
Section 11(3) recognises two cases where relief is available under ITA 2007 s 128 (which provides for relief where an employee makes a loss from an employment). Section 11(3)(b) applies in the case where taxable earnings are positive, but are outweighed by deductible amounts, in which case relief under ITA 2007 s 128 is restricted to exceptional cases.
This contrasts with s 11(3)(a) under which total taxable earnings for the year, even before deductions, are negative. The tribunal found that sense can only be made of this provision if it is accepted that negative earnings are deducted from positive earnings in calculating total taxable earnings for the year.
As illustrated in the example above, this means that the first effect of negative earnings arising is to reduce total taxable earnings, and that this occurs without the need to make any claim for relief. It is then only where negative earnings exceeds (positive) taxable earnings that the employee needs to claim relief, which he can do under ITA 2007 s 128 (which allows the difference to be set off against general earnings in that tax year and the previous year, with any further excess constituting a capital loss for those tax years). It is worth noting that with effect from 6 April 2013 (and subsequent years) income tax relief under ITA 2007 s 128 will be capped, in any given tax year, at the greater of £50,000 and 25% of that individual’s adjusted income.
The decision did not address the position of NICs relief on the amount that is repaid. As the decision is based on specific provisions in the income tax acts, it is not clear that similar relief would be available in respect of NICs.
In practice, although negative earnings automatically serve to reduce total taxable earnings for the year, an employee is unlikely to receive the benefit immediately. This is because (save possibly in the month in which the repayment is made) it would seem that the employer will need to continue operating PAYE on the normal basis during the year, irrespective of the potential full rebate. The employer will therefore over-deduct PAYE for the year, and the employee will need to claim repayment through self-assessment. This is potentially a significant disadvantage to the employee, due to the delay before the employee can receive the relief.
‘Claw-back’ provisions (contractual provisions whereby an employee can be required to repay cash and/or transfer shares back to their employer) are becoming ever more common in employee bonus and share plans. The Association of British Insurer’s Principles of Remuneration state that companies should operate claw-back and malus provisions, and the new directors’ remuneration report regulations will require quoted companies to state whether or not incentive plans include claw-back provisions.
To date, HMRC has been unwilling to accept claims for relief against income tax paid on value that is subsequently clawed-back, and therefore claw-backs are generally drafted to require the employee to repay only the net of tax value. This approach allows companies to ensure that executives do not receive undeserved remuneration, but does not allow the full excess value to be recovered and also leaves HMRC with a windfall.
However, the Martin decision may open the door to claw-backs on a gross basis.
In respect of bonus plans (as opposed to share-based plans), there is the question of whether a standard claw-back would constitute ‘negative earnings’. In the Martin case the bonus was paid upfront on a conditional basis. The position is slightly less clear for a claw-back in a bonus plan, because, in those plans, the conditions (such as remaining in employment) have to be met before payment is made. The repayment is then generally only triggered if, commonly, a misstatement of results or misconduct is subsequently discovered. However, the tribunal did not restrict the concept of negative taxable earnings 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.
There is, then, the further question of whether the principle can extend to a claw-back under a share plan. Share-based awards will, depending on their structure, be taxed in one of two ways: either under ITEPA 2003 Part 7, where the award takes one of the specific forms covered by that part (in particular, including a securities option); or otherwise under ITEPA 2003 s 62 as general earnings (where, for example, shares are transferred pursuant to a discretion, rather than a contractual right).
Where share-based awards are treated as general earnings, the same principles as under the Martin case would seem to apply – from a tax perspective these awards are indistinguishable from a cash bonus. Claw-back provisions often require repayment either in cash or in shares. The difficult question in the later case is what value constitutes the ‘negative earnings’ – presumably it will be the value of the shares at the time they are transferred back to the employer. This raises the possibility, where the share price has increased, of a windfall at the expense of HMRC, as the employee’s negative earnings may be greater than the positive earnings when the award vested.
Share options, taxed under Part 7, however, do not constitute ‘earnings’, but instead are ‘specific income’. The calculation of taxable specific income (TSI) falls under ITEPA 2003 s 12, not s 11, and s 12 does not include the equivalent language relating to negative taxable specific income. Inferences could be drawn from the difference. The first is that TSI cannot be negative so that the principle does not apply. An alternative is that the absence of the equivalent of s 11(3) indicates that no relief under ITA 2007 s 128 is available where negative TSI exceeds positive TSI, but this does not mean that TSI cannot be negative.
Even accepting this second reading, the situation is still less favourable in respect of the claw-back of share-based earnings taxed under ITEPA 2003 Part 7, because negative TSI could then only serve to reduce positive TSI arising in the same tax year. Unfortunately, therefore, the benefit of the Martin decision in respect of certain share plans may be more limited than appears at first sight.
Other specific issues might arise if this principle is applied in respect of share-based awards, such as the case where the employee entered into a s 431 election in respect of the shares that are subsequently clawed-back.
We wait to see whether HMRC will appeal the decision, and given the lack of judicial guidance in this area (in the tribunal’s own words) the decision cannot be immune from challenge. Even if the decision is upheld, it remains to be seen how far the principle can be applied.
Mark Ife is a partner, and Bradley Richardson is an associate, at Herbert Smith Freehills
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