The credit crunch and the subsequent financial crisis triggered a public debate on the question of ‘moral hazard’ in the financial trading sector. At the corporate level, the discussion was about bank bailouts. At the executive level, it was about bonuses. Pre-crash bonus structures are thought -by some- to have induced employees to ignore long-term risks in order to book short-term income. Should bonuses be clawed back then, if it transpires that unforeseen developments subsequently come to light, indicating earlier performance was in fact ‘faked’?
The market seems to have thought so. The UK Corporate Governance Code states that consideration should be given to the use of provisions that permit an employer to reclaim variable components in bonus structures in circumstances of misstatement or misconduct. The Association of British Insurers, which represents large institutional shareholders has ‘Principles of Remuneration’ which state that companies should operate ‘malus provisions’ (malus provisions allow for the reduction in deferred performance-related compensation upon the discovery of deficient performance). And the Prudential Regulation Authority has proposed extending the window for clawback for up to ten years where a firm or a regulatory authority has commenced an inquiry or investigation into a potential material failure. Other changes relating to the vesting of variable remuneration for senior managers leaving bailed-out banks are also being proposed.
Thus, as clawback provisions are becoming ever more common in employee bonus and share plans, the question of who bears the tax liability when an employee is required to repay cash, and/or transfer shares back to their employer, has yet to be properly resolved. When bonuses are paid, they attract income tax and NIC liabilities. Until now, many bonus plans which have clawback provisions tended to assume that the repayment of tax was not possible, and thus only required that the employee repay any clawbacked bonus net of the original tax deducted. In other words, the employer is left out of pocket.
The Julian Martin Clawback Case
The issue came up recently in the context of a clawback of a ‘golden hello’: A Mr Martin had commenced employment under a contract which entitled him to a £250,000 signing on bonus, which he was taxed on upon receipt. After tax, this equated to a net bonus payment of £147,500.
The employment contract which he signed included a clawback clause: if Mr Martin were to leave the company within five years of his start date, a proportion of his initial payment would have to be repaid.
It turned out that Mr Martin did leave within the five year window, which resulted in him making a repayment to the company of £162,500. This was in fact an amount greater than what he had originally received (£147,500), because of the deduction of tax from the bonus through PAYE and NIC. Mr Martin made a claim for relief for tax that had been deducted on the original bonus payment. After all, this tax was effectively a windfall in the Revenue’s hands.
He had to pursue the case through two sets of tribunals before the Revenue accepted he was entitled to that relief. Why were the Revenue so intransigent on this point? Perhaps much had to do with legislative basis on which relief was claimed: It relied on the term ‘negative earnings’. There was some confusion over what it actually meant. The Revenue weren’t prepared to accept that once the amount was paid, it constituted ‘earnings’ and thus could not qualify for relief as ‘negative earnings’.
How will this decision affect bonuses and employee incentive plans going forward?
Many employers with bonus or share plans will be asking themselves what this case means for their remuneration planning. The first point to make to the reader is that this article focuses on the tax consequences of clawback provisions. The employment aspects of clawing back amounts paid to an employee are going to be more important, and need to be thought about carefully.
From a tax perspective however, this case does suggest that clawback provisions in employment contracts might in the future include a requirement for the employee to pay back the whole amount, ie gross of income tax. This is because the employee is going to be able to reclaim that income tax (this will take time however). As this decision didn’t address employees NIC (which is deducted in the same way as income tax, under PAYE but addressed under different legislation) no relief for employees NIC can be assumed to apply. Similarly, Employers NIC, which is paid directly by the employer (and is their liability) , will not be affected by this case either. However, the Revenue are thought to be sympathetic on this question.
It is also worth pointing out that the tax relief in question here applies to clawback of ‘earnings’. That means signing on bonuses and cash bonus plans are most likely to be eligible for relief in the event of a clawback. By contrast, compensation payments made to employees whose employment has been terminated will not be eligible for relief. This is because compensation for termination of employment does not qualify as earnings.
How then will this decision apply to share and option based employee incentive plans? Will any income tax paid on the acquisition of shares be clawed back? This again will depend on whether the award of the shares falls within ‘earnings’. In some cases, share plans are taxed under different provisions which do not benefit from this ‘negative earnings’ relief. In circumstances where share awards are in fact taxable as ‘earnings’, there may be some scope for the relief to apply. Indeed, if the shares are worth more at the point the employer claws them back then when they were originally acquired, then (and this is conjecture) it potentially opens the door for the employee to enjoy a windfall by being left with income tax relief on a share award never ultimately enjoyed.
This bulletin should not be taken as definitive legal advice on any of the subjects covered.
