Where there has been misconduct, misstatement of results and in certain other circumstances, including regulatory failings, there is now growing focus on listed companies and financial services firms to have the ability to recover bonuses or shares from their directors and senior employees. This is known as clawback.
This is only starting to be provided for by companies, but the growing momentum for it is driven by regulatory and/or investor demand. See our previous Law-Nows on these developments:FRC publishes updated UK Corporate Governance Code
and Further regulatory proposals on pay
. Clawback is different from reducing or forfeiting bonuses or share awards which would otherwise be received in the future (and which is now starting to be distinguished from “clawback” by being called “malus” or “soft clawback”).
One of the uncertainties with clawback is the tax treatment. Crucially, can the director or employee get the tax back he or she has suffered on the bonus now being paid back? A recent tax appeal has confirmed an earlier decision that yes, tax can be claimed back, but only in certain circumstances.
The facts of the case were that an employee received a £250,000 signing-on bonus. The bonus was paid at the time he joined but a progressively declining proportion of the gross amount paid over was subject to clawback if he left employment within five years.
The employee left employment before the end of five years and was required to repay £162,500 of his bonus, which he did (the case report does not say whether his new employer assisted him with this, though this can often be the case).
The employee argued that his income should be reduced by £162,500 to reflect the payment he had made. HMRC disagreed. The employee argued that there were several ways he should receive relief but the judge at the first hearing ruled in his favour on one ground only. The appeal tribunal also ruled in the employee’s favour on the same ground albeit, for slightly different reasons.
Implications of decision
Although in the employee’s favour, the appeal decision still gives rise to a number of issues for bonus and share plans.
To start with, the decision concerned someone repaying a signing bonus to join a competitor. This is somewhat different from the normal circumstances of clawback, where there is a concept of damage to the business, but there are similarities and crucially the appeal decision in the employee’s favour rested on the repayment obligation simply being a contractual term rather than why a contractual term came into play. (HMRC interestingly did not dispute in principle that repayments by employees (or ex-employees) under a contractual provision reduce overall earnings – they just disputed in this case whether the contract was being followed, which will not normally be an issue). The decision therefore makes it important that the ability to claw back from an employee is included as a contractual term.
On that point, while this particular employee had the clawback terms in his employment contract, it does not seem material if the relevant terms were in a set of bonus plan or share plan rules instead, as these would still be contractual, but a voluntary payment even to preserve reputation would not appear to be tax deductible. The judgment also said that repayment had to be made to the employer (though recognised that there could be cases where a payment to a third party might be relevant, which would probably cover repayment to a group parent company, for example).
Finally, in most clawback clauses, the amount which can be clawed back is left to the discretion of the Remuneration Committee. In contrast, the amount repayable in this case was calculated by reference to a predetermined formula. Again, that in itself would not seem a problem on the basis of the analogy which was used in the case. If a bonus set at a company’s discretion would be earnings, then a repayment set at their discretion would be “negative earnings” (and so eligible for relief) too.
However, these are all interpretations of a judgment which does not directly address many of the points commonly considered in clawback. As such, until HMRC (which has been very reluctant to comment publicly on clawback) gives its views, this will remain an area of some uncertainty. Legislation introduced since the relevant payments in this case in any event limits an employee’s ability to offset net losses (such as repayments) against other income, meaning that the ability to claim tax relief may be of little use in some cases. There are particular issues too with repayments of amounts gained from share awards because the taxation of (share) gains is in a different part of the tax code from the tax treatment of the (presumably cash) repayment. Finally, in most cases the gross amount needs to be paid back to the employer in order to get credit, whereas tax returns (and a tax repayment) may take some time to process, meaning that the employee could be at a significant cash-flow disadvantage.
The bigger issues in this area are obviously when clawback itself should apply, the actual amount recoverable from a particular employee, particularly when share prices have fallen, and how the employer (and possibly the employee) should provide in practical terms for clawback. This could be achieved, for example, by providing for the employer to have ready access to cash or the employee's other assets to ensure repayment rather than have to pursue lengthy legal proceedings (though the employee may have very different views on this).
However, the tax position does now seem to be a bit clearer and this may encourage investors and regulators to press further for clawback clauses to be included.
for a link to the judgment
Also see our previous law-now, Tax relief given on bonus clawback
published when the case was first heard, which has more discussion of some of the underlying issues.