On 22 September, the Upper Tribunal (UT) handed down its judgment in the case of HMRC v Julian Martin  UKUT 429 (TCC), in which it upheld an important decision of the FTT on the correct tax treatment of bonuses clawed back from employees.
Mr Martin was employed by JLT Risk Solutions (“JLT”). Following a review of their remuneration structures, JLT decided to put in place a mechanism to retain and reward its key employees. Employees entered into a new contract of employment in return for a substantial bonus payment, which would be clawed back if the employees left the company. The claw back provisions worked on a time apportionment basis, spread over a five year period.
In Mr Martin’s case, the bonus advanced was £250,000, on which PAYE and NIC of £102,500 were withheld and Mr Martin received a net payment of £147,500. The following year, Mr Martin resigned his position with JLT and became liable to repay £162,500.
Mr Martin sought to amend his tax return for the year in which he received the £250,000 bonus payment, to reduce the taxable amount by the £162,500 that he had repaid to JLT. HMRC rejected Mr Martin’s amendments and an appeal was lodged with the FTT.
The FTT was asked to consider how this arrangement should be taxed; whether the £162,500 repaid by Mr Martin should be deductible against his taxable income and, if it was deductible, in which year any deduction should be allowed.
Two lines of argument were deployed by Mr Martin in the FTT:
- That his original tax return was incorrect and should have been made on the basis that the £250,000 payment was a contingent payment on account and should be adjusted to reflect the value that Mr Martin actually realised from the arrangement; and
- The repayment of £162,500 should be treated as “negative earnings” for tax purposes and should have reduced Mr Martin’s taxable income.
HMRC argued that the payment of £250,000 properly constituted PAYE income in the period that it was received and that the £162,500 that Mr Martin repaid constituted damages paid for his repudiatory breach of contract to remain in post for five years, which would not have ben deductible against Mr Martin’s earnings in the year.
The FTT agreed with HMRC that the full value of the original payment of £250,000 was employment income in the year that it had been paid to Mr Martin. They accepted Mr Martin’s arguments that the repayment of £162,500 was deductible against his income, but ruled that it was only deductible in the year that he made the repayment.
Both Mr Martin and HMRC appealed against the FTT decision and the arguments were put before the UT.
The UT’s decision relied heavily on the contractual arrangement between Mr Martin and JLT:
- The initial payment of £250,000 had been made as consideration for Mr Martin agreeing to enter into the new contract of employment – it was fully taxable in the year that it was originally paid to him and could not be seen as a contingent payment on account;
- The terms of the contract were clear – if Mr Martin left before the fifth anniversary of the entry into the new contract, then he would be liable to repay a proportion of the bonus, the repayment could not be seen as compensation for a repudiatory breach of contract because it was being made in accordance with the explicit terms of the contract.
The UT confirmed its agreement with the FTT’s view that the payment of £162,500 should count as “negative earnings”, as it had the characteristic of earnings, albeit paid in the “wrong” direction, because it was a payment made by Mr Martin to JLT.
The UT then considered in which year the £162,500 was deductible. Again, the standard rules on when earnings become taxable were key: the payment of £162,500 was not made in the same tax year as the original payment of £250,000 and therefore could not be offset against that amount in calculating Mr Martin’s taxable earnings; instead the £162,500 was deductible in the year that it was paid.
The case is important, because of the growing emphasis on clawing back bonuses and other remuneration for senior management. It is very important for practitioners to note the degree to which the decision hinged upon the form of the contractual agreement between Mr Martin and JLT, and clawbacks based on less clear contractual terms may not benefit from the same tax result.