Court upholds employee “negative earnings” loss claim

Tue 07 Oct 2014

Julian Martin (M) and HMRC’s cross-appeals on his negative earnings claims have been heard by the Upper Tier Tribunal (UTT).  The UTT confirmed the earlier FTT decision, but for different reasons, with the result that:

1. M’s claim that where part of a signing-on bonus was refunded  (the bonus having been taxed in full as earnings in the year of receipt (2005/06)) that part should cease to be earnings because it was repaid, failed; and
2. his claim that the repayment of the bonus in 2006/07 created negative earnings in that year, succeeded.

Repayment did not change the nature of the earnings actually received

One argument put forward for M was that the payment was in the nature of earnings that were to accrue over the five-year lock-in period. If accepted that would allow history to be rewritten making the sums received, and rightly taxed as income, cease to be income, with M amending his 2005/06 self-assessment. The judge rejected that argument because repayment only became due where M voluntarily terminated the contract, and not if it ended early at his employer’s instigation or on ‘neutral’ grounds such as ill health or death. Nor did the contract give rights which would accrue over time; he was entitled to receive a one off payment at the outset, which he did  and this was rightly taxed as earnings. He could not ‘un-earn’ this remuneration or be ‘un-paid’ it; he could only make a repayment based on a formula related to the time that had elapsed since the contract was signed.

Negative earnings

The Judge identified three questions which concerned the negative earnings question.

1. Can earnings that are negative for ITEPA 2003 s 10 purposes (taxable earnings from an employment) then be taken into account for s 11 purposes? S 11 allows for loss relief where earnings less deductions produces a negative amount: that is the loss. But was it right even to consider making a calculation under s 11 where the sum from which the expenses etc. were to be deducted was itself negative?
2. Is negative earnings “a contractual reversal under the terms of the contract of what had constituted earnings”?
3. Was the repayment contractual or was it liquidated damages for breach of contract?

All three questions were considered together as contributing to the decision whether M had negative earnings in 2006/07 when he made the repayment.

Question 1

S 11 determines earnings by taking allowable deductions off earnings from the employment. It was not disputed that that this could produce a negative result since the point of s 11 is to give loss relief.

Question 2

What was disputed was whether an employment income loss could only arise where the starting point was positive earnings. The judge ruled that a loss can arise regardless of whether it is created only by deductions, i.e. earnings can be a negative in themselves and that can give rise to a loss relief claim under s 11. The judge ruled that if a payment must be taken into account in arriving at the employee’s emoluments it must be possible for that payment to create negative earnings for which a loss under s 11 can be claimed. HMRC asserted that this would mean giving s 11 a different effect from its predecessor (ICTA 1988 s 380) contrary to the intention of a consolidating statute.  The Judge disagreed with HMRC and ruled that his interpretation of s 11 was that it made explicit what had been implicit in ICTA.

Question 3

The issue here was whether the payment made by M could be regarded as part of the calculation of M’s remuneration. Any sort of compensation for an employee’s wrongful act could not be characterised as potentially negative earnings (as this would instead be breach of contract). However, if there was a contractual term which provided for a ‘no fault’ termination, that could properly be taken into account because the payment would then arise out of the employment. HMRC argued that the contract appeared to deny M the opportunity to give notice within five years (so the repayment would not arise from M’s employment). However, this was belied by the fact that the contract specifically made provision for the basis of calculation of the repayment of the bonus if early notice was given. Since the contract was open-ended but the compensation provision was restricted to the first five years, the court found this did not amount to breach of contract.  Thus the payment could not be characterised as “liquidated damages”. Instead, in M’s case the contract was at most modified by agreement to enable consensual termination.

Distinguishing the First Tier Tribunal decision

The Judge acknowledged that his decision was not a mere confirmation of the FTT’s decision. Warren J analysed the ICTA 1988 provisions and how they had been transmogrified into what is now ITEPA s 11.

Practical point: what do employment contracts really say?

Consider the situation if M had had a fixed five-year contract, without any reference to compensation for early termination, that he wished to walk away from; the company could then have sued him for breach of contract. The compensation would be liquidated damages, the amount of which would be uncertain (on which M would not obtain tax relief).  In contrast, where the contract provides the basis for the repayment of a golden hello if the employee leaves within a set period, the amount of compensation the company is due is quantifiable (and the employee can obtain tax relief).  This illustrates the need for employers and employees alike to pay close attention to the wording of employment contracts to ensure that the contract achieves the outcomes that the parties wish.

National insurance contributions

The case only affected income tax but HMRC made it clear that they will follow the same conclusion in respect of NICs.