On 7 November 2005, Mr Martin entered into an employment contract with JLT Risk Solutions (JLT), which specified that he was to receive a signing bonus of £250,000 in return for committing to remain employed by JLT for five years. The bonus was repayable if Mr Martin left JLT before the end of the five-year period, and any repayment would be proportionate to the part of the five-year period remaining when his employment ended. On 25 November 2005, Mr Martin was paid his first salary payment and the bonus, and income tax and National Insurance contributions (NICs) were deducted.

On 2 August 2006, Mr Martin gave JLT 12 months' notice of termination, although an earlier release date of 31 December 2006 was later agreed. As a result, Mr Martin repaid £162,500 through three payments to JLT in the 2006/07 tax year, which was more than the after-tax amount he had received in respect of the bonus in the 2005/06 tax year.

Mr Martin sought to claim income tax relief on the proportion of the bonus he had repaid on the basis of a number of arguments. The First-tier Tribunal rejected some of the arguments, but accepted that the clawed-back proportion of the bonus should be treated as negative taxable earnings (www.practicallaw.com/9-524-3782).

However, the First-tier Tribunal disagreed with Mr Martin that the negative taxable earnings could be offset against the tax liability in the year that the bonus was paid (2005/06), stating that it must be recognised in the tax year in which repayment was made. The tribunal affirmed this decision, although for different reasons. The tribunal referred back to previous legislation to give meaning to the "undefined notion of negative earnings" rather than relying on the concept of "contractual reversal" adopted by the First-tier Tribunal.

The tribunal agreed with the First-tier Tribunal that:

The tribunal made clear that not every payment that an employee makes to an employer should be considered as negative taxable earnings, nor is the connection between payment and a contract of employment sufficient. The tribunal considered that the correct approach is to establish the attributes of positive taxable earnings and determine whether they apply to the repayment in question, with suitable adjustments to reflect the fact that payment is flowing in the opposite direction. Broadly, if a payment would be considered taxable earnings, its repayment would be considered negative taxable earnings.

HM Revenue & Customs (HMRC) argued that Mr Martin's repayment constituted liquidated damages and could not therefore be negative taxable earnings because the contract prevented Mr Martin from giving notice for five years, which he breached, leading to the payment of damages. However, the tribunal found that the repayment was made under a provision which restored amounts to JLT that it had paid out for a commitment that it did not receive in full, and so it was not a payment of liquidated damages.

The tribunal made clear that its conclusions were based on the specific contractual provisions in this case and were not intended to give any particular guidance about the application of the approach adopted to different facts.

Also, as Martin deals with circumstances where the governing legislation does not provide clear rules, this decision relies significantly on judicial interpretation. HMRC may well, therefore, appeal.

Clawback provisions are becoming more common in employee incentive arrangements than was previously the case. This is especially true in the financial services sector (see box "Clawback and financial services").

However, these concepts have also extended beyond the financial services sector and other companies now incorporate them for commercial or corporate governance reasons. Also, the Financial Reporting Council has revised the UK Corporate Governance Code to require UK listed companies to apply malus or clawback to directors' incentive arrangements (see feature article "Corporate governance: learning lessons and looking to the future", this issue).

In principle, an ability to offset tax liabilities against gross amounts that are clawed back provides some comfort for individuals who are subject to clawback provisions, but it is not without challenges from a practical perspective.

The tribunal made clear that its conclusions were restricted to the contractual provisions in this case. Provisions that are drafted differently may be susceptible to challenge as creating liquidated damages or payments that otherwise do not constitute negative taxable earnings. The exact drafting of clawback clauses may therefore be critical to the availability of relief through negative taxable earnings.

An individual subject to clawback must have sufficient positive taxable earnings in the year of repayment to offset the amounts repaid, otherwise a loss is created. While a taxpayer can claim a loss against general income under section 128 in the year an employment income loss arises or in the previous tax year, recent changes to the loss relief rules mean that loss claims are limited to the greater of £50,000 or 25% of the taxpayer's "adjusted total income" for that tax year.

This change may significantly restrict the value of any loss relief claim where an individual is subject to clawback of large amounts or where clawback is operated at a time when his income has significantly reduced; for example, after retirement or when he has moved to less well paid work.

In addition, the employment of an individual subject to clawback is likely to be terminated as a result of the circumstances that cause clawback to be operated, which would probably mean that the amount of positive taxable earnings against which negative taxable earnings could be offset in the year of repayment would be limited. The amount of relief available to individuals affected by clawback as a result of this decision may therefore also be limited.

It should also be noted that there is no equivalent mechanism for reclaiming either employer or employee NICs.