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How to get bonus clawbacks right

How to get bonus clawbacks right

Published: 24 June 2019

In today’s business sector, employers strive to not only recruit the best staff but also retain them. The most commonly used retention method is the bonus. While bonuses used to be paid purely for past performance, they are now increasingly used for ‘forward motivational’ purposes.

To protect themselves, however, or as an insurance policy, employers have started to include ‘clawback’ provisions in employment contracts. These are devices that enable the recovery of bonuses paid to employees who are either found to not be deserving of those monies or who depart employment shortly after payment.

Clawbacks are contractual provisions that require the return of monies (often paid to employees) on the occurrence of certain events, usually the termination of the employment. Most usually, agreement to the form of the clawback is necessary for the employee to receive the bonus in the first place.

What bonus clawbacks are legally viable?

Employers need to take care in the drafting of any employment contract provision which could have a detrimental effect on the employee, and clawbacks are no exception. This is mainly because the employer-employee relationship is not considered to be legally balanced and any lack of clarity will be construed against the entity which drafted the clause. Clawback provisions are legally viable, however, as exemplified in Tullett Prebon plc v BGC Broker LP and others, where the High Court held that a contractual provision requiring the employees to repay certain sign-on payments and loyalty bonuses if they resigned within a certain period, was enforceable.

However, clawback provisions are only legally enforceable if they are clearly stated in writing and signed by both parties before or at the time the bonus is awarded. Section 409A of the Internal Revenue Code 1986 prevents employers from renegotiating the terms of any repayment clauses ‘post-event’.

Such repayment provisions are likely to be considered void if they are determined to be either a penalty clause or they result in a restraint of trade. A penalty clause can arise if the repayment is activated by a breach of contract and the repayment disproportionately penalises the employee rather than merely compensating the employer for the actual loss suffered. A restraint of trade can occur where the repayment is triggered by an employee breaching their restrictive covenants (such as going to a competitor) and where such prohibition restricts the future freedom of the employee’s activities. In Sadler v Imperial Life Insurance Company of Canada, it was held that a provision stating that an employee’s right to post-termination commission would cease if he went to a competitor was an unlawful restraint of trade.

Although not a determinative requirement, to add to the potential ‘reasonableness’ of the clawback (and therefore its enforceability if challenged), employers should also consider some kind of ratchet-down of the payment recoupment over time; for example; 100 per cent recovery if the employee departs within three months of payment, 75 per cent if within six months, 50 per cent if within nine months, etc.

Negative implications

While clawback provisions have obvious benefits for employers seeking to protect their business, and may well act as an effective ‘insurance policy’ to deter employees from leaving their employment, they are subject to limitations. In addition to the drafting pitfalls, the use of clawbacks could actually undermine a bonus incentive scheme and cause employment relationships to become fraught, if an employer aggressively applies the clawback in all circumstances. While consistency in employment scenarios is a coveted position, ‘blanket application’ is rarely the best practice to follow. In addition, a competitor may partially or fully compensate a new employee for the loss of their former bonus, which diminishes the clawback effect as a deterrent against defecting employees.

Taxation: net or gross repayment?

For tax purposes, there is a ‘plus side’ for employers; bonus clawbacks are now likely to be considered negative taxable earnings (TE) under s 11 of ITEPA 2004 and so the employer can ask for the gross payment to be returned, rather than the net sum. The employee therefore has to request of HMRC that the payment should be offset against other earnings for the relevant tax year (the year in which the repayment is made) and to the extent that negative TE exceeds TE, the employee would be able to only then claim relief for this loss. The HMRC has provided guidance and examples at EIM00842 to EIM00845, but hastens to add that specific advice should be sought, as each case is individual.

This article was first published by People Management on 14 June 2019.

Andrea London | Partner | Head of Employment

For further advice, or to discuss your case, please contact Andrea London at andrea@fletcherday.co.uk or on 020 7632 1442

The contents of this article are intended for general information purposes only and shall not be deemed to be, or constitute legal advice. We cannot accept responsibility for any loss as a result of acts or omissions taken in respect of this article.