Such rules, followed by remuneration codes imposed by other regulatory bodies, gave rise to the possibility that cash or shares would be paid or transferred by employees to employers, rather than moving in the more customary direction from employer to employee.

More recently, renewed attention has been focussed on negative earnings as a result of the Covid-19 pandemic for a number of reasons. These include (i) directors and employees voluntarily handing earnings back to their employers to keep them afloat during the crisis, preserve their cashflow and avoid redundancies, and (ii) fixed or variable remuneration (whether cash or share-based) being forfeited by virtue of contractual clawback provisions being activated by a crisis-driven termination of employment or deterioration in the employer company’s financial results since the remuneration was paid or vested.

In all these cases, a critical question will be whether tax relief is available to the employee, under the statutory concept of negative earnings, in respect of cash or share-based remuneration that moves from the employee to the employer. If so, the next question will be: how wide is the scope of the concept? The wider the better from the employee’s perspective.

The legislation

The charge to tax on employment income is a charge to tax on general earnings and specific employment income. Arriving at the amount of general earnings that are so charged involves ascertaining the employee’s “taxable earnings” (called “TE” in ITEPA 2003 s.11(1)). One might be forgiven for thinking that this must be a wholly positive number. However, that is not the case, because ITEPA 2003 s.11(3) tells us that relief may be available under ITA 2007 s.128 (set-off against general income) “where TE is negative”.

It was not until September 2014, when Martin v HMRC [2014] UKUT 429 was decided by Warren J in the UT, that the concept of TE being negative was fully understood. That case decided that (i) negative earnings from an employment in a tax year could reduce positive earnings from that employment in that year for income tax (but not NICs) purposes, still leaving a positive amount of taxable earnings, or (ii) negative earnings from an employment in a tax year could exceed positive earnings from that employment in that year for income tax (but not NICs) purposes, giving rise to the possibility of relief under ITA 2007 s.128 in respect of the excess (ITEPA 2003 s.11). This far-reaching conclusion derives from the mere four words “where TE is negative” in ITEPA 2003 s.11(3).

Where an individual is an employee in a tax year and makes a loss in the employment in that year, ITA 2007 s.128 permits the employee to claim employment loss relief against his or her general income of the loss-making year, the previous tax year or both tax years. The relief is subject to the £50,000 or 25% of income limits in ITA 2007 s.24A.

The history

Whilst the origin of what became in 2003 the concept of negative earnings may date from some time ago, the history referred to in the cases seems to start with TA 1988 s.380, which gave relief for losses in “any trade, profession, vocation, or employment”. TA 1988 s.380 is the predecessor to ITA 2007 s.128. The trail seems to have been fairly cold even in 1988, because there does not appear to be any caselaw authority on losses incurred in an employment for the purposes of TA 1988 s.380. However, HMRC published guidance on that section (BIM75240), in which they said that the loss had to arise directly from the conditions of the employment and gave as examples (i) a departmental manager remunerated by a percentage of departmental profits and responsible for a corresponding percentage of any departmental losses, and (ii) a commercial traveller responsible for bad debts arising from orders obtained by him or her. In both of these cases, effect would normally have been given to the employee’s responsibility for losses or bad debts by a payment from the employee to the employer.

At the time of the hearing in the Martin case, the examples of the departmental manager and the commercial traveller were included in EIM32866, which added this further requirement in relation to ITA 2007 s.128: “An employee’s title to relief should not be admitted unless the loss arises directly from the conditions of the employment. The employee must be contractually obliged to suffer a part of the employer’s losses”. This further requirement was rejected by Warren J in the UT and HMRC’s counsel did not seek to support it either. The guidance at EIM32866 is now at EIM00825 under the heading “The law before ITEPA”. This may suggest that HMRC no longer support the above further requirement, though EIM00825 does not expressly retract it.

In Warren J’s view, the reference in ITEPA 2003 s.11(3) to negative earnings did not bring about a change in the law. Although the emphasis before 2003 was on the relief in TA 1988 s.380 and there was no statutory reference to “negative earnings”, he regarded ITEPA 2003 s.11(3) as making explicit that which was previously implicit in the pre-existing legislation, namely that earnings could be negative.

So, what are “negative earnings”?

In the Martin case, the taxpayer’s employer company decided that it would be advantageous to commit him to remaining employed for the next five years. Accordingly, the employer offered him a new employment contract, under which (i) the company agreed to pay the taxpayer a signing bonus of £250,000, and (ii) the taxpayer agreed that he would not give notice to terminate the contract within the five year period and, if he did, that he would repay a part of the signing bonus corresponding to the unexpired part of the five year appointment. Less than a year later, the taxpayer gave 12 months’ notice of resignation and, as a result, became obliged to repay 65% of the signing bonus to the company.

Following decisions made by HMRC as to the tax treatment of the repayment, the taxpayer appealed to the FTT arguing, among other things, that the repayment gave rise to negative earnings within ITEPA 2003 s.11. Perhaps surprisingly in the light of their practice mentioned above, HMRC accepted that the repayment was capable of constituting negative earnings but argued that, as the taxpayer had resigned in breach of his commitment to remain employed for five years, it did not in this case.

Warren J agreed with HMRC’s general proposition but disagreed with their application of it to the facts of the case. He held that, in essence, negative earnings are the converse of, or a mirror image of, positive earnings. The characteristics or attributes of negative earnings are, therefore, essentially the same, with suitable adjustments, as those of positive earnings. Accordingly, in deciding whether a payment by an employee to his or employer constitutes negative earnings, it is necessary to determine whether the payment arises directly “from” or “out of” the employment or is made for some other reason (Laidler v Perry 42 TC 351).

Warren J gives a striking example of a payment by an employee to his or her employer that would not be made by reason of employment and would not, therefore, constitute negative earnings, namely the repayment of money which a cashier had stolen from the employer’s till. The mere existence of an employment relationship is not enough.

Not surprisingly, however, in view of HMRC’s argument as to the taxpayer resigning in breach of contract, Warren J concentrates on termination of employment to illustrate the distinction between payments by employees that arise directly out of the employment and those made for some other reason.

For example, a contractual termination payment generally arises directly out of the employment, because it is part of the remuneration package for which the employee stipulates when entering into the employment contract (Dale v de Soissons 32 TC 118). Consequently, applying that principle in reverse, if an employment contract provides for an employee, on giving lawful notice to terminate the employment, to restore to the employer part of his or her signing on inducement payment, that reverse payment should normally constitute “negative earnings”, because it arises from the employment. It is a reverse Dale v de Soissons termination payment.

Conversely, damages paid by an employer to an employee for wrongful dismissal do not derive from the employment (Henley v Murray 31 TC 351). A payment received by an employee as compensation for the employer having unlawfully abrogated or repudiated the contract of employment does not derive from the employment. Consequently, applying that principle in reverse, if an employee pays damages to the employer as a result of abrogating his or her employment contract, the payment will not arise “from” the employment and, accordingly, will not constitute negative earnings. The payment will be a reverse Henley v Murray payment.

Warren J decided that, although the taxpayer in the Martin case resigned in breach of the notice provisions, the provision requiring him to refund part of his signing bonus was not a provision for damages. The partial refund was a reverse Dale v de Soissons payment. The taxpayer made the partial repayment in implementation of the employment contract, not in abrogation of it. Despite the resignation being in breach of the notice provisions, the repayment arose directly from the taxpayer’s employment and was made for the purposes of the employment.

What is the scope of negative earnings?

The Martin case gives clear guidance on the application of the concept of negative earnings to contractual bonus repayments made in the context of the termination of employment. The question, however, that arises from that case is: what other forms of value passing from an employee to the employer by reason of employment are capable of constituting negative earnings?

Voluntary payments

What of a director or employee who voluntarily hands earnings back to the employer company to keep it afloat during the pandemic? Does the voluntary payment constitute negative earnings? We have seen that, at least before the Martin case, HMRC did not regard employment loss relief as available except in the case of payments by employees that arose “directly from the conditions of the employment”. However, whatever HMRC’s practice may now be, the application of Warren J’s mirror image explanation of negative earnings to voluntary payments would suggest that they are capable of constituting negative earnings, provided they arise from the employment. They are reverse Cooper v Blakiston payments (Easter offerings given to a vicar by parishioners).

To take a different example, just as a discretionary bonus that the employer is not contractually obliged to make may constitute positive earnings, so a voluntary payment by an employee to the employer should, if made by reason of employment, be capable of constituting negative earnings. However, there is no authority on the point, as it did not arise in the Martin case.

Employee share options

What of an employee who is required to forfeit or retransfer a share option acquired by reason of employment, for instance on termination of employment as a bad leaver? Could the loss of the option constitute negative earnings?

In Sjumarken v HMRC [2017] STC 239, the taxpayer’s employment as an investment banker at BNP was terminated by a compromise agreement under which he received various cash sums and BNP shares. During his employment, the taxpayer had been awarded certain share options but they did not survive the compromise agreement. Before the FTT, the taxpayer argued that the forfeiture of the share options constituted negative earnings but did not pursue this argument at the UT hearing.

At the FTT, HMRC advanced two reasons why the forfeiture of the share options could not constitute negative earnings.

Firstly, HMRC argued that the forfeiture of the options could not constitute negative earnings, because their acquisition did not, by virtue of ITEPA 2003 s.475, constitute positive earnings. That argument seems misconceived. The acquisition of a share option by reason of employment does constitute earnings (Abbott v Philbin 39 TC 82). ITEPA 2003 s.475 does not remove the quality of earnings from the share option, only the charge to income tax on its grant.

Secondly, HMRC argued that the options did not belong to the taxpayer to give up, as they had lapsed according to their terms as a result of the termination of his employment. There was nothing to be confiscated, since they had never vested in him. The point about vesting seems wrong. An unvested share option can be very valuable. There does not seem to be any reason in principle why the transfer of that value from employee to employer should not be capable of constituting negative earnings. The point about lapsing is more difficult. Is the concept of negative earnings predicated on money or money’s worth being transferred from employee to employer? If so, the assignment of a share option from employee to employer may qualify, if made under the terms of the employment contract relating to termination.

The lapse of an option does not, however, require any such transfer. The option is simply extinguished in accordance with its terms. An equivalent reverse transaction might be a value shift out of shares in a company owned by an employer and into shares in the company owned by an employee on the employee’s shares vesting. This would not normally involve positive earnings arising to the employee. Applying Warren J’s mirror image principle, that would make it difficult to argue that the lapse of an employee share option on a bad leaver termination constituted negative earnings, even if it involved significant value moving from the employee to the employer.

Forfeiture of restricted shares: bad leavers: malus: clawback

What of an employee who is required to retransfer shares in the employer company acquired by reason of employment, for instance on termination of employment as a bad leaver or by virtue of provisions implementing a remuneration code? Could the forfeiture of the shares constitute negative earnings?

As an award of shares to an employee by reason of employment generally constitutes earnings, it would seem logical to conclude, applying Warren J’s mirror image principle, that a retransfer of shares triggered by a termination of employment as a bad leaver or by virtue of provisions implementing a remuneration code constitutes negative earnings, provided the forfeiture arises out of the employment. However, there is no authority on all fours with the point, as the Martin case involved a cash repayment, not a retransfer of shares.

Assuming a retransfer of shares can constitute negative earnings, the next question is the value of the negative earnings. Is it the value of the shares in the employer’s hands at the time of the retransfer (which might be their full market value) or their value in the employee’s hands at that time (which might be nil). There is much to be said, applying the mirror image principle, for the argument that the value of the negative earnings is the value of the shares in the employer’s hands. However, there is absolutely no authority on the point.

Where does this leave us?

The scope of negative earnings is almost certainly wider than has generally been appreciated. As a result of the financial crisis and now the pandemic, there will be many more cases in which value is voluntarily given up or compulsorily forfeited by employees in favour of their employers. This is sure to direct a much brighter spotlight on the extent to which these value shifts generate negative earnings. That will hopefully lead to more cases in which some of the unresolved points raised in this article are clarified.

This article was first published in Tax Journal.