Bonus payments can be a powerful incentive and reward tool, but they must be structured carefully to avoid legal pitfalls and ineffective tax consequences. Whether you operate a contractual or discretionary bonus scheme, fairness, transparency, and consistency are key.

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Types of Bonus Schemes

Bonus schemes generally fall into two categories:

• Contractual bonuses: These are guaranteed payments when certain criteria are met. Even if labelled “discretionary,” a bonus may become contractual through consistent practice, such as being paid every year to all staff without variation.
• Discretionary bonuses: These are awarded at the employer’s absolute discretion. To rely on this flexibility, the employment contract should clearly state that the bonus is discretionary, and the employer reserves the right to amend or withdraw the scheme.

Employers should ensure that bonus terms are either set out in the employment contract or clearly referenced in a separate, accessible document. Any changes must be communicated in writing.

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Setting Clear and Lawful Criteria

Whether discretionary or contractual, bonuses should be linked to clear, objective criteria. Withholding a bonus based on undisclosed or vague factors risks breaching trust, or worse, discrimination claims.

Common criteria include:

• Individual, team, or company performance
• Profit, sales, or turnover targets
• Conduct (e.g. no disciplinary action during the bonus period)
• Length of service (e.g. not eligible in first six months)

Avoid relying on undefined or subjective measures. A lack of transparency may lead to disputes and legal claims.

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Withholding Bonuses: What the Law Says

Discretionary bonuses can be withheld, but not arbitrarily. Decisions must not be irrational, discriminatory, or damage the implied duty of mutual trust and confidence.

Failure to explain why a bonus has not been paid may itself breach that duty (Commerzbank AG v Keen). Employers should document decision-making and ensure consistency in how discretion is exercised.

Contractual bonuses on the other hand, must be paid if the employee meets the qualifying criteria. If withheld, this can lead to claims for unlawful deduction from wages, or even equal pay challenges.

Bonuses and Maternity Leave, bonus schemes must comply with equality laws, particularly regarding maternity leave.

• If a contractual bonus covers a period worked before maternity leave, the employee must receive the full or pro-rated amount, depending on how much of the bonus period was worked.
• Employers can pro rate for periods of maternity leave, except for the compulsory leave period (2 or 4 weeks), which must not be deducted (Hoyland v Asda Stores Ltd [2006] IRLR 468 CS).
• Failing to pay a discretionary bonus to an employee on maternity leave may constitute discrimination, even if no direct comparator exists (Equality Act 2010).

Treating employees unfavourably due to pregnancy or maternity leave is automatically unlawful.

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Share Schemes

In addition to cash bonuses, or as a substitute (particularly where the company has a short to medium-term exit strategy or is cash-constrained, as is often the case with startups), many employers incentivise and retain staff through awards under a suitable share scheme.

Awards made under most share schemes can be highly tax-efficient, as the rewards are typically delivered in capital form and taxed under the capital gains tax regime. Capital gains are generally taxed at a significantly lower rate than income tax, and there are usually no national insurance contributions. Share schemes can also align employees’ interests with the long-term success of the company and, in certain circumstances, may be more tax-efficient than cash bonuses.

It is, however, not advisable to include share options directly in an employment contract. Instead, such awards are usually governed by the terms of the relevant share scheme rules, with the employment contract referring only to the employee’s eligibility.

In practice, a Macclesfield clause will normally apply. This type of clause makes clear that:

• Participation in the scheme is entirely discretionary.
• The company can amend, suspend, or withdraw the scheme at any time.
• Employees have no contractual right to future participation, even if they have received awards in the past.
• Termination of employment generally ends participation, unless the scheme rules specifically provide otherwise.

The purpose of a Macclesfield clause is to prevent employees from claiming that share options or bonuses are contractual entitlements, which could otherwise give rise to claims for breach of contract or unlawful deduction of wages if the scheme is changed or withdrawn.

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HMRC tax-advantaged schemes:

• Enterprise Management Incentives (EMI) designed for smaller, high-growth companies, offering significant tax advantages.
• Company Share Option Plans (CSOPs) allow employees to buy shares at a set price with favourable tax treatment.
• Share Incentive Plans (SIPs) allow employees to acquire shares in their employer with tax advantages.
• Save As You Earn (SAYE) employees save monthly and can buy shares at a discount after three or five years.

Non-tax-advantaged (unapproved) schemes: Employers can design their own arrangements, but these don’t benefit from special tax reliefs.

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Legal Considerations

• Documentation: Rules of the share scheme should be clearly set out, usually in a standalone plan, with individual option agreements.
• Leavers: Clarify what happens to share options if an employee resigns, is dismissed, or leaves due to redundancy, retirement, or ill health.
• Corporate Events: Set out how takeovers, mergers, or company sales will affect outstanding options or awards.

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Tax Implications

• Tax treatment depends heavily on whether the scheme is HMRC-approved. Approved schemes (e.g., EMI, CSOP, SIP, SAYE) offer income tax and NIC advantages.
• Non-approved share option schemes may trigger income tax and NIC when options are exercised, or shares are sold. Employers should seek specialist tax advice before implementation as in appropriate circumstances, share plan may be structured in a tax-efficient manner.

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Final Thoughts

A well-drafted bonus policy ensures fairness, motivates staff, and reduces legal risk. Employers should:

• Clearly define bonus and share scheme criteria and entitlements.
• Document whether schemes are contractual or discretionary.
• Apply rules consistently and fairly.
• Ensure compliance with equality and discrimination laws.
• Take advice on the tax implications of any share incentive arrangements.

By combining traditional bonus structures with well-designed share schemes, employers can incentivise performance, reward loyalty, and encourage employees to share in the company’s long-term success.

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