What Is a Tax Clawback Agreement?

A tax clawback agreement is an arrangement whereby the tax benefits received from a given venture are reinvested into that venture to cover cash shortages. A tax clawback is just one of many similar arrangements that cover various distributions such as profits, dividends, or even stock distributions.

Key Takeaways

  • A tax clawback agreement uses tax benefits received by a specific venture are reinvested into the same venture to cover any potential cash shortages.
  • Profits, dividends, and stock distributions are similar arrangements to tax clawbacks.
  • Dividend clawbacks and tax clawbacks are similar because they both use reinvestment to cover cash shortages. 
  • Clawbacks are basically a return of previously distributed money.

How a Tax Clawback Agreement Works

Tax clawbacks are among the most popular type of clawback arrangements, providing instant and easy access to additional financing for a company in need. Clawbacks are also used to describe what, in effect, amounts to a return of previously distributed money.

Tax clawbacks are also a way for the government to reclaim funds that have been abused in the private sector, and there are many situations where tax clawbacks may be necessary. In principle, however, the Internal Revenue Service (IRS) has the power to recover back taxes without a tax clawback agreement.

Clawback agreements can also exist in contracts between two private parties, in which one party contributes equity to a project or organization if the project or organization created tax benefits for the investor, but is now short on cash flow.

Tax Clawback Agreements vs. Dividend Clawback Agreements

Dividend clawbacks are similar to tax clawbacks in that they involve reinvesting to cover cash shortages. A dividend clawback is an arrangement under which those financing a project agree to contribute, as equity, any prior dividends received from the project to cover cash shortages.

When there is no cash shortfall, those investors who provided funding can keep their dividends. A dividend clawback arrangement provides an incentive for a project to remain on a budget so that investors do not have to return dividends received before a cost overrun.

Example of a Tax Clawback Agreement

For example, when Troubled Asset Relief Program (TARP) funds were used in some cases to finance executive bonuses in 2008, it prompted members of Congress to advocate for a tax clawback, whereby the executives in question would be forced to pay back some of the bonus money in the form of higher taxes.

In other words, say Company A agrees to take $100 million from the government to avoid bankruptcy, which would cost the economy thousands of jobs and overall harm the country. Company A takes the money but then uses the funds for bonuses and vacations for executives. Because the funds come with a tax clawback agreement, should Congress find out about Company A’s use of taxpayer money, politicians could claw back the funds and impose a higher tax rate on Company A in the future.