Finance Bill 2014 was published yesterday in draft form. It remains under consultation until 4 February 2014.
The Bill and the papers published alongside it confirm that two key anti avoidance measures affecting the taxation of partnerships will proceed, but unexpectedly with a far wider reaching impact than previously anticipated.
Broadly, the policy underlying these measures is to:
- Introduce the so-called salaried partners proposals which treat certain members of an LLP as employees for UK tax and national insurance contributions (NICs) purposes . HMRC is concerned that LLP arrangements are being used to effectively disguise employment relationships and the measures are, it is said, introduced to counter such conduct.
- Close down certain arrangements involving mixed membership partnerships (ie partnerships comprising individuals and corporates, or residents and non-residents) which, according to HMRC, artificially take advantage of the different tax attributes of partners by allocating profits or losses in a manner which minimises the overall tax liability of individual partners.
In both cases, the proposals have been subject to fairly substantive amendment since the May 2013 consultation document (as to which – see our earlier briefing), however, they remain problematic on several levels.
The new measures broadly take effect from 6 April 2014. At this stage, no grandfathering rules will be introduced.
Salaried partners proposals
These proposals apply only to LLPs and mark a significant departure from the original proposals, first published in the 20 May 2013 consultation document, in particular in that the common law distinction between partners and employees is no longer proposed as a test for salaried partner status.
Instead, only the so-called economic test survives in the Finance Bill: members of an LLP will be treated as employees for UK tax and NICs purposes where each of the following conditions are met:
- Condition A: the LLP member is to perform services for the LLP in his or her capacity as a member, and is expected to be wholly or substantially wholly rewarded through a “disguised salary” that is fixed remuneration or, if varied, varied without reference to the profits or losses of the LLP;
- Condition B: the member does not have significant influence over the affairs of the partnership; and
- Condition C: the member’s contribution to the LLP is less than 25% of the disguised salary.
A more detailed examination of the three conditions reveals the true potential impact of the proposed legislation.
Starting with Condition B, HMRC guidance suggests that 'sufficient influence' would not exist merely because a member has voting rights or the ability to participate in the election of senior management. Instead, according to HMRC, actual participation in the management of the affairs of the LLP is required. The reference to affairs is being interpreted to mean all the affairs - or business as a whole - of the LLP , as opposed to some aspects or some business lines only. On this basis, in the case of many professional partnerships Condition B is unlikely to be satisfied other than in relation to senior management. Even in the context of smaller operations conducted through LLPs the test may exclude most members. For example in a typical asset management business, key members would be responsible for managing one or more investment portfolios, but not the business of the firm as a whole. It follows that there may be a small number only of members in any LLP who may satisfy the sufficient influence test. We observe that typically such partners may not be the key executives who are, in the language of the general partnership legislation, carrying on the business of the partnership together with a view to a profit. Instead, they are more likely to be the persons who were appointed as the managers of the business. It is unclear to us why the test is structured to prefer the latter over the former in the context of the employed vs. self-employed debate. But it appears clear that the majority of members in LLPs will not be able to rely on this test for the purpose of escaping the consequences of becoming salaried members, and therefore being treated as employees for tax purposes.
Moving on, while the definition of contribution for the purposes of Condition C is technical, and complex, it is broadly restricted to capital contributed to the LLP, so does not include retained or undistributed profits which many times fulfil the same purpose as capital, nor is it clear that loan accounts would constitute capital for these purposes. The condition sets a significant capital contribution requirement: broadly it fails in the case of a member whose non-LLP profit related drawings (as to which see further below) exceed 25% of the same member's capital contribution. We note in this context that it is relatively unusual for professional partnerships to require significant capital accounts. Firms operating in the financial services industry and organised as LLPs may have regulatory capital requirements and so capital contribution from members is not uncommon as a business matter, but in such circumstances significant capital would typically be contributed by a small number of partners, and many times these would be the corporate partners backing the business, as opposed to the key working members who embody the business (and who would be considered partners in the general partnership context). We would not therefore expect Condition B alone to come to the rescue of members of LLPs in any realistic scenario.
This leaves Condition A. Paraphrasing the language already noted above, Condition A requires a member's remuneration in the form of a profit share from the LLP to amount to at least 80% (this is what HMRC consider the term "substantially" to mean) of the member's aggregate remuneration. The test is obviously aimed at fixed or guaranteed remuneration deals, which clearly do not relate to the profits of the LLP. But HMRC's guidance also states that amounts paid by way of bonuses linked to individual member's performance, as well as remuneration generally linked to individual performance (which presumably includes "eat what you kill" arrangements) would not be viewed as entitlements to a share of the profits of the LLP as a whole. Rather, HMRC believe such amounts relate to a share of the profits (or perhaps income) of that part of the business of the LLP within which the individual member operates, and against which his performance is measured. We do not agree with the way in which HMRC appear to interpret the impact of the proposed legislation in many cases. Fundamentally so-called bonuses relating to members performance, and "eat what you kill" models are methods for determining the size of a member's share of the profits of the LLP - as opposed to a substantive entitlement to a share in part only of the business of the LLP.
But leaving this point to one side, it is disturbing that HMRC view performance related profit shares and "eat what you kill" models when implemented in the context of an LLP as abuse of the tax legislation which requires counteraction. The same point can be made in relation to a large number of the examples provided in HMRC's guidance. We broadly agree in this context with that part of HMRC's guidance which notes as a technical matter that as drafted advances made to partners (in anticipation of future profits), and guaranteed payments, may be caught by Condition A. What the proposal seems to ignore is that business reality (and in the case of some firm the business model) anticipates the need for advances, and guaranteed payments, in the start-up years when profits may be slow, as well as when recruiting key members who are fundamental to the business carried on by all the members. It is again a concern that the proposed legislation sees such scenarios as correct hallmarks for the type of abuse which - rightly - should be tackled in the context of persons who do not embody the business of the firm and are at heart employees.
The emerging position seems to be at odds with the very purpose of the LLP legislation, introduced in 2000 in the UK for the purpose of facilitating a new form of incorporation which combines the legal and tax benefits of partnership, with limited liability and separate legal personality (see Explanatory Notes to the LLP Act 2000). It is difficult to understand why individuals who are at the heart of their firm's business and which on any general law assessment would be viewed as the embodiment of the business and hence as true partners, are considered by the UK tax legislation to be engaged in some abuse of the tax system. It is to be recalled that the general partnership concept is not determined solely by reference to the method of profit sharing. Hitherto, there has never been any suggestion that the position should be different in the context of LLPs, whether as a matter of the general law, or of tax law. In this context it is notable that in the 24 hours since the draft legislation has been introduced we have already seen businesses in the course of set up and which it would have made commercial sense to structure as partnerships, shifting away from LLP structures for no good reason other than the arbitrariness and therefore uncertainty associated with the new provisions. We doubt this was the intended goal of the provisions.
Finally, we note that the provisions only deem a member to be an employee for UK tax purposes, not for other wider legal purposes. In the context of international taxation this may give rise to individual obtaining a "hybrid status" (employees in some jurisdictions, but self-employed in others), with resulting arbitrage opportunities.
This analysis will apply for income tax law purposes only.
The new provisions will be supported by a targeted anti avoidance rule (TAAR) which is intended to stop taxpayers implementing arrangements designed to circumvent the new rules if these arrangements have no substantive effect other than to avoid these rules.
So, for example, while the salaried member legislation is aimed at UK incorporated LLPs and it may therefore be suggested that the use of a Jersey LLP or a US incorporated LLP, may escape the new legislation, doubts as to whether this is the case must arise in view of the TAAR.
(As an aside, it is odd that existing US LLPs with UK members - in respect of which it is unlikely that the TAAR would apply, will from now on be treated differently from UK LLPs.)
Mixed membership partnership proposals
The mixed partnership proposals apply to all partnerships as opposed to just LLPs.
The rules will also apply from 6 April 2014 although a TAAR will apply from 5 December 2013 (as to which see below).
The draft legislation will, where it applies, allow HMRC to:
- Treat partnership profits allocated to a corporate partner as arising to an individual partner for income tax purposes.
The legislation will apply where it is reasonable to assume that the effect (rather than the purpose) of the profit-sharing arrangement is to reduce the aggregate tax payable. HMRC consider that it will generally be clear that this condition is met if the individual member is taxed at high income tax rates (up to 45%) while the corporate member pays the standard rate of corporation tax (21% from 1 April 2014).
So, for example, the legislation will prevent profit allocations to a corporate member from having tax effect where these exceed the “notional” value of the services or capital the company provides to the partnership and this is the consequence of a connection between the individual member and the company. The determination of this notional value for services will follow principles already used where service companies provide services to a partnership. Where the corporate partner provides capital for use in the partnership, the return on this should not exceed a return which is economically equivalent to interest.
- Deny tax relief for those partnership losses which are allocated to individual partners in a mixed membership partnership where there are arrangements with a main purpose of diverting partnership losses from a non-individual to an individual in order that the individual may access income tax loss reliefs or capital gains relief.
A TAAR (applying from 5 December 2013) will apply to those arrangements which seek to circumvent the new rules – particularly where individuals provide services to the partnership through an intermediary entity rather than as a partner. The TAAR will be operative where it is reasonable to conclude that the individual would have been a member of the partnership but for the existence of the mixed membership rules. In such cases, the mixed membership rules will apply as if the individual were actually a member.
To address concerns about “economic double taxation”, corporate members will be allowed to make payments to individual members out of profits that have been reallocated to those individuals for tax purposes, without any additional tax charge arising.
There have been two notable departures from the May 2013 consultation:
- The application of the new rules now hinges on an objective test and not a purpose test as originally proposed.
- For AIFMD regulated firms, the new rules (which will also apply from 6 April 2014) attempt to allow for deferred remuneration in particular circumstances without tax arising on the entitled members. The rules are extremely complex but the stated goal is to allow members of AIFM partnerships to allocate “restricted” profits to the partnership. Such restricted profits are those profits that represent variable remuneration under the AIFMD other than upfront profits that are received in cash. However, instead, the legislation will impose a charge to tax on the restricted profits at the rate of tax (45%) to be paid by the AIFM partnership. When equivalent amounts are in future ultimately distributed to individual members, credit for the tax paid by the partnership will become available, to the individual.
On an initial review of the draft provisions it is unclear to us that they do in fact operate in the manner proposed in all circumstances. In any event, the complexity which they introduce to make deferred remuneration arrangements dictated by other legislation (i.e. the UK implementation of AIFMD) operate sensibly in the light of far reaching UK tax anti-avoidance rules is breath-taking.
The Government will consult on the terms of the draft legislation (but not the underlying policy) until 4 February 2014. If you would like assistance in responding to this consultation, please contact one of the authors.