Last week the Government published its consultation document on the taxation of partnerships. The consultation, which was foreshadowed at the 2013 Budget, sets out two areas of reform:
- Under statutory footing, certain members of an LLP (i.e. so called "salaried partners") will be deemed to be employees for tax purposes. In consequence, these members will be subject to employee NICs and the LLP will be obliged to account for PAYE and pay employer's NICs.
- To close down arrangements which seek
to, as far as HMRC is concerned, artificially take advantage of and arbitrage the different tax attributes of members of a so-called mixed member partnership (i.e.: partnerships comprising individuals and corporates, or residents and non-residents) by either allocating profits or losses in such a way so as to minimise the overall tax liability of the members.
The proposals, if implemented, are intended to come into force in April 2014, and no grandfathering of existing arrangements is proposed.
The effect of the proposals on partnerships operating in the asset management and financial services industry (including hedge funds and private equity firms) will need to be considered carefully, in light of the important regulatory changes (including AIFMD, CRD IV and the FCA's Remuneration Code) facing such industry.
These developments are discussed in more detail below. A link to the consultation document can be found here.
1. Treating so called salaried partners of LLPs as employees for tax purposes
This aspect of the consultation concerns only LLPs and will apply to individuals who come within the newly introduced definition of "salaried member", defined as:
- A member of an LLP who is an individual and who, on the assumption that the LLP is carried on as a partnership by two or more members of the LLP, would be regarded as employed by that partnership (the "first condition"); or
- A member of an LLP who does not meet the first condition but who broadly speaking (a) bears no economic risk (loss of capital or repayment of drawings) in the event that the LLP makes a loss or is wound up; (b) is not entitled to a share of the profits; and (c) is not entitled to a share of any surplus assets on a winding-up.
For affected individual taxpayers and the LLP itself, this legislation, if adopted, will result in partnership distributions being treated as "earnings" for PAYE and NICs purposes. In other words, the LLP will be required to pay employer NICs as a deemed employer of its salaried members, and will also be required to withhold PAYE and employee NICs in respect of salaried members, in the usual way as if such salaried members were employees.
HMRC has couched the salaried members proposals as a statutory reversal of the presumption that an individual member will not be treated as an employee of an LLP for tax purposes. This would put members of an LLP on equal footing with partners in a general partnership, in the sense that under the new proposals a member of an LLP would be treated as an employee (and not as a partner) in exactly the same circumstances where a person held out as a partner in a general partnership would be treated as an employee (and not as a partner).
We note that section 4(4) of the Limited Liability Partnership Act 2000 (the "LLP Act") already provides that a member of an LLP shall be regarded as an employee in circumstances where, if he and the other members were partners in a partnership, he would be regarded as employed by the partnership. So it seems HMRC do not consider the instruction in section 4(4) LLP Act as sufficient to allow a member of an LLP who is treated under the LLP Act as an employee, to be treated as an employee for tax purposes as well.
It appears that HMRC's difficulty lies with section 863(1) of Income Tax (Trading and Other Income) Act 2005 ("ITTOIA 2005"), which treats members of an LLP as partners for tax purposes. On this basis the concern appears to be that even where as a matter of the LLP Act a member may be treated as an employee, for tax purposes a member may only be treated as a partner. We do not necessarily share this concern. In the case of a general partnership, a person may either be a partner, or an employee, but not both (see Cowell v Quilter Goodison Co Ltd and Quilty Management Services Limited  IRLR 392). But in the case of an LLP the position is different: as a matter of the general law a person may be a member and an employee of the LLP, in the same way that a person may be a shareholder and an employee of a company (see Martin Tiffin v Lester Allridge LLP  EWCA Civ 35). With this in mind it would seem to us that while section 863(1) ITTOIA 2005 requires that a member is treated as a partner of the LLP for tax purposes, it does not and cannot deny the concurrent employee status for general law purposes, and therefore also for tax law purposes, of an LLP member who, as a matter of section 4(4) LLP Act, is treated as an employee. Amounts paid by the LLP to a person who is both a member and an employee of the LLP would then need to be assessed to tax, to the extent paid as remuneration for employment as employment income, and otherwise as partner distributions. It is likely that in cases where a member is also an employee per section 4(4) of the LLP Act, most if not all amounts paid to the member would be correctly characterised as employment remuneration as opposed to distributions to a partner, even if not labelled as such. On this basis, to our mind the proposals contained in the consultation document so far as relates to the so-called salaried members may not represent a true departure from the current position in law. That said, they certainly focus attention to the overriding principle that employment relationships should be taxed as such, irrespective of form. The legislation known as IR35 (contained, for income tax purposes, in section 48-61 of the Income Tax (Earnings and Pensions) Act 2003 and for NICs purposes in Regulation 6 of the Social Security Contributions (Intermediaries) Regulations 2000 (SI 2000/727)) provides another example for statutory rules which reflect the same principle, as does the case law (we note in this context the recent decision in PA Holdings (HM Revenue and Customs v PA Holdings Ltd  EWCA Civ 1414)).
The proposals do not lose sight of the fact that many LLPs are chosen as vehicles for genuine business undertakings: notably many professional practices as well as financial sector firms. The consultation document acknowledges this and notes that it is not expected that the position of members who have structured their business as an LLP but who in substance still carry on a business in partnership in common with others with a view to profit, who take risk in the business, and who are rewarded to a significant degree on the basis of a share in profits, would be affected.
The position of members with fixed drawing rights and no significant capital or other risk may be different in the light of the second condition, even in circumstances where the partner status of such members would have been respected in a general partnership scenario. It is thought, however, that that there are unlikely to be many cases which would fall into this category. Indeed, it will be interesting to see as the consultation progresses and legislation emerges, to what extent the second condition would be retained as an independent test, and if retained whether similar legislation would be introduced in the case of general partnerships.
In any event, one hopes that when eventually legislated for, the new proposals would not fetter the ability of individuals to set up business using the most appropriate vehicle for their needs. Such choice is expressly protected by the GAAR guidance (as to which see our briefing).
Also worthy of note is that the consultation operates entirely independently of HMRC's recent announcement that it regards "silent" and "sleeping" partners as liable to Class 2 and 4 NICs with effect from 6 April 2013.
2. Perceived artificial allocation of profits and losses
This section of the consultation focuses on partnerships of all forms, including non UK partnerships and those non UK entities which are treated as partnerships for UK tax purposes.
The focus is on arrangements which HMRC perceive result in profit sharing ratios to be calculated in a way that minimises the overall tax paid by the members and which does not reflect the risk, effort, and contribution made by the member.
HMRC raise two specific areas of concern:
- Partnerships with mixed membership which implement arrangements to allocate profits to members subject to a lower rate of tax (for example, a corporate member – subject to tax at 21% from 1 April 2014), and losses to members subject to a higher rate of tax (such as certain individual taxpayers); and
- Partnerships with members carrying different tax attributes which implement profit transfer arrangements. By way of example this would include arrangements pursuant to which a member accepts a reduction in profit entitlement (which would otherwise have been taxed as income) in return for a payment (e.g.: sourced out of a contribution of capital by other members which is not taxed as income).
A "just and reasonable" reallocation of profits and losses is proposed by the consultation document in the case of the first area of concern, the so called mixed partnership scenario, where one of the following conditions is satisfied:
- The profit condition: it is reasonable to assume that the main purpose or one of the main purposes of the partnership profit sharing arrangements was to secure an income tax advantage for any person. This will only arise where the profits are allocated to the member not within the charge to income tax which is in turn "economically connected" to the individual member (within the charge to income tax) such that the individual member stands to ultimately benefit (e.g. by reallocation of partnership capital) from the profit allocation to the member not within the income tax charge; or
- The loss condition: it is reasonable to assume that the main purpose or one of the main purposes of the arrangements is to allocate a partnership loss to a partner with a view to that partner obtaining a reduction in tax liability by way of income tax or capital gains tax relief.
In respect of the second area of concern, payments made to partners or their "connected persons" in the context of transfer arrangements will be treated for tax purposes as income received in the same period in which the transferred profit is received as income of the transferee partner or their connected persons. This will apply only where it is reasonable to assume that the main purpose, or one of the main purposes, of the arrangements is to secure a tax advantage which arises as a result of the differing tax attributes of the members. It is possible to contemplate various scenarios where mixed partnerships can be justified on non-tax grounds, for instance regulatory as well as non-UK tax related considerations would often require corporate partners.
In both cases, the proposals are intended to supplement the transfer of income stream rules as they apply to partnerships.
How the proposals will work in practice, if adopted into legislation, remains to be seen? While the principle of "just and reasonable" reallocation may in the first instance appear simple, the measurement of the relative contribution of different partners (including corporate partners) to the profit generation of a partnership may in practice be difficult to assess correctly: the fear being that the ensuing legislation may become a tool for seeking to tax partnerships on the basis that anything other than "maximum taxation", taking all types of members and tax attributes into account, is evidence of arrangements which fall foul of the new proposals.
Given the immense commercial flexibility of partnerships and their use in practice in so many different circumstances, a statutory departure from the general principle that partnerships may allocate profits as they see fit from accounting period to accounting period– at least in so far as the tax treatment is concerned – may have implications which are wider than those contemplated by HMRC in the context of what may be currently perceived as abusive. It is interesting in this context to note that the consultation document refers to HMRC's concern that the General Anti Abuse Rule (the "GAAR") will not be sufficient to counter the arrangements discussed here.
It will only be possible to assess the full impact of the proposed change of law when the relevant draft legislation is made available.
With this caveat in mind, it would seem that:
- Traditional professional partnerships, and financial services firms as well as hedge funds and private equity firms organised as partnerships, should not be affected in a fundamental way so far as the very choice of partnership or LLP as a vehicle is concerned. This is on the basis that the partnership and partner status will continue to be respected in relation to individuals who would have been considered, by the law going back at least a century, to be partners.
- At the same time the proposals clarify the employment status of individuals who would not be considered partners as a matter of the general law, and who sought to benefit from what HMRC refer to as a presumption of partnership status awarded to members of an LLP for tax purposes.
- It is not clear to what extent the proposals impact on the treatment of capital gains realised by partners and partnerships. In practice the law in this area is largely contained in an HMRC statement of practice (known as SP D12), but the consultation document is silent on any possible interaction with the CGT rules.
- The proposals clearly seek to put an end to more structured partnership arrangements, designed to result in tax efficiencies based on the different tax status of different partners, where HMRC feel existing anti-avoidance measures have not been sufficiently powerful. Members of partnerships displaying such characteristics would need to assess their position under the proposed new rules, bearing in mind in particular, that no grandfathering will be allowed.
- Finally, LLPs and partnerships more generally are widely used as a vehicle of choice in the asset management and financial services industry. Industry is currently considering the impact of the proposed changes to the regulatory environment, in the form of the new AIFMD rules, CRD IV and the FCA Remuneration Code, and will now also need to factor into the discussion the interaction of such changes with the proposed partnership rules; the potential for complexity in this context cannot be underestimated.