The UK Government is concerned that the current partnership tax rules create scope for tax avoidance through the use of the Limited Liability Partnership (“LLP”) structure to disguise employment relationships and the manipulation of the allocation of profits and losses among partnership members. To address these concerns, on 20 May 2013, the UK Government published a consultation paper setting out proposed changes to the tax rules for partnerships and LLPs. Draft legislation is expected to be published in late 2013, with any changes coming into force on 6 April 2014.
Disguising employment relationships through the LLP structure
Under the current tax rules, there is a presumption that LLP members are self-employed for tax purposes. This allows an LLP to be taxed more favourably on what is, effectively, employment income, as compared to individuals engaged on similar terms but as employees, and both the LLP member and the employer avoid Class 1 national insurance contributions (“NICs”).
The UK Government is concerned that businesses may use the LLP structure to disguise employment relationships in order to take advantage of this more favourable tax treatment. Of particular concern is the potential for LLPs to grant LLP member status to individuals whose role remains, in practice, tantamount to that of an employee.
By way of illustration, if an LLP member were, in fact, an employee, the business would generally be required to pay 13.8% in employers’ secondary Class 1 NICs. This amounts to significant amounts of lost revenue for the Government.
As such, the Government is consulting on proposals to remove the presumption of self-employment from LLP members and establish a test to determine the status of an individual. Under the proposal, an LLP member will be taxed as an employee if either:
- on the assumption that the LLP is carried on as a partnership by two or more members of the LLP, the individual would be regarded as employed by that partnership; or
- suffers no economic loss (in the form of loss of capital or repayment of drawings) if the LLP makes a loss or is wound-up;
- is not entitled to a share of the LLP profits; and
- is not entitled to a share of any surplus LLP assets on a winding-up.
If an LLP member is taxed as an employee, he will be liable for income tax and primary Class 1 NICs. The LLP, as the employer, will also be liable for secondary Class 1 NICs, although it will be able to deduct the employment costs from its taxable profits.
Manipulating partnership profit/loss allocations to secure tax advantages
Partners and members are taxed (or obtain tax relief) in accordance with their share of the partnership’s profits as allocated to them under the partnership agreement. As such, there is scope for partnerships to manipulate the allocation of profits and losses to secure a tax advantage, particularly through the allocation of profits to a company.
Whilst companies that are partners pay corporation tax at the main rate of 23% of profits, individuals are subject to a higher income tax rate of, at the top rate, 45% of earnings. Partnerships may allocate profits to company partners to exploit the difference between corporation and income tax rates. Individual members indirectly benefit from those profits by having an economic interest in the company. Partnerships may also allocate losses to individual members to allow such members to claim loss relief against their general income, which would otherwise be taxed at the higher income tax rate. In this way, the overall tax liability on the members is minimised.
In response, the Government has proposed that, where it is reasonable to assume that the main purpose, or one of the main purposes, of the partnership arrangement is to secure a tax advantage, the profits allocated to company partners will be re-allocated to members who fall within the income tax charge, and claims for loss relief will be refused.
Partnerships may also manipulate the allocation of profits and losses by taking advantage of members with differing tax attributes. A member may make a payment to another member in return for an increased profit entitlement which, due to their particular tax attributes, will secure a more favourable tax treatment for the profits. This may be on the basis of exploiting the difference between corporation and income tax rates or optimising losses.
In response, the Government has proposed that where it is reasonable to assume that the main purpose, or one of the main purposes, of such an arrangement is to secure a tax advantage, the payment received will be liable to income tax.
Prepare for changes
Although any proposed changes would not come into force until 6 April 2014, it would be prudent for LLPs and other partnerships to start reviewing their existing agreements and business structures, since any necessary changes will take time to implement.
With regard to the removal of the presumption of self-employment for LLP members, LLPs should have particular regard to non-equity “contract” or “salaried” partners. The Government’s proposal to treat as employees those LLP members who are not rewarded on the basis of the LLP’s profitability, and who are not subject to a significant downside if the LLP makes a loss, is likely to capture predominantly such partners. LLPs should be mindful that HMRC has indicated that it is unlikely to regard any entitlement to a share of the business’ profits as being significant if it would never exceed 5% of the individual’s fixed entitlement. As such, unless the membership terms for such persons change, many such partners run the risk of being classified as employees.
Interestingly, the Government has taken pains to point out that its proposals are not intended to affect the status of persons who are taken on as members “at an appropriate point in their career in recognition of their professional knowledge and personal skills, and who sacrifice an entitlement to salary in exchange for the opportunity to participate in the business in much the same way as a senior partner, even if as junior partners they are substantially rewarded by a fixed profit share”. This seems at odds with the overall principles of the proposals, and it remains to be seen how the Government proposes to isolate such partners from other non-equity “contract” or “salaried” partners who became partners at less “appropriate” points in their career.
An LLP may be minded to include specific terms in their existing agreements in order to prevent its members being classified as employees. Such measures are unlikely to be effective, however, as the Government has proposed that tax-motivated terms are to be disregarded if their sole intention is to disapply the legislation. LLPs should be aware that HMRC will look beyond the written agreement to the substance of the partnership arrangements in order to determine the classification of an LLP member.
In relation to the allocation of profits and losses, LLPs and other partnerships should consider whether they have a mixed membership of certain members who are liable to income tax in respect of partnership profits, and other members who are not so liable. That member may be a company, an individual not chargeable to tax, or a non-UK resident. If relevant, the business should carefully review whether the allocation of profits and losses secures a tax advantage for any individual/entity. Businesses will not be caught by the new proposals if they can demonstrate that their profit sharing arrangements reflect the contribution that their members make to the business. However, businesses should review whether significant amounts of profit are allocated to company members who make nil or negligible contribution to the business’ profits, which would be a strong indication that the arrangements are tax-motivated.
Partnerships and LLPs should also be aware that profit deferral and working capital arrangements will be addressed in the same way as other profit sharing allocation arrangements. Profit deferral arrangements occur where a proportion of the partnership profits are required to be retained within the partnership until a deferral period expires, whereupon the member may withdraw such retained profits. During the deferral period, the ‘retained’ profit is allocated to a company member in order to reduce the upfront tax charge. Working capital arrangements, on the other hand, are where profits are ‘retained’ in the partnership as additional working capital. As such, the individual members are only liable for income tax on the portion of the profits withdrawn as ‘remuneration’, while the remainder of the profits are allocated to a company member and taxed at the lower corporation tax rates. Businesses that operate such arrangements should carefully review whether they are (or could be construed as being) tax-motivated.
An uncertain future
Until such time as details of the legislation and its true impact are known, there will be a degree of uncertainty as to partnership taxation in the UK. It can also be expected that the UK Government will not be the only government reviewing partnership taxation as a means of reducing the scope for tax avoidance; partnerships may be seen as a “soft” target when appealing to a cut-weary electorate.