On 20th May, HMRC published a consultation document which proposes major changes to the taxation of partnerships in the UK. The consultation is particularly relevant to investment management LLPs – and especially to those LLPs which include corporate members. The consultation includes two main proposals: first, to treat “salaried members” of LLPs as employees for income tax and national insurance purposes; and secondly, where one of the purposes of a corporate member is to secure a tax advantage, to reallocate LLP profits attributed to the corporate member to the individual members so that all profits are charged to income tax.
At Budget 2013, the Government announced that HMRC would consult on two aspects of the tax rules applicable to partnerships:
- removing the presumption of self-employment for some LLP members to tackle the disguising of employment relationships through LLPs; and
- countering the manipulation of profit and loss allocations by partnerships to achieve a tax advantage.
The consultation proposals go further than anticipated in many respects and will pose significant challenges for most investment management LLPs. If implemented, the changes will take effect from 6 April 2014, with no grandfathering for arrangements entered into before this date.
The Presumption of Self-Employment
Individual members of an LLP are currently taxed as partners even if their membership terms are such that they would ordinarily be regarded as an employee. For example, HMRC’s consultation document states that “members will be taxed as partners even if they have fixed salaries, are not exposed to risk, take no substantive role in the management of the business and have no rights to profits or assets if the partnership ends”. As a consequence, such members do not pay primary Class 1 National Insurance Contributions (“NICs”) (and there is no corresponding secondary employer contribution) and income tax is accounted for on a deferred basis through self-assessment rather than at the point of receipt through PAYE. HMRC consider that this position is unfair and promotes tax avoidance.
The consultation document proposes that so called “salaried members” of an LLP (broadly those members whose terms of engagement with the LLP are “tantamount to an employment”) should be taxed as employees – so that Class 1 NICs would be payable and PAYE would be operated.
A member will be treated as a “salaried member” if:
- disapplying the presumption of self-employment which applies to members of an LLP, the member would be treated as an employee of a partnership by reference to the normal tests of employment applied by HMRC; or
- the member does not fall within the first category above but:
- has no “economic risk” (for example a potential loss of capital or repayment of drawings) in the event that the LLP makes a loss or is wound up;
- is not entitled to a share of the profits; and
- is not entitled to a share of any surplus assets on a winding up.
Crucially, any risk or entitlement will be ignored if, having regard to all the circumstances, it would be reasonable to regard the risk or entitlement as “insignificant”. For example, the consultation document states that an entitlement to share in profits that, for practical purposes, would never be more than 5% of any fixed entitlement is likely to be viewed as insignificant.
It is common for investment management LLPs to engage individuals as members of the LLP rather than as employees, with such individuals contributing a small amount of capital and having a right to fixed drawings – potentially with a further discretionary profit entitlement. The consultation document suggests that this may no longer be sufficient for the individual to be respected as a partner for tax purposes.
Investment management LLPs should review the position of members – and particularly junior or fixed share members – to evaluate whether or not they would be treated as “salaried members” under the new proposals. It may be necessary to vary individual members’ terms or the terms of the LLP deed itself in order to ensure that such members are subject to genuine economic risk and have a not insignificant entitlement to the profits and assets of the LLP. In some cases, LLPs (and the relevant junior or fixed share members) may determine that it would be preferable to accept the increased tax burden of employee status.
Partnerships with Corporate Members
Most investment management LLPs include a corporate member. One of the reasons for this is the increasing difference between income tax and corporation tax rates, which makes it attractive for LLPs to allocate profits to a corporate member. In most cases, this enables profits to be reinvested in the business after being taxed at the lower corporation tax rate.
The consultation document states that HMRC has seen an increasing number of planning arrangements which use the flexibility of partnership profit and loss sharing arrangements in order to secure tax advantages. The Government considers that such planning creates unfairness and market distortion within the tax system (in that mixed partnerships benefit from more advantageous tax treatment than partnerships without a corporate member) and that new legislation is required to prevent tax avoidance.
The Government intends to target two distinct types of arrangements involving partnerships with mixed members (typically companies and individuals):
- the allocation of partnership profits to corporate members which pay a lower rate of tax; and
- the allocation of partnership losses to individual members who pay a higher rate of tax.
Broadly, the proposed legislation would bite where it would be reasonable to assume that the “main purpose or one of the main purposes” of the arrangements is to secure a tax advantage. Where the legislation applies, the planning would be counteracted by allocating all profits allocated to corporate members to members within the charge to income tax or by disallowing any loss relief.
The consultation document states that the proposed changes are not intended to catch arrangements which are not tax motivated but, based on the wide scope of the initial proposals, it may be difficult to justify the use of a corporate member in the majority of cases.
Importantly, HMRC does not propose to limit the application of this measure to aggressive tax planning as was originally expected at the time of the Budget announcement. It is clear that it is intended to apply to LLPs which use a corporate member as a tax efficient means of reinvesting in the business (so called “working capital arrangements”) and also where a corporate member is used to enable the deferral of remuneration (which is increasingly common in light of ongoing regulatory change in this area).
In addition the Government also intends to target certain transfers of interests between partners with different tax attributes to counter members reducing their profit entitlement in return for payment made by other members who will be taxed more favourably on those profits.
LLPs with corporate members should closely monitor the progress of this consultation. It is highly likely that the proposals will be adopted in one form or another. If the proposals are implemented with the wide scope currently proposed, all LLPs with corporate members will need to consider amending the arrangements currently in place and varying the terms of the LLP deed accordingly. Even if the proposals are implemented in a more restricted form, LLPs which utilise corporate members for more sophisticated tax planning or member remuneration purposes are likely to need to restructure their arrangements considerably.
The consultation process will run until 9 August 2013, with a view to the proposals taking effect from 6 April 2014. Dechert will engage in the consultation process through its involvement with the investment management industry’s representative bodies.
Dechert will continue to publish updates on the progress of these proposals. If you would like to discuss how the proposals may affect you, or if you would like Dechert to make representations on your behalf through the consultation process, please get in touch with your usual Dechert contact or one of the lawyers listed below.
A copy of the consultation paper can be found here.