Firms need to take urgent action following government confirmation of imminent new tax rules.

Apart from the introduction of Limited Liability Partnerships (LLPs) in 2000 there have been few changes to partnership taxation for many years. However, last year HMRC became concerned that partnerships and LLPs were being used in ways that it did not like and it launched a consultation focusing on two main areas of concern. The Government has now published detailed draft legislation effective from 6 April 2014 which will change the landscape considerably for many partnerships.

Salaried partners

The first area of HMRC's concern involved the categorisation of individual members of an LLP between those who are self-employed and those who will in future be deemed to be employees for tax purposes.

There will be three tests relating to members. If a member fails all three tests they will be a "salaried member" and treated as employed. The first test asks whether over 80% of the partner's drawings is fixed, irrespective of the performance of the business. If so, the test is failed.

The second test asks whether the partner has significant influence over the management of the LLP. Taking the example of a large law firm, it is likely that this will apply to a relatively small group of partners who sit on the management committee.

The third test is whether the partner has contributed capital to the LLP equivalent of at least 25% of their expected fixed earnings. So if partner A receives a 'salary' of £120,000 then they would need to have introduced capital of £30,000 in order to meet this test.

Partners will only be regarded as salaried if they fail all three tests. However there are anti-avoidance provisions to prevent certain arrangements being put in place specifically so that an individual will not be treated as a salaried partner.

There are no special rules for new or retiring partners and all LLPs will need to review their existing arrangements as soon as practicably possible.

'Mixed' partnerships

The second area of HMRC's concern involves the way in which profits and losses are allocated in a case where a partnership (LLP or general) has individual members/partners and non-individual (corporate) members.

Where profit has been diverted from an individual member to the corporate member in specified circumstances, the profits of the LLP will be reallocated to the individual members who will be taxed on them.

The legislation applies where profits are allocated to a corporate member and two conditions are met.

The first test asks whether "it is reasonable to suppose" that amounts representing an individual member's deferred profit are included in the corporate's profit share so that the individual's tax liability is lower than it would otherwise have been.

There are three aspects to the second test and all three must be met to be within the condition.

  • The corporate's profit share exceeds the commercial return on its capital contribution.
  • The individual member has the "power to enjoy" the profit allocated to the corporate member.
  • It is reasonable to suppose that the corporate member's profit share is attributable to the individual member's "power to enjoy" and the individual member's tax is consequently lower.

Some comfort may be drawn from HMRC's statement that "The legislation does not apply to mixed membership partnerships in which individual and non-individual partners are genuinely acting at arms' length".

All 'mixed' partnerships will need to review their arrangements urgently.

We have taken great care to ensure the accuracy of this newsletter. However, the newsletter is written in general terms and you are strongly recommended to seek specific advice before taking any action based on the information it contains. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. © Smith & Williamson Holdings Limited 2013. code 1485/2013/db 13/1127 expiry 31/05/2014