UK: Exploitation Of Partnership Tax Rules

Last Updated: 30 May 2013
Article by Terence Pay

As announced at Budget 2013, the Government is consulting on how to change two aspects of the partnership tax rules in order to prevent tax loss arising from disguised employment relationships through limited liability partnerships (LLPs) and from certain arrangements involving the allocation of profits and losses among partnership (not just LLP) members.

Consultation on the proposals will run until 9 August 2013 and the new rules will apply from 6 April 2014.

Salaried members of LLPs

Under current tax rules, individual members of LLPs are taxed as self-employed partners and corporate members are liable to corporate tax according to their respective profit shares (if UK resident).

Individual members of an LLP are currently 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 ceases. This tax treatment applies even if they are engaged on terms such that the individual would normally be regarded as being closer to those of an employee.

The principal aim of the proposed changes is to prevent a member of an LLP benefiting from the default partner status if the terms of his engagement with the LLP are tantamount to the terms of an employment.

HMRC intends to require that an individual member who meets either of two conditions will be classed as a "salaried member" and, therefore, liable to income tax and primary Class 1 National Insurance Contributions (NICs) as an employee. The LLP will also be liable to pay secondary NICs as an employer.

Condition 1:

A "salaried member" of an LLP is an individual member of the LLP 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.

This condition aims to provide a relatively straightforward test that will clearly identify particular LLP members as employees in many cases.

Condition 2:

A "salaried member" of an LLP includes an individual member of the LLP who does not meet the first condition but who:

  1. has no economic risk in the event that the LLP makes a loss or is wound up;
  2. is not entitled to a share of the profits; and
  3. is not entitled to a share of any surplus assets on a winding-up.

These conditions are not intended to apply to members who:

  • are in essence partners of a traditional partnership now carried on as an LLP;
  • are taken on as members at an appropriate point in their career in recognition of their professional knowledge and skills; and
  • 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 though as junior partners they are substantially rewarded by a fixed profit share.

Profit & loss allocation schemes

HMRC claims that it has seen an increasing number of arrangements which use the flexibility of partnership profit and loss sharing arrangements to secure tax advantages. Unsurprisingly, such schemes have become increasingly common as the difference between income tax and corporation tax rates has increased.

The government plans to address three distinct types of arrangements:

  • Partnerships with mixed members (typically companies and individuals) where profits are allocated to a member that pays a lower rate of tax.
  • Partnerships with mixed members where losses are allocated to a member that pays a high rate of tax.
  • Partnership arrangements where members reduce their profit entitlement in return for payment made by other members who will be taxed more favourably on those profits.

Partnerships with mixed members

HMRC has stated that the proposed changes are not intended to affect those entering into arrangements that are not tax-motivated, but are intended to deter arrangements that exploit the tax treatment of mixed membership partnerships.

The proposals will only apply where a partnership consists of one or more members who are within the charge to income tax on partnership profits and one or more members who are not (e.g. a company); and either a "profit condition" or a "loss condition" is met.

Where the profit condition applies, HMRC is proposing that all or part of the profits allocated to members not within the charge to income tax will be allocated to members within the charge.

Where the loss condition applies, HMRC proposes that no income tax relief or capital gains relief will be given for the relevant partner's partnership loss for the period.

It is not clear if the rules will apply to partnerships consisting solely of corporate partners where one or more corporate partners is subject to income tax in the UK. However, it seems clear that the rules cannot apply to partnerships consisting of only non-UK resident partners with no UK source income.

Partnership members with differing tax attributes

HMRC also claims that it has seen a number of schemes in which:

  • a member (the "transferee") contributes capital to a partnership or makes payment to another member (the "transferor"),
  • in return for the transferee receiving a new or increased share of the profits; and
  • the transferee is either not taxed at all on the profit or is taxed at a much lower rate than the transferor would have been.

The government proposes to introduce legislation that will apply where the transferee member becomes entitled to a share of the profits or an increased share of the profits as part of a profit transfer arrangement and it is reasonable to assume that one of the main purposes of the arrangement is to secure a tax advantage.


It seems clear that the proposals aim to prevent tax avoidance schemes using partnerships rather than arrangements within traditional professional services firms.

Nevertheless, it will be necessary for many partnerships to review certain aspects of their tax structuring when further details of the proposed legislation are available, particularly where using the widespread practice of allocating profits to a corporate partner.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Terence Pay
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