UK: Tax Assault On LLPs And Partnerships

Last Updated: 11 June 2013
Article by Richard Mannion

Introduction

There have been a number of recent announcements affecting the tax and NIC status of partnership interests:

  • On 20 March 2013 changes were introduced to broaden the scope of the close company 'loan to participator' rules to include, amongst other things, a broader range of arrangements involving LLPs and partnerships.
  • On 4 April 2013 HMRC announced a change of view on the NIC status of sleeping and inactive partners, newly considering them to be within the scope of class 2 and class 4 NIC.
  • On 20 May 2013 HMRC issued a consultation document proposing the following changes to take effect from 6 April 2014: (i) removing the presumption of the self-employed status of LLP members for PAYE and NIC purposes and (ii) the tax treatment of profit & loss allocation schemes. Responses are requested by 9 August 2013. The NIC aspects will be dealt with in an NIC Bill, while the remaining matters will be dealt with in Finance Bill 2014. A response document to the consultation will be published in autumn 2013 and draft legislation will be issued for consultation late in 2013.

This note summarises the potentially significant changes proposed in the 20 May consultation, but please get in touch with your usual Smith & Williamson contact for a wider discussion of potential impact of all the changes mentioned above.

LLPs and partnerships potentially affected by the changes proposed on 20 May

The proposals could have a significant impact on many types of partnership and LLPs including the following:

  • Partnerships and LLPs with partners or members some of whom are subject to income tax (for example individuals) and some of whom are not (for example companies). Some partnerships may have introduced companies personal to individual partners as members in order to manage tax charges on profits;
  • LLPs with members who have so called 'fixed share' profit arrangements where their remuneration is to a large extent fixed;
  • Partnerships and LLPs with corporate partners or members whose main purpose is to act as a source of working capital for the partnership;
  • Partnerships and LLPs with corporate partners or members whose main purpose is to act as a source of deferred profits to be allocated to individual members in due course.

The 20 May 2013 proposed changes

The consultation proposals cover two areas:

  • LLPs and disguised employment arrangements.
  • Profit & loss allocation arrangements.

LLPs and disguised employment arrangements

In response to the increased use of LLPs to take advantage of reduced NIC liabilities as remuneration of LLP members is taxed as self-employed income, HMRC is considering providing limits and a targeted anti-avoidance rule (TAAR) on the self-employed status of partners.

The changes proposed will apply where a member satisfies either of two conditions, in which case they will be treated as employed by the LLP rather than self-employed. The proposed conditions are:

  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.
  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 (loss of capital or repayment of drawings) 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.

The consultation document envisages condition one being assessed according to HMRC's employment status guidance. In particular this will require a consideration of factors like the ability to profit from sound management, the perceived financial risk and the degree of control exercised over the individual partner.

For the purpose of the second condition, risks and entitlements will be ignored if, having regard to all the circumstances and in particular the total economic rewards available or likely to be available to the member, it is reasonable to regard the risk or entitlement as insignificant. For example a profit share which gives entitlement to no more than 5% over and above the 'fixed profit' entitlement, is likely to be regarded by HMRC as an insignificant entitlement.

The TAAR will ensure that an arrangement put in place with a main purpose of preventing either condition applying will be disregarded for that purpose. An example which would be caught by the TAAR is given of a member being entitled to 10% of profits if those profits exceed a figure that is many times the turnover. There would be no real opportunity for the extra profit share in those circumstances and so this example is not very helpful in demonstrating a dividing line between what would and would not be caught by the TAAR.

Where under one of the two conditions a member is regarded as a salaried member, the 'salary' costs would be tax deductible for the LLP. There would be consequent PAYE and NIC obligations.

Prior to outlining the proposed conditions the consultation document does helpfully include the following comment:

"[These conditions 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.]"

How this aim will be achieved will depend very much on the legislation once this is drafted, and how it is to be applied in practice (which might possibly be set out in guidance).

Profit & loss allocation arrangements

In response to increasing income tax rates and the divergence between the rates of corporation tax and income tax, HMRC has seen increasing use of:(i) mixed membership in partnerships (where members include both corporate entities and individuals) so that the income taxation of partnership profits is deferred, and; (ii) adjustment of profit sharing ratios in return for a payment so that the recipient of the increased profit share will be taxed more favourably on that profit share.

Two changes are proposed:

  • For mixed partnerships, where one or more members are subject to income tax on partnership profits and one or more are not, consideration will need to be given to a profit condition and a loss condition.
    1. Profit condition: where it is reasonable to assume that the main (or one of the main) purposes of the partnership profit sharing arrangements for a period of account is to secure an income tax advantage (defined as for ITA s684) for any person then all the profits allocated to the members not within the charge to income tax will be allocated to those within the charge. The basis of reallocation will depend on the economic connection between the members not within the charge to income tax and the members within the charge. This connection could be by some ownership entitlement (e.g. shares) or as a result of a side letter to an agreement, or another arrangement.
    2. Loss condition: where it is reasonable to assume that the main (or one of the main) purposes of the partnership profit sharing arrangements for a period of account 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 CGT reliefs, those reliefs will be denied for the relevant partnership loss for the period.
  • Where there is a profit transfer arrangement, whereby profits are transferred for a payment or an asset which is outside the charge to income tax, and it is reasonable to assume that the (or a) main purpose of the arrangement is to secure a tax advantage arising from the differing tax attributes of the transferor and transferee, then the receipt of the payment will be taxed as income of the transferor or connected person. The legislation would not apply where any payments are otherwise taxed to income, and there is an indication that the target of this measure does not include arrangements where family members use partnership profit sharing ratios to allocate profit between them tax efficiently.

The consultation document recognises that the above provisions will catch arrangements such as:

  • Deferred remuneration arrangements connected with potential forfeiture conditions or incentive arrangements, that might typically be used in hedge fund and banking sector; and
  • Partnerships that use corporate members as a means to financing working capital, for example where the corporate member's profit share is taxed at corporate rates and remains available to fund partnership activities, thus taking advantage of the differential between corporate and income tax rates in terms of capital required from members to finance partnership working capital.

However in both cases the Government considers that the risks of unfairness and market distortion override any commercial arguments for the continued tax favoured treatment of these arrangements, so these will be subject to the new rules in addition to the more obviously aggressive arrangements at which the changes are targeted.

With respect to deferred remuneration arrangements, the report recognises that European Commission proposals may require partnerships to operate 'downward performance adjustments' in respect of remuneration awards that have been made but not vested (partnerships may already be required to operate clawback arrangements). The consultation document therefore requests feedback on whether a retrospective relief could be given if a contingent profit award does not vest, or whether there should be provision for a member to elect to be treated as a salaried member instead.

Required action points for those affected

All partnerships should be considering the following action points:

  • A review of the partnership structure to assess the impact of the new and proposed changes;
  • A review of each LLP individual member's status in order to be in a position by April 2014 to determine whether to operate PAYE and employer's NIC on their profit allocations and to ensure class 2 and 4 NIC are properly operated. Consideration should be given to whether arrangements with partners or members should be changed so as to achieve the desired PAYE, NIC and income tax treatment without falling foul of anti-avoidance legislation;
  • A review of the impact of the changes on partnership or LLP arrangement that involve a company, whether the company is wholly owned by the partnership or a member of the partnership.

In assessing any actions consideration will need to be given to the general anti-abuse rule (GAAR) which will become operative on the date of Royal Assent of Finance Bill 2013 (expected to be some time in July). This is a self-assessment measure which will counteract tax arrangements (arrangements with a main purpose of tax avoidance) where those arrangements cannot reasonably be regarded as a reasonable course of action. The transitional rules mean the GAAR will only apply to 'tax arrangements' entered into on or after the date of Royal Assent of Finance Bill 2013.

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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