On 20 May HMRC released their open consultation on the tax rules applicable to partnerships, a move first alluded to in the Budget 2013 and a step that will undoubtedly get the attention of many in the industry given that, for many, partnerships have become the preferred entity of choice in the UK.
The proposal focuses on two aspects which HMRC believe result in unfair tax advantages for businesses operating through LLP structures.
1. Removal of the Presumption of Self Employment
The first aspect is the removal of the presumption of self employment to tackle disguising of employment relationships within an LLP and the introduction of tests to evidence self employment. An advantage may be obtained by members of LLPs over employees as employment related National Insurance Contributions (NICs) are not paid and there is a cashflow advantage as income tax is not deducted at source. The consultation proposes that if an individual meets either of the two conditions below they will be considered to be an employee:
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:
(a) has no economic risk (loss of capital or repayment of drawings) in the event that the LLP makes a loss or is wound up;
(b) is not entitled to a share of the profits; and
(c) is not entitled to a share of any surplus assets on a winding-up.
The first condition is assessed by reference to normal employment status tests such as whether there is right of control over what, where, when and how the individual undertakes their work, the basis and method of payment, provision of holidays, sick pay, pension arrangements, etc. The second condition is a more subjective test and this is recognised by HMRC in their discussion of this test when they say that risk or entitlement will be ignored if, having regard to circumstances and economic rewards, it is insignificant. For example, a member receiving a guaranteed salary of £200,000 irrespective of profits or losses of the business and not being required to repay drawings taken if profits are insufficient will be considered to be an employee.
Consequently, if one of the above conditions is met, the individual will be considered to be an employee and not self employed and Class 1 NICs will be due. Furthermore additional complications could arise where an employment relationship is deemed as this would also place such individuals within the remit of the notoriously complex disguised remuneration provisions and the employment related securities legislation.
2. Manipulation of profit or loss allocations
The second aspect aims to counter the manipulation of profit and loss allocations to achieve a tax advantage. There is currently a difference between corporate and income tax rates in the UK. This is coupled with the fact that members of LLPs are not taxed on amounts drawn from the business but on profits or losses allocated to them which may differ significantly to effort or capital contributed. Despite recent steps to address perceived avoidance in the area by extending the close company rules, HMRC clearly feel additional changes are required.
The consultation identifies three distinct situations that they plan to address:
1) LLPs with mixed members where profits are allocated to the member that pays the lowest rate of tax;
2) LLPs with mixed members where losses are allocated to the member that pays the highest rate of tax; and
3) LLPs where profit entitlements are reduced in return for payment made by members who will be taxed more favourably.
The proposal specifically mentions profit deferral arrangements whereby profits are allocated to a corporate member which has no material impact on the profitability of the business. HMRC recognises that there are regulatory requirements to operate deferral or clawback but states that these are exceptionally applied although this might change in the future. Whilst referencing AIFMD clearly HMRC have not provided any guidance on their thoughts. Precisely how an LLP business operating above or on the cusp of the AIFMD de minimus limit is expected to plan at present is unclear and disappointing given the imminent arrival of the regime in July.
Retention of working capital to finance growth is also specifically mentioned in the consultation and many regulated firms allocate profits to a corporate member to fund increasing regulatory capital requirements. HMRC considers those businesses who have structured themselves as LLPs with corporate members to have obtained an advantage over those LLPs without corporate members or companies as they are able to obtain cheaper working capital and not pay employment taxes. This is disappointing as it is equally possible for partnerships to add a corporate member and doesn’t acknowledge there will be a further tax charge when profits are extracted under law. A business should be entitled to structure itself however it sees fit and there is nothing preventing a business structuring itself as an LLP with a corporate member if commercially that works for them, indeed where part of larger corporate groups, not allowing for this appears unfeasible.
To counteract the perceived advantages, where an LLP has both members liable to income tax and members not liable to income tax, and it is reasonable to assume the main purpose, or one of the main purposes, of the LLP profit sharing arrangements is to secure a tax advantage, HMRC will reallocate profits depending on the economic connection between the members. For example, where the individual was a 50% shareholder of the corporate member and the corporate member was allocated £100,000 of profit, the individual would be assessed to income tax on an additional £50,000, reflecting their interest in the corporate member. The economic connection may not be as simple as shareholding but can also include arrangements documented in side letters or deferral arrangement when amounts vest.
Where an LLP has both members liable to income tax and members not liable to income tax and it is reasonable to assume the main purpose, or one of the main purposes, is to allocate a loss to a member with a view to them obtaining a reduction in their tax liability, then no relief will be given for that loss.
Finally, where a payment is made to the LLP or to a member in return for a share in profits in order to obtain a tax advantage, then the payment received will be considered to be income in the hands of the member transferring their rights or connected persons.
Targeted anti-avoidance rules will be introduced in Finance Bill 2014 when the proposals are due to be enacted to ensure that careful crafting of LLP Agreements does not conflict with the substance of the arrangements. Interestingly HMRC makes reference to the application of GAAR which they state may apply in some circumstances but admit that the flexibility to allocate profits and losses is currently permitted by legislation.
The closing date for comment on the consultation is 9 August 2013 with rules to be introduced in the Finance Bill 2014 and to take effect from 6 April 2014. There will be no grandfathering of arrangements entered into before 6 April 2014.
Given the gravity of the proposed changes we will be responding to HMRC’s proposals and will update you on further developments. In the meantime, it is important to remember that this is only a consultation and the proposed rules are by no means certain. Firms should take stock of their current arrangements, identify where the presumption of self employment may be weak, consider the profit allocation methodology applied and whether there are tax advantages obtained that may require reconsideration if HMRC’s proposals pass into law in 2014.
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