Potentially significant tax consequences from HMRC consultation on the taxation of partnerships

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In the 2013 Budget it was announced that HMRC would be consulting on two aspects regarding the taxation of partnerships. This consultation was released on 20th May and is relevant to all asset management partnerships and in particular those partnerships which include corporate members.

HMRC accept that people have a legitimate choice of entity through which to operate their business be that as sole trader, corporate or partnership. Each choice comes with its own tax attributes. However, HMRC consider that mixing companies and individuals in the same partnership opens up the opportunity to benefit from the low tax rates that a company offers but without the full tax consequences of being employees or owners of a company. There is no intention to limit the choice of a partnership as a business model however the consultation contemplates significant changes.

The consultation document covers the two areas announced in the Budget:

1. Removing the presumption of self-employment for some LLP members to tackle the disguising of employment relationships through LLPs; and

2. Countering the manipulation of profit and loss allocations by partnerships to achieve a tax advantage.

The consultation document does not go into the general scheme of taxation for partnerships but does make reference to this being looked at by the tax simplification project as a totally different work stream.

Timing

New legislation is targeted to be introduced from 6 April 2014. Responses to the consultation are due by 9 August and it is expected that draft legislation will be issued in advance for further consultation.

Although HMRC discuss loopholes and avoidance in the consultative document it does not seem that we will see earlier changes. Equally, it appears that the intention is for the changes to apply to all partnerships from that date with no “grandfathering” for existing arrangements.

Ending the presumption of self-employment

An individual member of an LLP is currently treated as self-employed regardless of the actual rights and risks that that they have under the partnership agreement. As a self-employed person, employment related National Insurance Contributions (“NIC”) are not payable and Income Tax is paid by instalments, in arrears, rather than under PAYE at the point of payment.

The consultation proposes that a “salaried partner”, as defined, will be treated as an employee with full NIC cost (and presumably PAYE). An individual will be deemed to be an employee if either:

1. The member would be an employee of the partnership by reference to the normal tests of employment as applied by HMRC. This is based on the tests set out in the HMRC Employment Status Manual which can be found HERE; or

2. The member has no significant economic risk that would lead to a loss of capital or the repayment of drawings if the LLP makes a loss, is not entitled to anything other than an insubstantial share of profits (suggested in the consultation to be 5% or less of any fixed entitlement), and is not entitled to surplus assets on a winding up.

A targeted anti-avoidance rule (TAAR) will stop the manipulation of the LLP deed to side step the new rules.

Comment:

The relationship that each member has with the LLP will have to be reviewed in the context of the new rules. Assuming that the first condition can be met, many members have limited capital at risk, are protected from having to repay drawings and may have limited rights to excess profits or assets in a winding up. Some of these protections may have to be removed and there may be challenge from junior partners to retain such protections with the consequence that they would have to be treated as employees with the higher tax cost that entails.

Mixed membership partnerships

The focus in the consultation is on the increasing number of arrangements which use the flexible allocation of profits by a partnership to secure tax advantages. There is an implication that HMRC see the mixing of companies and individuals as creating a distortion between businesses operating only as partnerships or only as companies.

The new rules would apply to mixed membership partnerships. That is one with members subject to income tax and others who are not which could be companies, non-residents or “others”.

Two scenarios are then contemplated;

1. Where profits are allocated to corporate members paying a lower rate of tax; and

2. Where losses are allocated to individual members who get relief for the loss at a higher rate.

The consultation suggests that the new rules only apply if it is reasonable to assume the main or one of the main purposes of the profit sharing arrangements is to secure an income tax advantage for any person.

If that is the case HMRC propose a just and reasonable reallocation of profits to those members in charge to income tax.

If losses are allocated to individuals relief will be denied for income tax or capital gains purposes.

There are a number of common commercial arrangements that are not explicitly covered in the consultation document so greater clarity needs to emerge during the consultation itself.


Finally, HMRC are looking at transfers of profit shares that are not already caught by existing anti-avoidance legislation. Broadly, any situation where it is reasonable to assume that the transferor would have been taxed the income would be treated as if the income is still that of the transferor.

If the targeted measures proposed in the consultation do not catch all possible arrangements that benefit individual members then it is clear that HMRC consider that the General Anti-Abuse Rule (“GAAR”) introduced from April 2013 may do so. There is no suggestion that the GAAR would be used now to challenge current arrangements.

Comment

While it might have been expected that HMRC would target the aggressive use of mixed partnerships, the consultation goes further and its scope potentially captures any profits allocated to a corporate member. There are many commercial reasons why a company is a member, for example from a previous “conversion” to an LLP or as a conduit for an overseas business to control a UK subsidiary. These may be covered by the tax advantage carve out but the consultation gives no further details. If enacted as suggested, at best, significant uncertainty will be created.

There is a discussion on the use of companies to provide for working capital and or to hold profits subject to deferral or claw back. Each of these scenarios seems to be caught.

For deferrals and claw back HMRC seeks views on two possible options. First, whether there should be retrospective relief if a contingent profit share does not vest (but presumably tax would then apply to the member to whom such profit is reallocated). Secondly, if a member can elect to be treated as a salaried member . It is not clear if that election would be just in relation to the deferred amount or all profits. There could be an impact on how other members would be treated as they would likely not get an immediate deduction for what is now a deferred salary payment.

The consultation is silent on aspects such as carry partnerships or investment partnerships where different profit waterfalls may apply depending on the profile of the partners. Strictly, these could be in the definition of a mixed partnership and will also need to consider the direction of the consultation.

Next steps

All investment managers operating as partnerships will need to consider a review of their structure. It is likely that further clarity will emerge during the consultation and Throgmorton intend to take an active role and will issue updates during the process.

Tax
22 May 2013
 

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