As announced in Budget 2013, and following consultation over the summer, draft legislation will be included in Finance Bill 2014 introduced to counter: the disguising of employment relationships in relation to salaried members of limited liability partnerships (LLPs); tax-motivated allocations of business profits or losses in partnerships where the partners include both individuals and companies (mixed membership partnerships); and tax-motivated disposals of assets through partnerships. If anything, the rules contained in the draft clauses are less clear and, especially in relation to salaried members, more people may be affected than previously thought. There is some more thinking to be done, or at the very least some more guidance to be published, for HMRC to be clear about what ought to be caught.
While few practitioners will have been caught by surprise by the publication of the draft legislation on ‘salaried members’ and ‘partnerships with mixed membership’, some of its content has turned out to be unexpectedly controversial.
I do not propose to run through the rule changes in detail again here. Rather, it may be of interest to focus on some of the key points in the rules where the changes may have come as a surprise or given rise to further questions.
Under the draft legislation, a member of a limited liability partnership (LLP) will be treated as an employee for tax purposes where 80% or more of their compensation is ‘disguised salary’ (condition A), unless either they have significant influence in the business (condition B) or a capital contribution of at least 25% of that disguised salary (condition C).
If all three conditions are satisfied, the member will be treated as an employee for all tax purposes, including NIC, PAYE and rules such as employment-related securities and disguised remuneration.
As a preliminary point, the 20% requirement for the non-disguised salary in condition A, and the 25% threshold for the capital contribution in condition C, both represent major departures from the position that had been expected following the consultation. The position was expected to be that variability in profit shares and capital contributions would not be taken into account if they were ‘insignificant’, and it was understood that ‘insignificant’ would be interpreted as representing approximately 5%. Such significant changes so late in the day will leave many firms with little time to reconfigure their remuneration and capital structures if they want to ensure that their junior partners are not caught by such rules.
Condition A
Given the potential difficulty in failing either of the other two conditions, whether condition A can be failed, and hence the meaning of ‘disguised salary’, is likely to be a key point.
The draft legislation provides that an amount is disguised salary under the following conditions:
Guaranteed drawings will fall within this definition, whereas a simple percentage profit share in the residual profits of the firm after guaranteed drawings will not.
Therefore, for firms with a very simple structure containing only these two elements, the test should be straightforward to apply.
However, few firms are set up with such simple profit sharing mechanisms. There is often a middle layer of profit, which either forms part of a bonus pool or is awarded based on other more personal or sector-specific criteria. Whether this counts as ‘good’ or ‘bad’ remuneration under these rules is still very unclear.
Is my bonus disguised salary?
Variability in remuneration purely by reference to personal performance or piece-work is not determined by reference to the profits of the firm as a whole and so is disguised salary. However, that is still not clear – what about if it is by reference to both?
For example, consider a bonus pool where the size of the pool depends on the profits of the firm as a whole, but the share that an individual partner takes in that pool is determined by reference to personal performance. According to one example in the Technical note and guidance accompanying the legislation (‘the guidance’), this would not count as disguised salary.
One way of reconciling this may be that even if a member’s share of the bonus pool varies according to personal performance, if the bonus pool itself varies by reference to the firm’s performance, this should not be treated as disguised salary. In that scenario, one can say the share is variable ‘by reference to’ the profits of the firm as a whole and is in practice affected by the overall amount of those profits – even if there is no direct correlation.
There will still be many areas of uncertainty, even if this principle were agreed by HMRC. What about firms with an ‘eat what you kill’ policy? If there is no pooling of profits at all, does that mean the profits are disguised remuneration, even though such models are arguably even less like employment than traditional equity-based partnerships?
Similarly, what about large professional services firms which practice in different areas, say tax and corporate finance? Does a tax partner’s profit share have to be affected if the corporate finance department makes very little profit, but the firm as a whole is still profitable?
It seems that there is some more thinking to be done, or at the very least some more guidance to be published, for HMRC to be clear about what ought to be caught by the new rules.
Condition B
HMRC suggests in the guidance that ‘significant influence’ for the purposes of condition B will be narrowly interpreted such that few partners in larger firms are expected to meet this condition. On that basis, what counts as ‘disguised salary’ will be the critical issue. However, for smaller firms failing this condition may be an option.
Condition C
The capital contribution requirement for condition C can only be met by an actual contribution of cash (or retained profits).Attempting to get around the rules by, for example, arranging non-recourse finance for members will not succeed (there is a targeted anti-avoidance rule). Promises to commit further capital if required are also not sufficient under the current draft.
The rules do not apply to partners in general or limited partnerships. This creates a distinction between the tax treatment of LLPs and such partnerships which was not the intention when LLPs were first introduced. One of the justifications for this departure from that principle was that members in LLPs do not have the same amount at risk as general partners. However, that does not explain why the capital contribution requirement under condition C has to be provided in cash, when general partners may never have to make a contribution.
Not what we were expecting
As a final thought on this legislation, when the consultation was announced it was widely accepted that some action was needed to prevent the abuse of the presumption of self-employment for LLP members. This draft legislation goes very much further. The creation of salaried partner status – taxed as an employee but with no employment rights – seems more like a revenue-raising exercise apparently aimed at changing the tax treatment for many who would have been partners in general partnerships, but whose firms have converted to LLP status to benefit from limited liability, with the promise that the tax treatment would remain the same.
The ‘partnerships with mixed members’ rules are primarily intended to counter planning involving the allocation of partnership profits to companies. The aim of this planning was to benefit from the lower corporation tax rates on those profit allocations (23% this year compared to up to 47% for individual partners’ profit shares including class 4 NIC).
The planning it counters
At the more benign end of the scale, this planning was often used where there was a need for cash to be retained in the business for working or regulatory capital purposes. By ensuring that some profits were only taxed at the corporation tax rate, more after-tax cash was available.
Alternatively, cash could be retained by the corporate member as a ‘money box’ for later distribution, or the cash could later be reallocated to the individual members based on performance conditions (described in the new rules as ‘deferred profit’). The latter was particularly attractive, as it could result in individuals receiving cash having suffered only the corporation tax rate, with no further tax to pay.
The rules
The draft legislation applies to all partnerships, not just LLPs, and to allocations of profits to any non-individual partner. However, the main focus is on the position where a company is a member (the corporate member) of a trading LLP and so that is the structure I will refer to.
The legislation works by first identifying any part of the allocation to the corporate member which represents:
Deferred profits of an individual are reallocated to the individual from whom they are deferred.
Where a profit allocation is attributable to an individual’s power to enjoy it, and is in excess of the corporate member’s ‘appropriate notional profit share’ it is reallocated to the individual. The ‘appropriate notional profit share’ is a commercial interest rate on capital contributed and remuneration for any services provided by the corporate member.
Whose deferred profits?
The question is whether the allocation to the corporate member represents remuneration of an individual which has been deferred, whether subject to conditions or otherwise.
The profits are reallocated to the individual irrespective of whether it is likely that the profit share will ultimately vest. Therefore, even if it is positively unlikely for the whole of the allocation to vest, due to tough conditions placed on it, the individual will still be taxed on it.
What if the deferred profit allocated to the corporate member is completely uncertain and there is no provisional allocation of it to the individuals (however informal)? The legislation pre-supposes that the individual will be identifiable so there could be a technical argument that if an individual cannot be identified then there can be no re-allocation (although another approach would be to follow the allocations made to the individual members for the year in which the profits arise in the first place).
Alternative investment fund managers (AIFM) relief
One of the main justifications for deferred profit planning has always been that some firms have little choice but to defer profits subject to performance conditions to comply with regulatory remuneration codes. The draft legislation accordingly provides a relief for partnerships which are managers of alternative investment funds for the purposes of the Alternative Investment Fund Managers Regulations, SI 2013/1773. In order for this to apply to any deferred profits, they must be awarded in line with European Securities and Markets Authority Guidelines and the firm has to make an election.
An individual can then choose for his or her deferred profits to be allocated to the firm itself, which is treated as a taxable entity for this purpose and pays tax at the additional rate (45%). The individual partner then gets credit for the tax paid by the firm when the remuneration vests.
If the deferred profits do not in fact vest in that individual, there is no further tax to pay on them (they have already borne tax at the additional rate), but equally if they are then allocated to an individual who pays tax at a lower rate, or to a corporate member where that allocation is not otherwise caught by these rules, there is no credit or repayment. This seems unfair, especially where the conditions are tough such that the most likely outcome may be that the profits are allocated to and retained by the corporate (and so ought really only to bear corporation tax unless otherwise reallocated under these rules).
Conversely, where the AIFM treatment is available is that the profits allocated to the firm do not bear NIC, so there is a small cash flow advantage there.
Profit allocations attributable to a power to enjoy them
If a corporate member’s profit share is not an individual member’s deferred profit, then the next question is whether one of the individual members has power to enjoy those profits.
Meaning of ‘power to enjoy’ and ‘connected with’
‘Power to enjoy’ is widely defined and it would be a fair summary to say that if an individual may benefit economically from profits allocated to the company then he or she has power to enjoy them.
An individual is deemed to have power to enjoy any profits arising to the corporate member if that individual is connected with the corporate member otherwise than by partnership. Notwithstanding the exclusion of connection through partnership in that definition, the individual partners are all still connected with one another and so if they together control the corporate member any one individual member will be treated as connected to the corporate member.
Individuals are also treated as having power to enjoy anything a person connected with them has power to enjoy. Connection through partnership is again not excluded here and so if any one partner has power to enjoy an allocation to a corporate member then all partners will be treated as having that power to enjoy.
It will, therefore, be rare that an individual partner will be able to claim he has no power to enjoy an allocation to a corporate member. However, in order for the profits to be reallocated to the individual they must also be ‘attributable to’ that power to enjoy – and so this becomes the key test.
Meaning of ‘attributable to’
While the response document to the consultation rejects arguments for a subjective motive test, the guidance makes clear that ‘attributable to’ means ‘because of’. In particular, it states: ‘If the particular facts show that any economic connection between the individual and non-individual members does not result in profit being shifted from the individual partners to the non-individual, the mixed membership partnership legislation will not apply.’
An example is a listed PLC investing in the LLP in which the partners have small stakes for unconnected reasons.
An even more helpful example is where the corporate member used to carry on the business on its own account and contributed it to the LLP for succession planning reasons. In those circumstances (presumably provided the profit share retained by the corporate member is commensurate with the business contributed) the guidance confirms the rules will not apply.
Thus, ‘attributable to’ are the key words in the legislation and, while they may not quite add up to a subjective motive test, they do suggest that the legislation might not apply when there is a genuine commercial reason for the allocation to the corporate member.
Confusion reigned on 5 December as the press releases and legislation itself referred to a commencement date of 5 December 2013, but the rules expressly provide that the operative provisions (i.e. those which have the effect of reallocating profits to individual as opposed to corporate members) will not take effect until April 2014 – with split year treatment for periods of account which straddle 5 April. Only anti-forestalling provisions have immediate effect.
Having expected to be able to answer clients’ questions on 10 December 2013, if anything the rules are less clear and, especially in relation to salaried members, more people may be affected than previously thought. By the time these questions have been resolved the effective date will be more or less upon us – with many not knowing what that means.
