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UK Partnership tax changes – how complex can it be?

Robert Mellor, Partner, and Moonir Kazi, Senior Manager – Tax

PricewaterhouseCoopers LLP

Q1 2014

Following last year’s consultation exercise, HMRC issued draft legislation and guidance notes in December 2013 detailing a raft of very significant changes to the taxation of partnerships in the UK. These changes take effect from 6 April 2014 and therefore businesses structured as LLP’s need to engage with these changes. To aid this we have set out below some of the practical implications which arise from the new rules.

“Salaried members” of LLPs

A member of an LLP will be deemed to be a “salaried member” (and therefore employed for tax purposes) at any time when all of three conditions detailed below are satisfied.

Condition A – “disguised salary” from LLP

Condition A is that it is reasonable to expect that member’s remuneration from the LLP for the performance of his services as an LLP member will comprise 80% or more “disguised salary”. The concept of “disguised salary” is therefore critical but currently its precise scope still remains not entirely clear.

HMRC currently states in its guidance notes that “disguised salary” includes the following: a fixed sum (e.g. salary); a bonus based on a member’s personal performance rather than the overall profits of the LLP; a guaranteed profit share; and non-refundable drawings.

To date there have been concerns that a number of common commercial practices would create situations where profit allocations would be deemed to be “disguised salary”; these include the  payment of a profit share “bonus” calculated on the performance of a partner’s own portfolio, “desk” or Fund rather than the overall profits of the LLP; where a bonus is calculated as a percentage of a global profit pool (rather than the LLP profit pool); and fixed monthly drawings which are in principle refundable if the LLP has insufficient profits but which the partner  is in practice unlikely to be required to repay. It was expected at the time of writing that the next HMRC Guidance Note (due mid-February) would address some of these areas, but not all.

On the other hand, HMRC may be prepared to accept that where a bonus is calculated as a share of the overall profits of the LLP and the member’s personal contribution or performance is used to determine his share of those profits, the bonus will not comprise “disguised salary”. As it stands, whether or not an individual satisfies this test will hinge on the drafting of the LLP agreement and how the document defines the calculation of a member’s remuneration.

Condition B - “significant influence over affairs of LLP”

Condition B is that a partner does not have a “significant influence over the affairs of the LLP”. HMRC states in its guidance notes that the test is whether or not the member has a “significant influence over the business as a whole, rather than individual components of the business”.

Whilst the initial HMRC appeared to restrict significant influence only to members of the LLP management it is expected that the next HMRC Guidance Note will reflect a wider group of key business risk takers (possibly extending to the heads of compliance and risk, CIO, senior portfolio managers and other regulated roles) as falling to be treated as having significant influence.

Care needs to be taken where there is a corporate managing member of the LLP as the rights and influence of the corporate member can act to undermine the argument that the individual members have “significant influence.

Condition C - “contribution” to LLP

Condition C is that a partner’s “contribution” to the LLP is less than 25% of the amount of the “disguised salary” which it is reasonable to expect that the LLP will pay the partner in the relevant tax year (for his performance of services for the LLP in his capacity as a member of the LLP).

This “contribution” to the LLP does not include any amount which the member may be called upon to pay in the future, any undrawn profits of M (unless they have been capitalised) or any amount which is part of an arrangement to enhance M’s capital contribution to the LLP and thereby avoid M being a “salaried member” where there is no intention that the arrangement should have permanent effect or the arrangement gives rise to no economic risk for the member.

It seems that capital subscribed by a partner for shares in a corporate member of the LLP or its parent company does not constitute a “contribution”, notwithstanding that the capital is subsequently contributed by the corporate member to the LLP. This does not take account of commercial considerations, which means it is often not appropriate to make investments through the LLP.

It is expected that HMRC will allow an initial period of “grace” after 6 April 2014 for a partner to “top up” his capital contribution to a level sufficient to avoid “salaried member” status.

“Mixed partnerships” provisions

These anti-avoidance provisions apply when the firm’s profits are allocated to a non-individual member (usually a corporate) and basically seek to assess whether profits have been allocated to a non-individual (and away from individual LLP members) in order to achieve an overall lower rate of tax.

Where the provisions apply, for tax purposes, some or all of the corporate’s profit share is reallocated to the individual, determined on a “just and reasonable” basis. The individual partner is then subject to income tax (and self-employed NICs) on the reallocated profits.  A “just and reasonable” adjustment is made to the corporate’s tax liability.

Contrary to what HMRC’s consultation document indicated, it seems that there is no requirement for there to be a tax avoidance motive for the provisions to apply (e.g. that “the main purpose, or one of the main purposes, of the arrangements is to avoid tax”) this therefore means that many commercially driven arrangements are caught, such as retaining working capital in a corporate member, structures where LLPs are subsidiaries in a group and LLP members are equity holders at a group holding company level and seeding structures where LLP members “co-invest” in equity alongside the seed investor at the holding company level.

One part of the anti-avoidance, targeted at non-deferral structures, is fraught with subjective language such as an “appropriate notional profit”, “power to enjoy” , “reasonable to suppose”  and “attributable to” which will lead to complexity and confusion for LLP members.

There will still be circumstances where a corporate member of an LLP will be entitled to receive a share of LLP profits and which will not result in the reallocation of those profits to individual LLP members; therefore at this stage we would not expect to see corporate members leaving LLPs.

Global profit pools

Global profit pools raise a number of difficult issues, some of which are briefly considered below.

There is no “commercial motive” defence to the mixed partnerships provisions. Consequently, it is probably no defence to the application of the provisions where some of the LLP’s profits are allocated to a corporate member with a view to their forming part of a global profit pool operated outside of the UK.

Where an LLP member has an interest in an offshore parent company of the LLP or corporate member which entitles the member to participate only in the offshore parent company’s non-UK profits (and not in its share of the LLP’s profits), it is possible that A may not have a “power to enjoy”.

AIFM arrangements – statutory deferral regime

The rules do contain an administrative relieving provision for LLPs which are AIFMs under the AIFMD provisions and which operate a deferral arrangement (be it as prescribed under AIFMD or otherwise). 

There is currently a drafting issue with these provisions as they apply to an AIFM “wholly or mainly” carrying on an AIFM trade, which would preclude those AIFMs which manage a significant number of managed accounts or UCITS products, although it is expected that HMRC will address this point.

Under this approach, the LLP can elect to make income tax payments (but not NICs) on the profits which are subject to deferral. At the end of the vesting period the individual to whom the profits are ultimately vested receives those profits with an associated tax credit so that no further income tax is payable.

These provisions address the potential double taxation scenario where deferred profits in year 1 do not ultimately vest in the partner to whom they were allocated but instead are received by a different partner in say, year 3.

Next steps

Further guidance is expected from HMRC in mid-February and HMRC have made it clear that there will not be a deferral of the 6 April 2014 start date. LLPs should review their LLP agreements, corporate governance structures and any side letters to individual members in light of the new proposals with a view to being able to document by 6 April why it is “reasonable” to treat an LLP member as being self -employed and not as a salaried partner whose “profit share” is subject to PAYE and NIC.

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