December saw the publication of draft legislation in respect of several changes to partnership taxation, potentially the most significant changes in this area in a generation.
The changes relate to:
- the taxation of individual limited liability partnership (LLP) members whom HMRC considers in substance to be employees of the LLP;
- the tax motivated allocation of business profits and losses in partnerships; and
- Alternative Investment Fund Managers' deferred remuneration.
It is worth noting that the changes apply to LLPs (in the case of disguised employment) and partnerships generally, irrespective of the type of trade or business carried on. Effectively, therefore, no real account is taken of the commercial differences between different businesses, e.g. capital requirements, predictability of income streams and operation and strategic management.
While the legislation is in theory in draft, it follows extensive consultation over the summer and accordingly any meaningful changes to the draft legislation itself are unlikely. It is hoped, however, that more clarity and certainty will be forthcoming in the next draft of the guidance, expected in mid-February.
1. LLPs: Disguised employment
New rules with effect from 6 April 2014 will, for tax purposes, treat as an employee any member of a UK LLP who meets certain conditions. The consequences are significant, as this will not only bring the individual within the PAYE and NICs rules but the individual will also be an employee for the purposes of the employment-related securities legislation which may therefore apply to any interests in underlying fund vehicles and investments which members of an LLP acquire after the new rules come in, if those members are regarded as employees for the purposes of those new rules.
HMRC has attempted to reassure professional partnerships, including those in the hedge fund and asset management industry, that these anti-avoidance proposals are not directed at them but this message is manifestly not reflected in either the legislation or much of the guidance.
The conditions
To fall within the rules, a member needs to meet all three of the conditions imposed. In other words, if even one condition is not met there is no need to consider the other two and the member will be taxed as a partner. Broadly, the conditions are:
Condition A is that the individual will be substantially remunerated for his or her services through "disguised salary", i.e. a fixed salary or a variable bonus based on their performance rather than a share of the profits of the overall business. HMRC guidance states that Condition A will be considered to be met if 80 per cent or more of the amounts payable to the individual for services to the LLP are expected to be in the form of a disguised salary.
Moving to a unitised LLP profit share rather than a fixed amount will be helpful as, in theory, there is then a real risk of exposure to the profits and losses of the LLP even if the LLP's income is relatively steady or fixed.
There also seems to be some scope for retaining quite a significant surplus profit pool for discretionary allocations to members if those allocations are made out of the overall profits of the LLP and not by reference to the performance of an individual member (irrespective of the profits of the LLP) and a share of this may be sufficient to mean that, in comparison with any fixed drawings or guaranteed profit share, the fixed or guaranteed component is less than 80 per cent of the overall package that the individual might reasonably expect to get.
This is an area which will hopefully be clarified further in the guidance.
Condition B is that the individual member does not have a significant influence over the affairs of the LLP.
This is very subjective and the guidance suggests that very few people will get out under this head. Simply sitting on the management committee seems to be enough, although this ignores the fact that particularly in larger partnerships a management committee/ function is required because the business is too big to manage otherwise. This does not necessarily mean, however, that a person on the committee has less significance than a member who is not, especially where the management committee cannot take any strategic action without a majority of the partners voting in favour of it.
Condition C is that the member has contributed by way of capital less than 25 per cent of the "disguised salary" it is expected will be paid to that member for that tax year.
This test is more likely to be useful although it belies the fact that some businesses do not have significant capital requirements. Twenty-five per cent of the "disguised salary" may, however, be a largely arbitrary number, with HMRC effectively saying that, notwithstanding anything else and however disproportionate to the actual capital requirements of the business, if you actually put a significant amount of money at risk, they will accept that you should be treated as a partner.
Some of the detailed mechanics, such as how the rules will operate for members moving in and out of the regime, are not clear. It may be that much of this will be worked out on a largely informal basis with local inspectors, although HMRC must be wary of a two-tier system developing between those businesses with a CRM and those without.
There is no suggestion, as yet, that clearances will be available which may leave LLP members in a difficult situation when it comes to self-assessing, especially given guidance that is, in places, confusing.
2. Tax motivated profit and loss allocations in partnerships
Anti-avoidance measures have been introduced to prevent partnerships (including LLPs) with both individual and corporate partners allocating "excessive" profits to the corporate partners. The rules are aimed at situations where the corporate partner is controlled by an individual partner who may wish to divert profits to the corporate where the profits will be taxed at a lower rate than if received by the individual directly. The profits could then be withdrawn later in a more tax-efficient manner.
The new legislation provides for the reallocation of profits in two circumstances.
(X) where the excessive profits allocated to the corporate partner represent the "deferred profit share" of an individual partner; and
(Y) where the corporate's share is excessive in the sense that it is not commensurate with the capital it has invested and services it provides, the individual partner has the "power to enjoy" any element of the profit share allocated to the corporate partner (for example, by reason of the individual holding shares in the corporate partner receiving the profit allocation), and it is reasonable to suppose that at least part of the corporate's share is attributable to that power or arrangements.
The legislation should not therefore apply where the individual and corporate partners are genuinely acting at arm's length.
Similar provisions apply to prevent the allocation of partnership losses to an individual partner, instead of a corporate partner, to enable the individual to access certain loss reliefs.
3. AIFM partners: deferred payments
The remuneration proposals issued by the Financial Conduct Authority pursuant to the Alternative Investment Fund Managers Directive (AIFMD) can, in certain cases, require the remuneration paid to certain key individuals in an AIFM firm to be deferred.
For individuals taxed on a self-employed basis, this would result in a "dry" tax charge, as these partners are required to pay income tax and Class 4 NICs on profits as they arise rather than when received, which could be some years later in the case of the deferred element of their remuneration.
The new AIFM provisions will allow the AIFM partnership or its delegate to elect to pay the tax on deferred remuneration and any remuneration in the form of instruments that must be retained for at least six months rather than the individual partner.
The tax is charged upfront at the additional rate of income tax (currently 45 per cent) on that income with no reliefs or allowances to be available to set against it. When the remuneration ultimately vests with the member, it will be treated as taxable income but credit will be available for the tax initially paid by the partnership and any overpayment of tax may be repaid. The upfront charge on the partnership applies only to income tax and the partner will be liable to Class 4 NICs at the time the remuneration vests.
Please click on the links below for the other articles in the January 2014 tax newsletter.
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