A revised technical note and guidance has been published on the "Salaried Members" rules which will, from 6 April 2014, treat an individual member of an LLP as an "employee" for tax purposes if certain conditions are met.
There is some good news in the guidance as to how the legislation is to be applied. First, HMRC have responded to a range of examples and scenarios provided to them. While the facts in those examples are not always stated as clearly as one would have liked, the examples do clarify some of the thornier issues that advisors and heads of tax have been wrestling with in practice. Second, HMRC have confirmed that the targeted anti-avoidance rule (TAAR), which is drafted excessively widely, will be applied in a more measured way in practice.
Clearances will be available under the so-called non-statutory business clearance procedure, although not until Royal Assent. Depending on the approach taken, and the potential PAYE and NICs costs, a clearance application may be worth strongly considering.
Conditions A-C
By way of reminder of the background, HMRC had been concerned that, up till now, there was a statutory assumption that all members of UK LLPs should be taxed as if self-employed, no matter the terms of their membership. Rather than removing that statutory assumption and reverting to the case-law such as Tiffin -v- Lester Aldridge, FA 2014 will introduce conditions A-C as indicators of status. HMRC's stated aim in introducing these conditions is to give rise to a "more certain outcome" than the "wide-ranging test" that applies to a general partnership. The fact that we now need 58 pages of guidance as to how the new legislation works means it is questionable whether that has been achieved.
The FA 2014 rules only apply to UK LLPs, with existing rules continuing to apply to LLPs established outside the UK. However, the "Salaried Members" rules are not just relevant for UK resident members of LLPs; they will be relevant to any member of an LLP that spends any time working in the UK.
The guidance note does not contain revised legislation but it seems that only a couple of specific changes to the legislation are likely. Thus, the basic approach remains as before, namely, that the "Salaried Members" legislation will apply to a member of an LLP if three conditions, known as conditions A, B and C (the Conditions), are all satisfied. Where those three conditions are all satisfied, the income tax legislation (including all benefits in kind and employment-related securities rules) is applied as if the member were an employee.
If any one of those three conditions is not met in relation to a particular member then the "Salaried Member" rules do not apply to that member and the member should continue to be treated as self-employed for tax purposes. The test is on a member-by-member basis and thus one could find that different members passed or failed different Conditions at different times such that some might fall foul of these rules and some might not.
Finally, remember that the way these rules are drafted means that, perhaps rather counter-intuitively, the individual members will each want to fail at least one Condition.
Condition A: disguised salary
Condition A is met where a member receives more than 80 per cent of pay by way of "disguised salary". Broadly, this means calculated without reference to the overall profitability of the LLP.
Bonuses and performance related pay
A major concern with last year's guidance was how this test would operate where remuneration was based to some degree on the personal performance of the member, e.g. by way of lock-step, bonus pools or "eat what you kill" systems. The new guidance is clearer around certain sets of arrangements. So, for example:
- Amounts paid in respect of units allocated to members, whether on the basis of seniority, equity investment, performance or otherwise, should not be treated as disguised salary as these will simply determine what proportion of the profits will be received. It is also permissible to issue extra units at the end of the year to reward personal performance.
- "Eat what you kill" models in which members are paid a share of the profit according to the amount of fees he or she has brought in are not caught, but those where the member receives a proportion of some other figure (e.g. billings) would be. For such an important distinction, it is a shame that this example is dealt with in three lines in the guidance.
- Bonuses based on a percentage of salary will be disguised salary, but bonus pools made up of a proportion of profits which will be allocated according to personal performance (provided an amount of profit is earmarked for this purpose and depending on the terms of reference of the remuneration committee) are not.
HMRC returns a number of times to the analogy of looking at the profits of the overall business as a cake. The proportion of the cake received by a member may depend on a number of factors, including personal performance. However, if the total amount of cake the member receives depends both on the size of the slice and on the size of the cake, it will not be disguised salary. This analogy, together with the wide range of specific examples given, provide some comfort as to how many remuneration arrangements will be treated. If one compares this cake analogy with the much less helpful example on discretionary bonuses (example 14), one can see there are potentially advantages to moving towards a "unitised" profit pool for certain LLPs.
Costs plus arrangements
The biggest surprise, and headache for many, is that the new guidance makes clear HMRC's view that where UK LLPs are remunerated on a "costs plus" basis, no member will be able to fail condition A. That is because the levels of profits of LLP vary with the remuneration owed to the members (and other costs), rather than vice versa. Whilst it is perhaps not that surprising that this is where HMRC have ended up, it is very unhelpful that such an important point has only become clear six weeks before the legislation starts to bite.
Period over which Condition A must be considered
There is nothing in the legislation to state what period one needs to consider Condition A over; that will be determined by the length of the relevant arrangements. Two of the examples make clear that that could be a period of three years in relevant cases. That approach can help in a number of scenarios.
Guaranteed payments/floors and caps
Unconditionally guaranteed fixed amounts would be treated as disguised salary. Care will be needed around how messages are delivered to members and new joiners. Similarly, unless it is realistic to expect that a cap will not be engaged, capped amounts will be treated as disguised salary because such amounts would not be affected by the level of the firm's profits.
Drawings on account of profit share
This is an area where HMRC seem to have struggled. The initial draft of their guidance stated that priority profit share drawn monthly where "realistically the member will not be required to repay it" would be disguised salary. The new draft is not much different. Disguised salary will include drawings where they represent a priority minimum payment which would only be refunded in the event that the profits are insufficient to cover those drawings and other members with the same preferential right to payment, and where the LLP always makes profits significantly greater than those minimum drawings. However HMRC then go on to acknowledge that genuine payments on account of a share of overall profits are partial realisations of an anticipated profit and therefore will not generally be disguised salary. Unsurprisingly, the guidance acknowledges that there can be a fine line between these two cases.
Condition B: Significant Influence
Members with significant influence over the business as a whole will fail this test.
The implication from the original guidance was that, where a firm has a management committee, only members of that committee would fail this test. HMRC still considers that condition B is unlikely to exclude many members of very large partnerships, which will commonly need to delegate management or other strategic functions to a committee, and specifically notes that merely being able to vote on matters important to the firm is unlikely, in itself, to constitute significant influence, although it has now been made clear that being on such a committee is not a prerequisite. A non-exhaustive list of the types of decisions relevant to this test is set out and includes matters such as the appointment of new partners or key personnel, formulating the firm's business plan, and making decisions on important financial commitments.
On the asset management side, the really useful example is example 32. That example details a member (approved with CF4 status from the FCA) who "makes significant investment decisions in relation to one of the funds under management". That is said to constitute "significant influence" for these purposes. Whilst that does not necessarily sit well with what is said elsewhere (particularly 2.5.6 of the guidance about significant influence over parts of businesses being insufficient to fail the condition), it is helpful.
Condition C: Capital Contributions
HMRC has ignored calls to move away from this test which, in order to be failed, requires a capital contribution of at least 25 per cent of the amount of disguised salary expected. HMRC has simply reiterated that this proportion demonstrates the requisite real financial risk to the member resting on the success or failure of the business.
One helpful change is that existing members as at 6 April 2014 will have a three-month grace period in order to obtain loan finance for the capital contribution as long as they have made an unconditional commitment to provide the capital. Those becoming members after that date will have two months before which the capital must be contributed, again provided a firm commitment has been made.
Targeted Anti-avoidance Rule (TAAR)
The TAAR ignores arrangements where the main purpose or one of the main purposes of such arrangements is to ensure that the "Salaried Members" legislation does not apply. Note that there is no mention of tax avoidance there. For the many LLPs looking at tweaking their arrangements, the wording of the TAAR was concerning as it was drafted far too widely. However, HMRC have confirmed that, in applying the TAAR, they "will take into account the policy intention underlying the legislation, which is to provide a series of tests that collectively encapsulate what it means to be operating in a typical partnership. [HMRC] would not consider that genuine and long-term restructuring that causes an individual to fail one or more of the conditions to be contrary to this policy aim."
Please click on the links below for the other articles in the February 2014 tax newsletter.
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