What was the issue highlighted in the original consultation?
The whole idea of introducing LLPs was to provide a corporate vehicle that would be taxed in the same way as an (unincorporated) partnership. Unfortunately the framers of the Limited Liability Partnerships Act 2000 went a bit too far in enshrining this principle. They introduced a provision, or one might say a 'quirk', that had the effect that individuals who are members of an LLP were to be always taxed as if they were partners in a partnership established under Partnership Act 1890 (i.e. a traditional partnership) - even if they were engaged on 'salaried partner' terms – ie on terms that were closer to employment terms so that under existing tax law they would be taxed as employees.
This has produced a perceived unfairness where a salaried partner of an LLP receives more favourable tax treatment than an individual who is an employee of a company, or even a salaried partner within a general (ie unincorporated) partnership, engaged on similar terms. The LLP is also not liable to employer’s NICs on a member’s profit share, unlike on an employee’s salary. As HMRC saw it, LLPs were being used to disguise employment and to avoid employment taxes.
What was the original proposal?
First, to remove the 'quirk', the presumption that all individual LLP members are treated as partners and hence self-employed for tax purposes.
Second, to set out the factors to be taken into account in deciding whether an individual member of an LLP should be treated as an employee for the purposes of employment taxes. The original proposal was that that employment taxes would apply to an LLP member if:
- the individual would be regarded as an employee if the tests set out in the HMRC Employment Status Manual were applied; and/or
- the member was exposed to financial risks and given a reward commensurate with their having an 'ownership interest' in the partnership.
Have HMRC's plans changed?
HMRC is no longer proposing to apply the tests set out in the Employment Status Manual as it was felt that these tests would not be appropriate for many LLPs. The problem is that many LLP members would have 'failed' these tests and would have been categorised as employees for tax purposes, even where those members hold a genuine equity stake in the partnership.
HMRC is instead proposing to introduce a three step test to determine a member's genuine equity stake in the partnership. In detail, an LLP member will be treated as an employee for tax and NICs purposes if all of the following conditions are met:
- The member performs services for the LLP in his or her capacity as a member, and is expected to be wholly or substantially wholly rewarded through a 'disguised salary' that is it is fixed or, if varied, varied without reference to the profits or losses of the LLP. The "substantially" test is likely to be met if (looking forward by reference to budgeted profit) less than 20% of the projected income of the member is likely to depend on the profits of the firm, as opposed to being fixed or dependent on the member's own performance or other factors such as interest rates. It is likely that most "Fixed equity" partners will meet this condition. It is even possible that some full equity partners might meet this test if for example a firm shares out profits to them by reference to a combination of "salary tranche", or lockstep tranche, with an element of participation in a remaining profit pool on top of this that is projected to be less than 20% of the whole.
- The member does not have 'significant influence' over the affairs of the partnership. This will go to the wider governance of the LLP, so even substantial influence over a part of the business such as being office managing partner or running a division will not help. In large partnerships it may be that only a very few partners on a board of management will be considered to fail this test. Conversely with a small LLP with four or five members even a junior member may be able to demonstrate significant influence.
- The member’s contribution to the LLP is less than 25% of the 'disguised salary'. This is about investment: has the member made a significant investment in the LLP, so that the member has a real risk of losing their contribution if the business fails? Capital contributions funded out of non-recourse loans are likely not to qualify. Only capital or borrowing that is committed for the period of the member's membership of the LLP will be counted. Retained earnings (unless converted into permanent capital) or short-term loans will not count.
These new rules, and accompanying anti avoidance rules, are expected to come into force on 6 April 2014.
So what do you need to do?
If your LLP includes any members who pass all the above tests, this could be expensive. Re-categorisation as an employee will bring the unwelcome application of PAYE, employee and employer's NICs as well as other consequences such as pensions auto-enrolment, employment-related benefit in kind rules and the employment related securities rules. There is also a potential for uncertainty where members are on the margin so that they dip in and out of employment status. For example this could happen, without any other changes taking place, if projected profits fluctuate so that the so-called disguised salary in some years is more and in other less than 80% of projected remuneration. This could cause the application of opening year and closing year rules and all the complication that goes with this. Applying these rules could be enormously complex where the firm has other than a March 31 year-end as the deemed salary (where it is ruled that there is disguised employment) will arise in a different tax year to the allocation of profit (where it is ruled that there the member properly qualifies to be treated as a partner).
It is worthwhile therefore acting quickly to assess the status of LLP members under the new rules. Where there are members who may currently pass all the above tests for self-employment a decision can be made whether to change their membership terms so that they fail at least one of these tests. In practice the easiest of these to satisfy is the test relating to capital. The next few months are likely to see many awkward conversations between managing partners and junior partners about the requirement for the latter to provide more capital – as well as a sudden rush to the banks that lend in this sector for more bank lending to such partners.
Every cloud has a silver lining, and every new tax law creates new opportunities. The tenor of this legislation is to make is very easy to re-categorise a member of an LLP as a disguised employee. Whilst generally this may be a bad thing as discussed above, there may be some circumstances where such a treatment would be welcome; for example where a member is working abroad and is brought into UK tax only as a result of being treated as a partner or where it is beneficial to trigger a large amount of carried forward overlap relief.