Earlier this year, HMRC started a consultation on two aspects of the partnership tax rules with a view to:
- clarifying the difference between self-employment and an employment relationship with regard to LLP members; and
- countering the manipulation of profit or loss allocations to achieve a tax advantage.
Disguised employment relationships
What is the issue?
The first strand of the Consultation focused on arrangements to avoid paying certain employment taxes because the "employee" is a member of an LLP. Currently, individuals who are members of an LLP are taxed as if they are partners in a general partnership, even if they are engaged on terms closer to those of employees. This could be perceived to be unfair, based on the fact that if treated as a partner, an individual receives more favourable income tax and NIC treatment than if treated as an employee engaged on similar terms. There is also an overlap with employment rights – remember that an "employee" enjoys more rights than a self-employed person or a worker.
How is this issue going to be tackled?
The first proposal is to remove the presumption, contained in the Limited Liability Partnership Act 2000, that LLP members are not to be regarded as employees for NIC and income tax purposes. The Government has already brought forward draft legislation to amend the NIC rules and this week's Autumn Statement is likely to make provisions to amend income rules.
Secondly, new rules will be set out to determine which LLP members are employees and which are not. Again, this week's Autumn Statement will probably cover this, but one of the tests outlined in the Consultation looked at a member's economic risks and entitlement to share in profits or surplus assets should the LLP make a loss or be wound up.
So what should you do?
Many LLPs will be concerned about these proposed changes. For some, it will potentially have a material impact on the costs associated with "salaried members". You should review your partnership arrangements in order to assess what impact the proposed changes will have. It may be a choice between accepting that some members will be regarded as employees for tax purposes and be subject to PAYE and employee NIC arrangements, or changing the rights so that they look more like equity partners, e.g. in relation to the requirement of advance capital or rights to vote or variable profit share. You do not need to implement any changes until the final rules are confirmed, but you should start to think about what changes may be practical now.
Once the final rules are published, you will have to act quickly, as the new rules are expected to come into force in April 2014.
Special rules for Alternative Investment Fund Management (AIFM) firms
During the consultation, HMRC were notified of an issue which impacts on AIFM firms operating as partnerships (including LLPs) and their members who are obliged under the FCA's AIFMD Remuneration Code, and the European Directive which this implements, to defer vesting and/or paying part of the "variable remuneration" of staff, including LLP members. The application of these rules to LLP profit shares is difficult in the first place, but the tax treatment of partnerships adds to the challenge in that all profits are taxed in the year in which they arise whether or not they are distributed.
At present, the combined effect of AIFMD and tax rules is that partners will be subject to tax and NIC on certain profits they cannot access in the base year as, in accordance with the AIFMD rules, these profits will be deferred for three to five years. HMRC proposes to introduce new rules to address this issue, so that AIFM partnerships can comply with the AIFMD rules in a way that avoids individual partners' payment of tax on partnership profits that they cannot access in the base year. This is dealt with in part in the Government's National Insurance Contributions Bill, but further rules are expected to be brought forward between now and the start of the next tax year.
HMRC's response is pragmatic rather than principled and does not deal with the issue that in fact other financial services firms not being AIFMs face similar rules about deferment of remuneration. Other employers might argue that the risk mitigation of aligning staff to long-term performance rather than short-term profits also applies to them and if they are deferring the vesting or payment of remuneration, why should they be put at a disadvantage.
We will report on any Government responses to these inevitable arguments as and when they are made.
Profit and loss allocation schemes
HMRC is also concerned by partnerships involving mixed members (typically companies and individuals) and arrangements where profits are sold through partnership arrangements. They have focused on arrangements which use the flexibility of partnership profit and loss sharing arrangements to secure tax advantage, in particular:
- Partnerships with mixed members (typically companies and individuals) where profits are allocated to a member that pays a lower rate of tax.
- Partnerships with mixed members where losses are allocated to a member that pays a high rate of tax.
- Partnership arrangements where members reduce their profit entitlement in return for payment made by other members who will be taxed more favourably on those profits (partnerships with members with differing tax attributes).
To quote from the Consultation document: "Typical arrangements that HMRC has under review involve large professional firms using a partnership structure and making substantial profits. The company member makes nil or negligible contribution to generate the firm’s profits, but significant amounts of profit are allocated to it. Wider arrangements result in those profits flowing through the company for the economic benefit to some or all of the individual members. The allocation of profits to the company reduces the income tax payable, and because of rate differentials or other arrangements in which the companies are involved, is claimed to give rise to a significant overall tax saving. In the most aggressive cases, it is claimed that no tax at all is paid either by the company or the individual members when they access the profits."
We are awaiting the final proposals for tackling these schemes which are likely to be announced in this week's Autumn Statement. However, industry analysts have expressed serious concern that, although HMRC is targeting tax avoidance schemes, they might at the same time prejudice legitimate tax planning arrangements.
Look out for an update on the HMRC's detailed proposals in future editions of the Partnerships Update.
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