What was the issue highlighted in the original consultation?
Profit sharing within partnerships can be flexible and this flexibility has in the past been used to generate tax advantages. Various structures have been used to allocate profits may be allocated to a low tax entity, such as a company, while individual partners taxable at higher rates ultimately receive the benefit of those profits in low-taxed or even non-taxable form.
What was the original proposal?
HMRC wanted to say that profits allocated to a corporate partner would be treated for income tax purposes as arising to an individual partner where:
- the partnership comprises one or more members who are persons within the charge to income tax and one or more members who are not (e.g. an individual and a corporate member);
- there is an economic connection between those members, by which the individuals are able to benefit, directly or indirectly, from partnership profits allocated to the non-individual members; and
- it is reasonable to assume that the main purpose or one of the main purposes, of the partnership profit-sharing arrangements was to secure an income tax advantage for any person (the 'main purpose test').
Have HMRC's plans changed?
Yes, and no.
There were calls to row back from this proposal. Many argued that the proposals were an over-reaction and that it would be better to develop more targeted rules to deal with the mischief HMRC had identified. Many focused on the benefits of retaining profits in a partnership to fund working capital (where profits are taxed at low corporation tax rates rather than higher personal tax rates). Preventing this would give incorporated businesses an advantage of sorts over partnerships. Others focused on the many and varied commercial reasons for having mixed member partnerships.
However HMRC has not changed its overall approach. Their argument is that they want to make a structural change to partnership tax rules to prevent overall tax loss, rather than just to combat specific instances of tax avoidance.
That said, HMRC has altered its proposals. The "main purpose" test has been dropped and replaced with a (relatively) more objective one. The aim of the new test is to see if it is reasonable to assume that the effect (not the purpose) of the mixed member profit sharing arrangement is to reduce the aggregate tax payable. The new rules will prevent profit allocations to a corporate member from having tax effect where these exceed the 'notional' value of the services or capital the company provides to the partnership and this is the consequence of a connection between the individual member and company. The "notional value" is measured prescriptively so that for example it may not include more than a small mark-up on the costs of providing a service (and excluding any costs of engaging someone who is also a member of the LLP) or a reasonable return on any capital or loan advanced to the LLP.
In addition, HMRC has made a significant concession for Alternative Investment Fund Managers (AIFM) firms as discussed below.
Again, these new rules, and accompanying anti avoidance rules, are expected to come into force on 6 April 2014.
So what does this mean for you?
If you are a partnership with mixed memberships you will need to review your profit allocation arrangements carefully. The new legislation is drafted extremely widely and it is unlikely that any arrangements that were set up to avoid or defer tax will survive.
Even where the mixed membership arrangement has been created for other reasons it must be remembered that the legislation will be designed to capture arrangements where it is reasonable to assume that the effect (not thepurpose) of the arrangement is to reduce the aggregate tax payable. This does potentially open the door to people unwittingly falling foul of the new rules. In addition, anti avoidance rules are in place for those who attempt to circumvent the new rules.
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