One of the more ominous announcements in the Budget was the launching of a consultation on tax avoidance through use of LLPs and partnerships. Partnerships and LLPs are well established structures for investment funds and business services, popular due to their flexibility and tax transparency. However, the Government is concerned that this flexibility has been abused for tax avoidance purposes.
We included some initial thoughts in our Budget blogs http://blogs.olswang.com/budgetblog/2013/03/20/partnerships-and-llps-trouble-ahead/ and http://blogs.olswang.com/budgetblog/2013/03/20/partnerships-and-llps-further-thoughts/. The consultation document has now been published with proposals for inclusion in next year’s Finance Bill, and it is fair to say that HMRC’s opening position is a harsh one.
As expected the proposals include measures to counteract disguised employment, removing the presumption of self-employment for LLP members. Under current law it is significantly easier to secure self-employed status for fixed-share LLP members than it is for fixed-share partners in a general partnership and the Government believes that some businesses have exploited this by taking on large numbers of low paid workers as LLP members to save NICs and circumvent employment protection, thereby obtaining a competitive advantage over other businesses. One might think it would be sufficient simply to abolish the presumption of self-employment and put LLPs on a similar footing to other partnerships, but the proposals go further than this. Even LLP members who would not have been treated as employees of a general partnership will be “employed members” if they:
- have no economic risk (loss of capital or repayment of drawings) in the event that the LLP is wound up or makes a loss;
- are not entitled to share in profits (beyond a fixed share); and
- are not entitled to a share of the surplus assets on a winding up.
To prevent employers dressing up a fixed share as a variable profit share, insignificant adjustments (no more than 5% of the fixed share) will be ignored for this purpose, as will contrived theoretical profit entitlements which will not arise in reality, such as a percentage of profits over a threshold which will clearly never be achieved. It is unclear whether any account will be taken of seniority or participation in management, so there may be risk that fixed share or junior equity members in professional LLPs might be classified as employed members even though they have been promoted to LLP membership in recognition of seniority and expertise and may well have fallen on the self-employed side of the line in a traditional partnership.
Profit and loss allocation schemes
Partnerships are transparent for tax purposes and have considerable flexibility in how they allocate their profits and losses between partners. Profits allocations do not have to be in proportion to cash distributions and it is possible to allocate certain types of profit to some partners in priority to others. A concern has arisen that partnership arrangements have been used for tax avoidance, including the allocation of a disproportionate amount of profits to partners which pay tax at a lower effective rate than other partners or, conversely, the allocation of losses to partners liable to higher effective rates of tax.
The proposals will mainly affect partnerships with mixed members, individuals liable to income tax and one or more partners with a lower UK tax liability, typically a company. Three types of arrangements are addressed:
- Where a substantial proportion of the profits is allocated to the company (or other lower taxed) partner and it is reasonable to assume that one of the main purposes is to reduce or defer the income tax liability of the other partners or any other person, the profits will be reallocated on a “just and reasonable basis” to the individuals who have an economic connection with the company such as shareholdings in the company.
- Conversely, where losses are disproportionately allocated to the individual partners for the purpose of reducing their income tax liability, no relief will be given for those losses against income tax or capital gains tax; this will apply whether or not there is an economic connection between the individuals and the corporate or lower taxed partners.
- Certain profit transfer arrangements will be counteracted, where a partner transfers of all or part of its entitlement to partnership profits to a new or existing partner which is taxed on those profits at a lower rate. Typically the transferor receives a lump sum which is not taxed as income as the partnership structure disapplies general tax rules which would tax it as income. Often the partnership is created specifically to facilitate a tax efficient income transfer. It is proposed that, where there is payment for the transfer and it is reasonable to assume that the transfer is tax-motivated, the payment should be taxed as income in the hands of the transferor. This will not apply if the general income streaming rules already tax the payment as income or if the new mixed partnership rules already reallocate the income of the transferee.
These proposals potentially go beyond counteracting the more aggressive types of tax planning involving partnership. A number of commonly seen partnership arrangements may become subject to scrutiny and possible counteraction.
In the context of professional partnerships, the differential between the rates of corporation tax and income tax (plus NICs) has increasingly led to the introduction of corporate partners, particularly where money is to be retained within the business for working capital purposes; allocation of such amounts to the corporate partner prevents individual partners becoming liable to income tax at 45% on profits which are not distributed to them but they may benefit from it indirectly through their interests in the company. This looks set to become more difficult. HMRC recognise that being taxed on undistributed profits is a disadvantage of operating through partnerships compared to companies but does not buy the argument that it should be possible to use a corporate partner to mitigate this. They regard this as trying to obtain some of the benefits of a corporate structure without the disadvantages.
Partners in investment partnerships usually have a mixture of tax attributes; in the case of limited partnerships there is usually a corporate general partner for liability reasons and many limited partners are exempt funds or non-UK residents attracted to partnership structures due to their fiscal transparency. The main advantage of such partnerships for individuals is the capital gains treatment of carried interest, rather than income tax planning. However it is possible that these proposals might have might have unintended impact on long-standing and uncontroversial features of investment partnerships previously approved in the BVCA Guidelines and the 2003 MOU. It is understood that the BVCA have given some input in the consultation and no doubt they and others in the industry will continue to do so as it progresses.
Unfortunately HMRC seem to have anticipated and rejected most of the reasonable objections to their proposals which they plan to introduce in April 2014 with no grandfathering. Consultation will continue until 9 August.
Please contact us if you have comments which you would like us to raise.