Partnership Taxation - A review of two aspects

24 June 2013

Stephen Musgrave, Simona Rainer

HM Revenue & Customs (HMRC) is consulting on changes to two aspects of the tax rules for partnerships relating to disguised employment and profit and loss allocation schemes.

As announced in this year's Budget, the Government wants to prevent tax losses arising from disguising employment relationships though limited liability partnerships (LLPs), and from certain arrangements involving allocation of profits and losses among partnership members.

It intends to change the tax rules, and is seeking views by 9 August 2013.  HMRC will "consider" meeting interested parties to discuss the issues arising depending on the level of interest expressed.

Disguised employment

The tax treatment of LLP members is that of a partner in a partnership, which means that they are treated as being self-employed. The Government is concerned that individuals misuse LLP member status and are in fact employees of the company but avoid income tax and Class 1 National Insurance Contributions.

 "Genuine" LLP members, i.e. those who share the business risk, carry out business with a view to profit and are rewarded on the basis of a profit share, are not intended to be affected by the proposals. Equally the proposals are not intended to catch those individuals who become LLP members at an appropriate knowledge and skills level to participate in the LLP and who are rewarded by a fixed profit share. 

The aim of the proposals is to:
• Remove the presumption that all individual LLP members are treated as partners and, therefore, self-employed for tax purposes; and
• Set out the factors that will be taken into account in deciding whether an individual LLP member should be treated as an employee for the purposes of employment taxes.
Under the proposals, an individual LLP member will be classified as a "salaried member" and as such be liable to income tax and Class 1 NICs in the same way as an employee.  The LLP will be liable for secondary NICs (but able to deduct employment costs from its taxable profits), if either:
• On the assumption that the LLP is carried on as a partnership between two or more members of the LLP, the individual member in question would be regarded as employed; or

• The individual member in question does not meet that test but:

• has no economic risk (loss of capital or repayment of drawings) in the event that the LLP makes a loss or is wound up;
• is not entitled to a share of the profits; and
• is not entitled to a share of any surplus assets on a winding up.
A "risk" or "entitlement" will be assessed by taking into account the circumstances and the likely rewards under the terms of the LLP agreement. It is proposed to disregard risks or entitlements which are "insignificant". Profit shares which do not exceed 5% of any fixed entitlement would be disregarded under the current proposals.  

The introduction of a targeted anti-avoidance rule is also envisaged in order to avoid LLP members putting in place sham agreements containing significant profit shares which however are not actually paid and the member in fact only receives a guaranteed salary. 
It is anticipated that the above changes will come into force from 6 April 2014.

Profit and loss allocation schemes of mixed LLP members

A mixed LLP consists of one or more LLP members subject to income tax, and members that are not subject to income tax (for example a corporate member  or a non-resident member).
Allocation of profits to low tax rate members: mixed LLPs allocate profits to a low tax rate payer. For example, a low tax rate corporate member, beneficially owned by some or all individual LLP members, receives a profit allocation of the LLP which results in a tax saving compared with the tax that would have been payable had the profit share been allocated to an individual LLP member.

As the corporate LLP member is owned by some of all LLP members, it retains the benefit in the profit share via its economic interest in the corporate LLP member. However, by allocating the profit share to the corporate LLP member the individual members benefit from a tax saving by channelling the profit via the corporate LLP member (i.e. a "clearly tax-driven" scheme).

The Government also proposes to target:

• profit deferral: a profit share is allocated to a corporate LLP member (beneficially owned by one or more individual LLP members) but payment is deferred to avoid an upfront tax liability. Upon expiry of the deferral period the corporate LLP member is dissolved and the individual LLP members receive a profit share in the form of distributions ;and 
• working capital arrangement: a profit share is allocated to a low tax rate LLP member but retained in the LLP as working capital to grow the LLP. 

Profit-sharing arrangements will only be targeted where it is reasonable to assume that (one of) the main purpose(s) of the arrangement in the relevant accounting period is to secure an income tax advantage for any person (the "profit condition").  This condition will only apply to profits allocated to a company if there is an economic connection between the advantaged person and the company such that the person may benefit from the company's profits (such as by virtue of shareholdings or under a side agreement).

Proposal: HMRC will reallocate profit shares which fall within the avoidance categories on a "just and reasonable" basis to allow HMRC to take all relevant circumstances (including the relationship between the advantaged person and the company) into account.  This proposal will apply to income tax and NICs.
Exceptions: HMRC states in the consultation paper that the proposals are not intended to apply to the use of partnership structures by family members to allocated profits between them in a tax-efficient manner, such as in the Arctic Systems case (Jones v Garnett [2007] UKHL35).

The proposed new rules are intended to apply from 6 April 2014 to profits and losses arising on or after that date, and there will be no grandfathering of arrangements entered into before that date.
Allocation of losses to high tax rate members: under these arrangements losses are allocated to high tax rate individual LLP members able to claim loss relief against their income and then allocate later profits to low tax rate corporate LLP members.

Arrangements will only be targeted where it is reasonable to assume that (one of) the main purpose(s) of arrangements in force for a period of account is to allocate a loss to a LLP member (advantaged person) with a view to that member obtains a reduction in tax liability by way of income tax reliefs or capital gains reliefs (the "loss condition").  Unlike in the case of profit cases there is no need for the advantaged person to have a connection with any relevant company. 
Proposal: HMRC suggests that no income tax relief or capital gains relief will be given for the advantaged person's partnership loss for the relevant period.  This proposal will apply to income tax and NICs.

Partnership members with differing tax attributes

HMRC also wishes to target arrangements of capital injections into the LLP or payments from one LLP member (the transferee) to another LLP member (the transferor) in return for an increased profit share. The profit obtained by the transferee member is equal to the profit forgone by the transferor member, who would otherwise have been within the charge to tax on income on the profit. The reasons for this include the transferee member being a company and the transferor member being an individual, the transferee member being exempt from UK Income tax and the transferee member having losses.

The proposed new rule is to apply if both:

• The transferee member becomes entitled to a share (or an increased share) of profits (relevant profits) as part of a "profit transfer arrangement". An arrangement is a "profit transfer arrangement" if it is reasonable to assume that the transferee member's entitlement results from receipt of money or any other asset by the transferor member and that, in the absence of the arrangement, the transferor member would have been charged to tax on income on the relevant profits.  This applies whether the receipt of money or other asset were direct from the transferee to the transferor or indirect (for example, through the partnership).  To prevent sidestepping of the rule, it is also to apply if the transfer or payment is by a person connected with a relevant member; and

• It is reasonable to assume that (one of) the main purpose(s) of the arrangements is to secure a tax advantage.  The consultation paper states that this tax advantage will arise as a result of the differing tax attributes of the transferor and transferee members, but it is not clear whether this is intended explicitly to limit the condition for application or is merely provided by way of explanation.

Proposal: The payment received will be treated for tax purposes in the period of receipt as income of the transferor member (or relevant connected person), chargeable to tax in the same way, and to the same extent, as that in which the relevant profits would have been chargeable absent to the arrangement.

Exceptions: This proposed new rule will not apply where:
• The arrangement is already caught (and therefore taxed appropriately) by legislation concerning transfers of income streams and structured finance arrangements (Chapters 1 and 2, Part 16, Corporation Tax Act 2010).
• The rules in relation to mixed member profit or loss transfers apply.
• To relevant payment is otherwise charged to tax as income.
• The relevant arrangement is an Arctic Systems-type case (see Profit and loss allocation schemes above) as these involve no payment for transferred profits.

However, the proposed new rule would override any "exclusivity" provision of the tax code.

It remains to be seen if HMRC meets with interested parties in order to discuss the proposals after the holiday season and if some or all proposals are ultimately implemented in their current form, or are subject to change as a result of the consultation period.