The changes which came into force on 6 April 2014 represented a fundamental change to LLP taxation, for both individual partners and firms. Jon Cartwright looks back at how we got here, and what law firms need to do now
It has been a year of taxation upheaval for many professional partnerships, and particularly limited liability partnerships (LLPs), with fundamental changes made to the way some partners are taxed. This article looks at where it all started and where we find ourselves now. Most practices will by now have put into place the required measures to avoid falling foul of the new rules, which took effect from 6 April 2014. For any that have not, what follows should help them put appropriate measures in place.
Stage 1: the initial consultation
On 20 May 2013, following an announcement in the March 2013 budget, HM Revenue and Customs (HMRC) released a consultation paper setting out proposals for tackling two forms of perceived abuse in relation to partnership taxation. The changes were proposed to come into effect from 6 April 2014.
The first aspect covered was “disguised employment” – the longstanding presumption of automatic self-employment for tax purposes for all members of all LLPs, irrespective of their relationship with the LLP. The principal tax advantages were the saving of National Insurance contributions for employers, and reduced individual contributions for members. The consultation proposed that LLP members be instead termed a “salaried member” if either:
- on the assumption that the LLP were carried on as a partnership, the LLP member would be an employee of that partnership (the normal test used to assess whether an individual is employed or self-employed); or
- the LLP member has no economic risk, is not entitled to a variable share of profits, and is not entitled to a share of surplus assets on a winding-up (a test focusing on the financial ‘risk and reward’ normally experienced by the self-employed).
The second aspect covered in the proposals related to mixed partnerships, where one or more of the partners / LLP members is a limited company owned by individuals who are themselves partners in the partnership, and partnership profits are allocated to the company on a non-commercial basis, to take advantage of lower corporation tax rates and reduced tax liabilities. The consultation set out the circumstances in which partnership profits allocated to a company would be wholly or partly reallocated back to the individual members who own the company, and tax relief on partnership losses would be denied.
The consultation period ran to 9 August 2013, during which time many representations were made to HMRC by interested parties, including ourselves.
Stage 2: draft legislation and guidance
In December 2013, HMRC published draft legislation, outlining the “salaried member rules” – an employment test, made up of three conditions, and substantially different from that set out in the consultation, which, in our view, was no longer wholly logical in many real life business situations. If all three conditions were met within an LLP, the LLP member would be deemed to be employed for tax purposes, but if any one were failed, the individual would remain self-employed for tax purposes post-5 April 2014. The conditions were:
a) the member’s profit share is wholly, or substantially wholly, fixed; and
b) the member does not have significant influence over the affairs of the LLP; and
c) the member’s capital contribution to the LLP is less than 25% of their expected annual profit share.
In relation to mixed partnerships, the rules were broadly similar to those outlined in the consultation, but more detail was provided on the reallocation of profit share: any share allocated to a limited company partner / member exceeding a “commercial amount” would be reallocated to individual partners with an interest in the company, and taxed on them as if they had received the profit share themselves.
The “commercial amount” was defined as the aggregate of:
a) a return on the capital the company has invested in the partnership, calculated on a commercial basis; and
b) consideration for services provided by the company, and only by the company, to the partnership, again calculated on a commercial basis.
The draft legislation also introduced an anti-forestalling measure to prevent mixed partnerships taking action pre-5 April 2014 to side-step the new rules.
HMRC invited comments on the draft legislation by 4 February 2014.
Stage 3: revised guidance
On 21 February 2014, HMRC issued revised guidance on the salaried member rules in response to the comments received.
“Wholly, or substantially wholly” under condition a) was explicitly defined as 80% or more, and payments made on account of profit share (drawings) were defined as not determinative – that is, it is the profit share itself that is measured.
The salaried member rules test was substantially different from that set out in the consultation, which, in our view, was no longer wholly logical in many real life business situations
No changes were proposed to condition b), but HMRC gave greater clarity to the meaning of “significant influence”.
It was clarified that members would be deemed to have made the necessary capital contribution for condition c) where they had given an unconditional commitment at 6 April 2014 for the capital to be contributed within three months of that date (so, by 6 July 2014). New members would be deemed to have made the necessary capital contribution where they had given an unconditional commitment for the capital to be contributed within two months of becoming a member. “Capital contribution” would include amounts contributed for the “permanent endowment” of the LLP – this would therefore include long-term loans.
Further guidance was also given on anti-avoidance measures, particularly around condition c).
No changes were announced to the mixed partnership rules.
Stage 4: the final bill
The Finance Bill 2014 was published on 27 March 2014, including some further (fortunately minor) amendments, and a further 57 pages of revised guidance on both sets of rules.
Subject to any final amendments as the Bill passes through Parliament (none are anticipated), the new rules for salaried members and mixed partnerships have reached the end of their journey.
The current salaried member rules
A member of an LLP will be a “salaried member” and taxed as an employee with effect from 6 April 2014, where the following three conditions are all met.
a) It is reasonable to expect that 80% or more of the amount payable to the member for their services as an LLP member:
- is fixed; or
- is variable, but is varied without reference to the overall amount of the profits or losses of the LLP; or
- is not, in practice, affected by the LLP’s overall amount of those profits or losses.
b) The mutual rights and duties of the members and the LLP do not give the member significant influence over the affairs of the LLP.
c) The member’s capital contribution to the LLP is less than 25% of the anticipated amount payable to the member for their services as an LLP member during the tax year.
Practice points – condition a)
The test is applied at 6 April 2014, when a new member joins, and when there is a change to the way a member’s profit share is calculated. It is applied for the period over which a member’s profit share arrangement is in place (typically 12 months where there is an annual ‘pay’ review), and reapplied at the end of that period. It is applied looking forward not backwards; the amount of the variable profit share must be based on profit forecasts when assessing the 80% threshold.
Profit shares which appear to be variable but which, in practice, are not varied in reference to the LLP’s profitability, will be treated as fixed. Variable profit shares (including bonuses) must be linked to the LLP’s overall profits, not to personal or departmental performance or turnover.
It is the member’s profit share that is measured, and any drawings paid on account of it are ignored. The test is applied to profits available for allocation between the members – that is, profit per the statutory accounts.
Profit-sharing arrangements must be clearly documented at the time the test is applied.
Practice points – condition b)
The test is applied at 6 April 2014, when a new member joins, and whenever there is a change to the rights and duties of the members and the LLP.
Where the LLP has a management board, any members not on the board are very unlikely to have significant influence. The member must have significant influence over the LLP as a whole, not just a department or office. The kinds of decisions made by a member with significant influence might include:
- appointing new members or key personnel, and / or allocating roles;
- deciding where the firm conducts its business, and what business it conducts (including new services to be offered);
- making business acquisitions or disposals;
- managing of key contracts (for instance, with the bank);
- making decisions on important financial commitments;
- formulating the firm’s business plan;
- approving major new clients or investments, especially where this is a regulatory requirement; and
- deciding the firm’s marketing strategy.
The rights and responsibilities of members must be clearly defined in the LLP agreement, and this needs to be an accurate reflection of what happens in practice.
Practice points – condition c)
This test is applied at 6 April 2014, when a new member joins, on each 6 April thereafter, and whenever there is a change to the member’s contribution to the LLP or to the way a member’s profit share is calculated. It is applied to the member’s expected profit share for each tax year (in contrast to condition a), where the test is applied for the period over which a member’s profit share arrangement is in place).
The capital contribution is the amount of money or other property that the member has contributed, in accordance with the LLP agreement, to the LLP’s permanent endowment. It includes undrawn profits, provided the members have, by agreement, converted them into capital. It does not include amounts that the member can be called upon to introduce, amounts held by the LLP for the benefit of the member (such as tax reserves), or amounts that are not at economic risk or are not permanent in nature. The contribution need not be classed as capital in the LLP accounts – members’ loans can be included, provided they are long-term and have the same degree of permanence as capital.
It came as no surprise that the vast majority of fixed-share LLP members went down the route of failing condition c), as it was the easiest thing to do
A member is deemed to have made a contribution at 6 April 2014 if an undertaking is given for it to be made by 5 July 2014, and the contribution is actually made by that date. A new member is deemed to have made a contribution at the date of joining if an undertaking is given for it to be made within two months of joining (or by 5 July 2014 if later), and the contribution is actually made by that date.
Where the member enters into financing arrangements to fund the contribution, the contribution will be ignored where:
- it derives from a non-recourse or limited recourse loan;
- the LLP loans the contribution back to the member after it has been made, or loans the member the funds to make the contribution;
- the LLP pays or otherwise bears the interest cost (unless it does so as agent for the member, and the member bears the cost as drawings or a deduction from profit share); or
- the LLP’s bank provides the funds to the member, and in
- consequence, the LLP reduces its own exposure to the bank.
The member’s contribution and its enduring benefit for the LLP should be clearly set out in the LLP agreement.
What has happened since?
It came as no surprise that the vast majority of fixed-share LLP members went down the route of failing condition c), as it was the easiest thing to do, as evidenced by many thousands of loan applications being received by the main clearing banks. Many of the largest practices had no choice but to go for option c), either because they had so many members that one individual could not have significant influence, or because their fixed-share members’ profit shares were based on individual or team performance.
Condition b) seems to be the next most popular condition to fail, particularly for smaller practices. Where practices have become an alternative business structure in order to allow their finance director or other senior employee to become a member, then this condition has also been the one to go for as, in most cases, these individuals already had significant influence.
From what we have seen, relatively few practices seem to have gone down the route of failing condition a).
The current mixed partnership rules
As mentioned above, these have changed very little since they were first set out in the draft legislation.
As a reminder, where a non-individual partner (typically a company) receives a profit share exceeding a “notional amount”, and one or more individual partners have the power to enjoy that profit share (typically through shareholdings in the company), the excess profit share will be reallocated to the individual partner(s) and taxed on them instead of the non-individual partner. For the calculation of the “notional amount”, see Stage 2 above.
The notional return on capital is to be calculated as a commercial rate of interest payable on the partner’s capital contribution to the partnership – that is, the amount of money or other property that the partner has contributed to the LLP’s permanent endowment. The interest rate can reflect the level of risk involved, and HMRC expects the rate paid to third party lenders (where applicable) to be a benchmark.
The notional consideration for services is the arm’s-length value of those services; in most cases, HMRC expects that value to be cost plus a “modest mark-up”. Any services provided by the non-individual partner that involve any other partners are ignored, and no value is placed on those services. In addition, any payment actually made for the services, such as a service fee, is deducted in calculating the notional consideration.
There is no HMRC / legislative definition of what a “modest mark up” means, but many advisers in this area cite up to 5% to fall within the definition of modest. Some advisers, including us, have researched margins used by similar third party service organisations to provide a guideline framework. Remember that the level of contractual responsibility placed on the company to provide the services needed by the partnership ‘come what may’ can also be an important factor.
Where a partnership has an accounting period straddling 6 April 2014, a separate accounting period is deemed to start on 6 April 2014 and end on the normal accounting date. The new rules then apply only to this deemed period, so any arrangements in place prior to 6 April 2014 should not be caught.
What Clyde & Co means
Clyde & Co LLP v Bates van Winkelhof  UKSC 32 seems to cut right across some of the above. With regard to changes to the automatic self-employment of fixed-share partners, the HMRC message is that any change to PAYE if you do not manage to fail one of conditions a), b) or c) is purely a change in the tax collection mechanism – that is, there is no change in underlying self-employed contractual terms, so no need to worry about things like pensions auto-enrolment, unfair dismissal rights and so on.
In short, the case of Clyde & Co appears to have concluded that all types of LLP members (equity and fixed share) apparently have ‘workers’ rights’, irrespective of anything else. Watch this space.