HMRC published a consultation document on 20 May 2013 which proposed major changes to the taxation of partnerships. This was of particular relevance to investment management LLPs – and especially to those LLPs which include corporate members. The consultation included two main proposals: firstly, to treat “salaried members” of LLPs as employees for income tax and national insurance purposes; and secondly, where a partnership included both individual and corporate members to, in certain circumstances, reallocate LLP profits attributed to the corporate member to the individual member so that all profits were charged to income tax.
The consultation process ran until 9th August 2013 and a wide variety of representations were made to HMRC by a number of organisations, including the investment management industries representative bodies. HMRC stated that draft legislation relating to these changes would be released at or around the time of the Chancellor’s pre-budget review, with a view to such legislation being included in the Finance Bill 2014.
The Chancellor’s pre-budget review was held on 5th December 2013. As part of that review, HMRC released draft legislation relating to the second of the proposed changes, namely for those partnerships having a mixed membership. It is anticipated that draft legislation relating to the “salaried member” proposed change will be released on 10th December 2013.
Partnerships With Corporate Members: Draft Legislation
Many investment management LLPs include a corporate member. One of the reasons for this has been the increasing difference between income tax and corporation tax rates, which make it attractive for LLPs to allocate profits to a corporate member. In most cases, this enables profits to be reinvested in the business after being taxed at the lower corporation tax rates. Corporate members have also been used to enable the tax efficient deferral of remuneration for individual members.
In the consultation document, HMRC made it clear that they intended to target arrangements involving partnerships with mixed members (typically companies and individuals) where either partnership profits are allocated to corporate members who pay a lower rate of tax, or partnership losses are allocated to individual members who pay a higher rate of tax.
The draft legislation released on 5th December now sets out the detailed rules dealing with partnerships with mixed membership. There are two separate rules set out in the draft legislation. The first rule will apply where a corporate member is allocated profits of the partnership in circumstances where either all or part of those profits represent the individuals “deferred profit” or in circumstances where the individual has the “power to enjoy” the corporate’s profit share and it is reasonable to suppose that all or part of the corporate’s profit share is attributable to the individual’s power to enjoy.
The first case of “deferred profit” deals with the position where an individual’s remuneration has been deferred, whether pending the meeting of conditions or otherwise, and this is likely to catch arrangements which have been put in place to meet remuneration code requirements and the like. Much wider, however, are the “power to enjoy” provisions, as an individual will be deemed to have the power to enjoy the corporate’s profit share if the individual is a shareholder in the corporate or otherwise benefits from, is entitled to benefit from or may benefit from its profit share. Where these provisions are in point, the individual’s profit share is increased by an amount which it is reasonable to suppose is attributable either to the individual’s deferred profit or the individual’s power to enjoy. Note that no allocation of the corporate’s profit can be made to the extent that its profit represents an appropriate notional return on capital (which is to be calculated as treating the corporate’s capital contribution to the partnership as a loan and then calculating a reasonable rate of interest thereon) or such sum as represents the arms length consideration that the corporate would receive in respect of any services which it has provided to the partnership.
The legislation also includes provisions which will reallocate excessive profits to an individual who is not in fact a partner of the partnership, but where it is reasonable to suppose that the individual would have been a partner but for the new rules, and the whole or part of the corporate’s profit share is attributable to the individual’s power to enjoy the corporate’s profit share or to deferred profit arrangements.
The draft legislation will also deny certain income tax loss reliefs and capital gains relief for a loss allocated to an individual partner where the individual is party to arrangements, the main purpose of which or one of the main purposes of which, is to secure that some or all of the loss is allocated to the individual instead of a corporate member with a view to the individual obtaining relief.
Although the press release states that these provisions have immediate effect from 5 December 2013, the draft legislation would not appear to catch arrangements relating to an accounting period ended before 6th April 2014 and only apply to the accounting periods of partnerships beginning on or after 6th April 2014. However, in cases where a partnership has an accounting period which straddles 6th April 2014 that accounting period will be split into two, with the post 5th April 2014 part of that accounting period treated as a separate accounting period which will be subject to these new rules.
The draft legislation is, on its face, widely drafted and it is not entirely clear how widely it will be applied in practice. In particular, it is unclear to what extent an allowance will be made for profit of a corporate member that could be considered to be an “ownership” return which is properly due to the ultimate shareholders of the corporate member, particularly in circumstances where the shareholders are partly comprised of people who are not engaged in the business and partly of people who are. We certainly envisage that HMRC will look hard at any circumstances where “excess” profits are reinvested through the corporate member into the LLP.
Partnerships with year ends after 6th April 2014 may wish to close an accounting period before 6th April 2014 so as to preclude the application of the new rules for that period.
Dechert will continue to liaise with industry body representatives in relation to the draft legislation.