The First Tier Tax Tribunal on 29 June, 2022, issued its judgment in Bluecrest,¹ the first case considering the application of the salaried member legislation to members of a hedge fund management LLP. The judgment will be of significant importance to the large number of investment management LLPs who have sought to rely on their members failing Condition A (disguised salary) or Condition B (significant influence) to fall outside the rules, many of whom may have been subject to lengthy ongoing HMRC enquiries on the point.

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Key Takeaways

• Investment management LLPs may wish to review and reconsider their existing salaried member analysis in the light of this new and significant judgment. However, given that the case is likely to be appealed, and that it is only a First Tier Tax Tribunal decision which is not binding on other tribunals, firms should be cautious before placing too much reliance on the decision.
• Although much will depend on specific circumstances, the judgment is generally positive for investment managers.
• The judgment reaffirms the commonly held understanding that profit allocations which vary by reference to personal or divisional profits will be disguised salary. For profit allocations to vary by reference to the profits of the LLP as a whole, there must be a “link” to those profits, although the judgment concludes that the threshold for the link to profits is a “low one”.
• Helpfully, the tribunal determined that the scope of “significant influence” is significantly wider than HMRC’s guidance and practice suggests. This provides helpful clarity for members who exercise influence over investment decisions but not over the overall management affairs of an LLP. It also clarifies that non-portfolio managers can have significant influence but it will be important to ensure adequate evidence is available to demonstrate this even in the case of those with overall responsibility for a key function such as finance or legal.

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The Salaried Member Rules

Prior to the introduction of the salaried member rules in 2014, all individual members of an LLP were deemed to be self-employed for tax purposes. As members in an LLP are taxed more favourably than employees in some respects (in particular, due to the absence of employer NICs and PAYE obligations), the salaried member rules were introduced to prevent the disguising of employment through LLPs by ensuring that individual members of an LLP who are engaged by the LLP on terms that are tantamount to employment are taxed as employees.

Accordingly, the legislation sets out conditions which are collectively intended to encapsulate what it means to be operating as a partner in a typical partnership. Broadly, the rules apply (so that a member is a salaried member and taxed as an employee) where each of the following tests is passe

• Condition A: it is reasonable to expect that at least 80 percent of the total amount payable by the LLP to the member will be “disguised salary” (“disguised salary” is broadly remuneration which is fixed, or which is variable but is varied without reference to the overall profits or losses of the LLP, or is not in practice affected by the overall amount of those profits and losses);
• Condition B: the member does not have significant influence over the affairs of the LLP; and
• Condition C: the member’s capital contribution to the LLP is less than 25 percent of the total disguised salary, which it is reasonable to expect will be payable by the LLP to the member.

In effect, if a member fails one or more of the above tests the member will be respected as self-employed and will not be treated as a salaried member.

The dispute in Bluecrest concerned whether the members failed Condition A and/or Condition B. Condition C was not in point as it was agreed that the members had not made the required capital contributions to fail Condition C (as is typically the case in the asset management sector).

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Key Facts

• Bluecrest is a hedge fund management group. Bluecrest Capital Management (UK) LLP provides sub-investment management services to the Bluecrest group’s funds working under the lead offshore investment manager from time to time, and also provides back office services to other group entities (such as legal, finance and IT services).

• The members of the LLP in the years under assessment fell into three broad categories: (1) “infrastructure” members (such as the head of compliance, head of operations and legal); (2) portfolio managers and discretionary traders (each of whom was responsible for managing a portfolio (or book) or a team of investment managers); and (3) front office (such as risk managers and product researchers).

• Members were potentially entitled to receive three categories or tranches of remuneration: (1) priority distributions or fixed draw (where individuals received a fixed amount every month – typically £150,000 per annum for portfolio managers); (2) discretionary allocations (determined at the discretion of the board and which comprised the largest part of members’ remuneration); and (3) income points allocations (where any profits of the LLP remaining after discretionary allocations were allocated between members pro rata by reference to the number of “income points” held by each member). The large majority of income points were held, indirectly, by the founder, meaning the third tranche of remuneration was not material to the members in question.
• For the purposes of Condition A (disguised salary), HMRC and Bluecrest were in agreement that the priority distributions were disguised salary (being fixed) and that the income points allocations were not disguised salary (being variable by reference to the profits of the LLP as a whole). The dispute regarding Condition A, therefore, concerned its application to the discretionary allocations. The portfolio managers’ discretionary allocations were calculated on a formulaic basis by reference to personal performance – essentially the profit (if any) on their individual portfolios (subject always to the overriding discretion of the board). For non-portfolio managers (so infrastructure and front office members), discretionary allocations were calculated on a judgment basis using a bottom-up assessment taking into account their individual performance and current market rates for individuals performing such roles.
• In 2014, following the introduction of the salaried member rules and based on professional advice received, Bluecrest made certain resolutions to vary its profit allocation process so as to bolster its position that profit allocations were variable by reference to the profits of the LLP as a whole. In particular, it reaffirmed that it would not make discretionary allocations in excess of the available profits and discretionary allocations would be scaled back in the event of insufficient profits.

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The Judgment

In summary, the tribunal judge decided the following:

Disguised Salary

• Portfolio Managers. Portfolio managers’ discretionary allocations were disguised salary because they varied by reference to individual performance and not by reference to the overall profit of the LLP. In the tribunal judge’s view, the discretionary allocations were more akin to an employee’s performance-related bonus than to a partner in a traditional firm sharing in the overall profits and losses of the partnership. The tribunal judge noted:

“…the partners are not really concerned about whether the partnership has a “good year”, provided there are sufficient profits to meet their individual allocations. This is different from the traditional partnership structure where partners generally benefit when a partnership has a good year."

The fact that individual allocations were at risk of being scaled down in the event the available profits of the LLP were insufficient to meet all discretionary allocations was not sufficient for the allocations to be variable by reference to the profits of the LLP as a whole. There is no need for discretionary allocations to “track” overall LLP profits but there must be a link (albeit that the threshold is a low one). In the tribunal’s view, the discretionary allocations did not have the required link to the overall profits and losses of the LLP. The judgment states:

“… there is no evidence that, as a matter of fact, when the board came to consider the final discretionary allocations, it took into account the accounting profits of the appellant when considering the individual allocations of the portfolio managers (or indeed the non-portfolio managers)."

• Non-Portfolio Managers. Non-portfolio manager members’ discretionary allocations were also disguised salary, in this case because, although not formulaic, there was no clear evidence that the discretionary allocations had been made by reference to the overall profits and losses of the partnership.

“Whilst… the variable remuneration calculation for non-portfolio managers takes into account the financial performance and future financial stability of the appellant [Bluecrest], that is very different from demonstrating a link to that calculation and the appellant’s profits.”

“There is no evidence that either during the iterative process of establishing the preliminary discretionary allocations, nor during the process of the board approving it and this making it final, that the profits of the appellant were taken into account…”.

It seems clear from the judgment that “bottom up” profit allocations, which start by reference to individual performance, will present greater concerns for the purposes of Condition A than “top down” profit allocations, which start by reference to overall profits. However, although the judgment does not explain what would amount to a sufficient link, it seems possible for either a bottom up or top down approach to work provided that there is a separate and clearly identifiable step of referring the proposed allocations back to overall LLP profits and adjusting by reference to those profits. It seems members should experience some genuine element of exposure to the overall profits of the LLP – for example, in respect of any particular year, the implication is that, at least to some extent, their remuneration should have been greater if the overall profits had been greater and less if the overall profits had been less.

• Anti-Avoidance. Somewhat unhelpfully, the tribunal concluded that had the resolutions made by Bluecrest in 2014 been successful in creating a sufficient link to the profits of the LLP for Condition A to be failed, the changes would have been disregarded under the broad targeted anti-avoidance rule which applies to arrangements designed to secure that the salaried member rules do not apply. HMRC’s guidance states that genuine and long-term restructuring to ensure arrangements fall outside the salaried member rules will not fall foul of the anti-avoidance rule but there may now be some additional uncertainty as to whether actions taken to improve the salaried member analysis (for example, actions taken in response to this judgment) are sufficiently substantive to avoid being disregarded.

Significant Influence

• Contrary to HMRC guidance and the approach HMRC has consistently taken in its enquiries, the tribunal judge determined that there is no justification in limiting significant influence to “managerial influence” only (of the type that would typically be exercised only by a core management/executive committee). Significant influence may also extend to financial influence (for example in the context of the portfolio managers). In addition, significant influence is not restricted to the affairs of the partnership generally but can be over a specific aspect of the affairs of the partnership. For the purpose of this analysis, it is important to focus on the particular business of the partnership. Therefore, in the context of the activities undertaken by the investment manager, if it can be shown that an individual member significantly influences either the investment activities, or the provision of back-office services (or both), then that member will have significant influence over the affairs of the LLP.
• Portfolio Manager Members. Portfolio managers were determined to have significant influence both quantitatively and qualitatively. Each portfolio manager was responsible for managing US$100 million or more. While such a portfolio, and the resulting fee income, may not necessarily be significant in relative terms (bearing in mind an overall AUM of Bluecrest of US$3.9 billion), the fees generated on such activities were considered to be significant in absolute terms. One assumes that the appropriate threshold may vary from firm to firm depending on its AUM and other factors but the line will be difficult to draw. From a qualitative perspective, those portfolio managers who were made up to be members of the LLP had, in earning such promotion or status, necessarily demonstrated the personal managerial and operational qualities required to be a partner (when viewed in the context of a traditional partnership). The judgment does not consider the position of investment professionals who do not have individual responsibility for investment decisions – for example where decisions are made on a committee basis or where recommendations are made subject to a final CIO sign-off. While it seems clear that such members may have significant influence, demonstrating it may be significantly more challenging than for managers with sole responsibility for individual portfolios as in the Bluecrest set-up.
• Non-Portfolio Manager Members. On the facts, the tribunal judge determined that the evidence submitted did not establish that any non-portfolio manager member had significant influence over either the investment or service provision elements of the LLP’s activities. This is not to say that such members cannot or do not have significant influence – only that it was not sufficiently evidenced in the case. Perhaps, from a Bluecrest perspective, and with a detailed understanding of the operations of an investment management LLP, it was thought to be self-evident that infrastructure members had significant influence (consider, for example, a CFO, head of technology and other heads of departments) but in the tribunal’s view, this was not sufficiently evidenced.

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Next Steps

First Tier Tax Tribunal judgments are not binding precedent and accordingly the decision should be treated with appropriate caution. In addition, it seems likely that one or both of Bluecrest and HMRC may wish to appeal the decision. Even so, the judgment should serve as a timely reminder of the need to undertake a detailed analysis of the application of the salaried member rules and to maintain evidence to support that determination, and managers may wish to review their current policies and procedures in the light of this decision.

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Footnotes

1) Bluecrest Capital Management (UK) LLP v HMRC (TC/2019/09328)