HMRC doesn't understand how section 4(4) of the LLPA actually works

“We can’t see the wood for the trees so let’s cut them all down” summarises HMRC’s extraordinary approach to the taxation of LLP members.

As most readers will be aware, between May and August 2013 HMRC conducted a consultation exercise in relation to proposals to alter the tax treatment of LLPs and partnerships. A main plank of those proposals was a change to the way in which LLP members are regarded for income tax and national insurance contributions (NIC) purposes in order to counter the perceived unfairness resulting from salaried LLP members being treated as self employed (so-called ‘disguised employment’). The outcome of the consultation was a foregone conclusion from the outset and it is clear that new legislation will have effect from 6 April 2014.

The first stage in this process has now been achieved with the first reading of a new National Insurance Contributions Bill, the intended effect of which was summarised in a tax information and impact note (TIIN) ‘Partnerships review – NIC changes for disguised employment and profit deferral under AIFMD’, issued on 15 October 2013.

It is stated in the TIIN that the proposed changes to the NICs legislation will “specifically disapply Section 4(4) of the Limited Liability Partnerships Act (LLPA) 2000, which otherwise deems LLP members not to be employees for all purposes”. This is, indeed, just what clause 13 of the NIC Bill provides.

To understand why it would be hard to find a more egregious misstatement of the effect of a statutory provision, it is necessary to analyse the way in which section 4(4) of the LLPA was drafted and, in practice, works.

Section 4(4) of the LLPA

Even to the initiated, this section is a peerless example of unclear and confused drafting. It provides: “A member of a limited liability partnership shall not be regarded for any purpose as employed by the limited liability partnership unless, if he and the other members were partners in a partnership, he would be regarded for that purpose as employed by the partnership”.

Let us be clear: the section has nothing whatsoever to do with tax and deals only with the possibility that a member of an LLP might also be its employee. Although an LLP is nothing like a traditional partnership because it has a distinct legal personality of its own (a reality so often overlooked by LLP members and their advisers), the draftsman considered the analogy to be relevant, making the fundamental error of assuming that a partner can also be employed by his own partnership.

Unfortunately, that proposition has long been recognised as a legal impossibility, for the simple reason that a partnership has no separate personality and a partner can never actually employ himself: the two positions are mutually exclusive (see, for example, Cowell v. Quilter Goodison Co. Ltd [1989] IRLR 392). Nevertheless, the legislative intention was tolerably clear – to establish the principle that a member can, in appropriate circumstances, be an employee of his own LLP.

Employment tribunals and the courts were, as a result, left to grapple with the application of this misbegotten test and, ultimately, have attempted to make sense of it, first by positing the existence of a hypothetical partnership and then analysing whether the member whose status is in question would properly fall to be regarded as a partner or an employee of that partnership (see (Tiffin v. Lester Aldridge LLP [2012] 1 WLR 1887 and Van Winkelhof v. Clyde & Co. LLP [2012] IRLR 992). Whether the Court of Appeal’s suggestion that LLP arrangements should be viewed through the “prism of partnership” is more doubtful, but this is not the place to debate that issue.

An important aspect of section 4(4) which appears to be largely overlooked is that the employment test is cumulative, not an alternative to membership: the member at all times remains a member of the LLP with all the rights and duties (contractual or otherwise) that go with that status.

The issue addressed by the section is whether the member may also be treated as an employee and have corresponding rights and duties in that capacity. Which contractual rights and duties will be assigned to membership and which to employment will be a matter for the court (or employment tribunal) to decide when applying the statutory test but, if the member is held to be an employee, it is likely that the elements of the package seen as determinative on that issue (such as remuneration) will fall on the employment side of the line.

Deeming? What deeming?

Contrary to the assumption made by the draftsman of the TIIN, there is no question of any deeming under section 4(4). The starting point is, inevitably, membership of the LLP: without that, the section cannot be applied at all.

Proof of membership can normally be resolved by reference to the particulars registered at Companies House. Then the employment test under the section is applied and it will either succeed or it will not. Either way, there is no deeming, apart from the partnership, which is deemed to exist solely for the purpose of applying the statutory test.

The only relevant deeming in this area results from the terms of what is now section 863 of the Income Tax (Trading and Other Income) Act 2005 and the consequent (and acknowledged) willingness of HMRC to treat even employed members as self employed in most cases. If HMRC wants to move away from that position, so be it, but to attribute the abuse identified to section 4(4), however inexpertly it may have been drafted, is quite simply absurd.

So, practitioners will now have to operate two distinct employment tests, one for employment law purposes and the other for income tax/NIC purposes. And seemingly all because HMRC could not understand how section 4(4) of the LLPA actually works. Is that a sensible basis for new legislation? Call for the chainsaw…

Roderick I’Anson Banks is a specialist in disputes and drafting issues facing partnerships and LLPs (www.partnershipcounsel.co.uk)