Redefining membership: The UK's new definition of 'salaried member'

Since the birth of LLPs in the UK, Her Majesty's Revenue and Customs (HMRC) has watched the growth of this wunderkind and taken a keen interest in ensuring the LLP structure is not used as a tax avoidance vehicle.

In the summer of 2013, the government consulted on two aspects of the tax rules relevant to LLPs: disguised employment and profit and loss allocation schemes. Not just accountants were interested in and responded to that consultation exercise. Lawyers specialising in employment and partnership law also had a great deal to say about the key question of how a 'salaried member' of an LLP should be defined in any new legislation.

In brief, the government's intention is to:

1. remove the presumption that individual LLP members are treated as partners and hence self-employed for tax purposes; and

2. set out factors which would be taken into account to decide whether an individual member is an employee.

The consultation document referred to a number of problems with the current approach. We were told that using an LLP vehicle to avoid tax creates unfairness for other taxpayers, and that some low-paid workers who would otherwise be employees were being taken on as LLP members as a condition for obtaining work.

The government expressed concern that this would lead to the loss of certain benefits and protections associated with employment. This seems a little inconsistent given that the government has created a European first by introducing legislation that enables employers to offer employment which is conditional on giving up employment protection rights in return for a shareholding. One suspects that the prospect of widening a revenue stream is in fact the chief driver of change.

Notably, we were told the new definition of a 'salaried member' was not intended to catch those who become LLP members through professional progression, even if as junior partners they might be rewarded by a fixed profit share rather than a varying slice of equity. That all seems to have changed. The lower partnership echelons of large firms now seem to be fair game as far as HMRC is concerned.

The new legislation will come into effect from April 2014. The two-condition test for a 'salaried member' initially proposed in the consultation has been replaced in the Finance Bill (published on 10 December 2013) by a series of other tests. If a member meets conditions A, B and C, he will be treated as an employee for tax purposes.

Condition A

The member performs services for the LLP in his capacity as a member of the LLP and receives a disguised salary. Salary is disguised if it is one of the following:

1. fixed;

2. variable with no reference to profit or loss; or

3. not in practice affected by profit or loss (the syntax in the draft goes a little awry, but this seems to be the intended meaning).

So far, so worrying. A vast array of fixed-share members in LLPs are caught in this first trawl of the net.

Condition B

The mutual rights and duties of the LLP and its members do not give the member in question significant influence over partnership affairs. How is significant influence to be defined? This, and condition C below, are new ideas not envisaged in the consultation.

But, this condition could potentially be even murkier. The HMRC guidance seems to suggest that, in a large firm, significant influence can only be wielded through membership of a management committee.

Fixed-share partners may actually control significant portions of the goodwill of the business but, without equity, they are technically unable to participate meaningfully in the management of the firm. However, are they truly without significant influence? What of those LLPs in which the membership agreement, with its complex weighted voting mechanisms, is often ignored in favour of a simple show of hands?

So far, so still worrying. While condition B may shake some out of the net, a substantial number of fixed-share members will remain flapping in it.

Condition C

At the relevant time, the member's capital contribution is less than 25 per cent of the 'disguised salary' (aka fixed share of the profit) for that tax year.

This may be the cause of some celebration among finance directors of LLPs whose calls for capital from more junior members may now be lent considerable weight. At least with low interest rates, capital is cheap, for now.

But, beware: the legislation will, predictably, contain anti-avoidance provisions that will prevent the pumping of capital or reduction of profits in order to circumvent this condition.

Complexity and confusion

In theory, conditions B and C are more consistent with the multi-factorial approach of both employment tribunals and tax tribunals when testing for employment status. However, the law is already complex in this area; it has spawned two major Court of Appeal decisions (Tiffin [2012] EWCA Civ 35 and Van Winkelhof [2012] EWCA Civ 1207) and a Supreme Court ruling (Autoclenz [2011] UKSC 41) in the past couple of years alone.

Lawyers have long lamented the lack of a harmonised approach between employment and tax tribunals when assessing employee status. It is already a cause of unnecessary confusion and large legal/accountancy fees. Introducing new tests for 'salaried members' adds yet another layer of complexity and confusion - as well as boosting the fees of professional advisers.

For some readers that may seem welcome but, despite initial assurances that professional firms are not the target of these changes, we must all ensure our own houses are in order. It makes sense for all LLPs to carry out a comprehensive audit of their structures and hierarchies. Some firms may even question the benefit of remaining in an LLP, given that these rules will not apply to general partnerships.

In many firms, the distinction between full equity and fixed-share members may be largely ignored for now. LLPs may need to grapple with whether to bust these 'partners' down to employee status now - and acknowledge employee entitlements such as maternity/family leave, working time limits and equal pay - to align with tax status. Taking an early decision about the correct labelling of individuals may be prudent preparation for when the taxman cometh.

The author gratefully acknowledges the assistance of Leigh Sayliss with this article.

Anne Pritam is a partner specialising in employment and partnership law at international law firm Stephenson Harwood (www.shlegal.com). She was co-chair of the Employment Lawyers Association working group, which prepared a detailed response to HMRC's consultation on the proposed changes to the partnership tax rules.