Streamlining partnership: The wider impact of the UK LLP tax changes

Lawyers enjoy a challenge. Once they got their heads around the concept that failing a test was a good thing, LLPs set about taking to steps to ensure that none of their partners would be treated as salaried members under the much-heralded changes to partnership tax rules in the UK. Following publication in early December 2013 of draft legislation and HMRC guidance, there was intense activity by many law firms to meet the deadline of 5 April 2014.

Although yet to be enacted as legislation (Royal Assent is not expected until early July), the new salaried member rules are now well documented and firms have had to assume that they are operative with effect from 6 April 2014. Under the new rules, an individual LLP member will be a salaried member and treated as an employee for tax purposes if the following three conditions are all met:

1. it is reasonable to expect that at least 80 per cent of the member’s remuneration for his or her services as a member will be disguised salary, which is an amount that is fixed, variable without reference to the overall profits or losses of the LLP or is not, in practice, affected by the overall profits or losses of the LLP;
2. the member does not have significant influence over the affairs of the LLP; and
3. the member’s capital contribution to the LLP is less than 25 per cent of his or her expected disguised salary for the relevant tax year.

The cost to firms of partners being salaried members will be the requirement to pay employer’s national insurance contributions at 13.8 per cent of their remuneration on a monthly basis. Clearly, this can be a significant cashflow burden for many firms and it’s no surprise that it is something that they have been keen to avoid.

Lack of clarity

Although the government stated in the Autumn Statement of 2012 that it would consider whether partnerships should be reviewed as part of its rolling examination of high-risk areas of the tax code, the story really began with the March 2013 Budget. The government announced that it would consult on measures to remove the presumption of self-employment for LLP members to tackle the disguising of employment relationships through LLPs.

Two months later, HMRC’s consultation document was published.
It stated that the aim was for legislation
to be introduced in the Finance Bill
2014, with the changes taking effect
from 6 April 2014. Interestingly, with hindsight, the closing date for comments on the consultation was 9 August 2013.

The immediate conclusion was that the typical equity partner in a law firm would not be at risk of being a salaried member. What, though, of fixed-share partners in their various guises? There was a degree of optimism that law firms would not be at significant risk of finding their non-equity partners treated as employees. However, it was always inevitable that the majority of firms would want to take steps to avoid what was likely to be a significant additional cost to the business if it had to pay employer’s national insurance contributions for its non-equity partners.

The issue facing firms in May 2013 was the changes they should make to their structures and profit-sharing models. For a lucky few, change was not required because the firm only had equity partners or few, if any, fixed-share partners. Moving to an all-equity model with largely variable profit-sharing arrangements was realistically the only appropriate path for firms wishing to engage in a process of change at that point.

Even though my own firm had commenced a wholescale review of its members’ agreement and remuneration structure at the beginning of 2013, we recognised that it was going to be difficult to second guess what the ultimate test for a salaried member would be following publication of the HMRC consultation document.

In fact, most firms understandably adopted a ‘wait and see’ approach before the draft legislation finally appeared in early December 2013, together with HMRC guidance indicating how it would interpret the three conditions, with examples for each. A combination of this delay and the actual tests themselves led to widespread criticism and three months of lobbying for changes to the proposals and the postponement of their introduction. However, as we saw, HMRC was
not for turning on this.

Crunch time

With only a short period before the 5 April deadline, it was at this point that firms had to address what changes should be made to their partnership structures and, for the first time for the majority, put meaningful proposals to partners. It became clear that, for many firms, the non-equity partners who were currently treated as self-employed would be at risk of being employees for tax purposes. Engagement by management boards and committees was near universal.

It was also immediately clear that the easiest of the conditions to interpret was in relation to the level of capital contributions. Less than four months was always going to be too short a period to undertake the necessary internal consultation to make any significant changes to the highly-evolved partner remuneration systems operated by many firms to address Condition A.

Only partners in small firms would clearly fail the influence test in Condition B. In the subsequent two versions of the guidance notes published by HMRC, it accepted that influence may exist in wider circumstances than the original guidance indicated. However, in practice, this was the one test where firms had the least opportunity to make changes to their governance arrangements to give partners sufficient influence over the affairs of the LLP unless it was a partnership of around ten or less partners.

So the focus was on introducing new capital to firms. Thankfully, the recognised banks in the sector were very much open for business and, in principle, willing to lend to partners to fund new capital contributions.

In addition, this is one area in which HMRC acknowledged the practical problems of the banks coping with the demand for new loans, which must have been in the thousands. As a consequence, provided that partners had committed to make the requisite capital contribution by
5 April 2014, they will still fail Condition C if it is paid to the firm by 5 July 2014.

Market impact

Now that we are past the 5 April deadline, both practitioners’ experiences (including my own) and numerous press reports support the view that the introduction of additional capital was the most common approach adopted by firms to avoid their partners being treated as salaried members.

The legal press has already reported that firms including Hogan Lovells, CMS Cameron McKenna, Nabarro, Weightmans, Eversheds, Addleshaw Goddard, Baker & McKenzie, Field Fisher Waterhouse, Trowers & Hamlins, Stephenson Harwood, Hill Dickinson and DWF made cash calls to their fixed-share partners in response
to the new tax rules.

There have been suggestions that some junior partners may have been required to contribute as much as £100,000 by way of additional capital. It would be fair to assume that the base level of contribution in most reasonably-sized firms will have been at least £30,000.

However, the introduction of additional partner capital has not generally been made in isolation. Most firms have understandably taken steps to soften
the blow of imposing this new financial burden on one category of partners.
This has typically come in the form of the opportunity to increase their profit share (for example, an entitlement to a share of the firm’s overall profits or an enhanced bonus arrangement) and/or by giving this group of partners enhanced voting rights.

For some, this is most likely a short-term arrangement which will need to be revisited in future, particularly where firms have an aspiration to ensure that the fixed-share partner group also fails Condition A by having a sufficiently variable profit share. The short timeframe also meant that there was typically insufficient time to undertake the lengthy and wide-ranging consultation process necessary to propose and consider comprehensive changes to the firm’s partnership agreement.

Firms have generally taken steps to document which changes have been made to demonstrate to HMRC which of the conditions partners will fail. There is an expectation that HMRC will, in future, take a greater interest in a firm’s constitutional documents as well as its actual practice.

Firms have also needed to bear in mind that implementing changes to address the new tax rules would not be straightforward. Any proposal to impose additional risk in the form of making and funding a significant capital contribution was always likely to be controversial.

Proper engagement with the affected partners and a full explanation of the proposed changes helped firms to meet the target deadline. The wrong approach ran the risk of partners causing disruption or resigning and the inevitable consumption
of management time and resources.
In extreme cases, where there was the threat of partners refusing to comply with the changes, firms had to consider whether they had the power to remove them.

Ultimately, some firms have had to accept that some of their fixed-share
partner group will be salaried members under the new tax rules. Discussions will have taken place as to how the additional tax burden will be borne between the firm and the relevant partners.

Long-term benefit

For firms engaging with the process following publication of the HMRC consultation document in May 2013
or earlier, they will have undertaken
a significant partner consultation,
leading to a new remuneration model voted on and approved by 5 April.

In most cases, this will have required the adoption of an all-equity model so that former fixed-share partners will have equity points (or the equivalent), often coupled with a base profit share.
It would also appear that a number of firms adopting this approach have also required a capital contribution so that partners fail Condition C.

Notwithstanding the development of a traditional two-tier system of partners being long established and it having been an appropriate structure for many firms, there is a lot to be said for trying to break down the barriers in partnerships to create an effective single tier in which all of the partners have an interest.

There are inevitable pros and cons to the removal of the distinction. However, the introduction of an all-equity system can bring benefits such as greater transparency of remuneration, all partners having a meaningful interest in the performance of the business, and a system which is more effective in motivating them to grow their individual contributions.

One clear advantage of removing any distinction between equity and non-equity partners is that it engenders a greater sense of ownership, risk and reward. Over the longer term, this has the likelihood of reaping benefits for the business as a whole and creating firms with more traditional partnership characteristics. That may just be, in the end, the most meaningful benefit of having to go through this entire process.

Fergus Payne is partner and joint head of the partnerships and LLPs group at UK law firm Lewis Silkin
(www.lewissilkin.com)