Tax bomb: Prepare for the April 2014 tax changes to UK LLPs

The UK government announced fresh legislation in early December 2013 attacking the tax status of many members of LLPs. HMRC also published draft guidance on the interpretation of the proposed legislation at the same time. The legislation is due to be effective from 6 April 2014, so firms have little time to consider their position and to effect any change in their arrangements if they wish to ensure that they are not affected by these new rules.

Members of LLPs who are treated as salaried members will be taxed as employees rather than self-employed partners from 6 April 2014. The biggest consequence will be the employers’ national insurance contributions (NIC) burden on the firm, at 13.8 per cent of the individual’s income from that date.

Proposals vs. consultation

The proposed changes are aimed at those who do not have what HMRC regards as ‘the attributes of partnership’. This may impact upon different individuals than those whom readers will have envisaged when considering the government’s consultation on this area of taxation during summer 2013.

In spring 2013, the chancellor noted that LLPs were being used as tax avoidance vehicles. The consultation document stated that “LLPs can be used to disguise employment and to avoid employment taxes. There is evidence that LLPs are increasingly being used and marketed on that basis”.

The proposals outlined in the original consultation document were framed in a manner to identify individuals who, although members of an LLP, were in reality employees in the government’s eyes. The subtext was that the target was particularly firms using marketed schemes.

Many professional firms would have concluded that, if the eventual legislation followed the spirit behind the consultation document, they would not be affected. Unfortunately, the proposals differ from the original consultation. It now seems that large professional firms operating within LLPs have become one of the targets in what looks more like a revenue-gathering exercise than an anti-avoidance challenge.

The three conditions

When reading the proposed legislation, note that it is written in a manner that you want to fail one condition. Pass all three conditions and you are classed as a salaried member and liable to be taxed as an employee.

The three conditions are:

• Condition A: The members’ profit share is wholly or substantially wholly ‘disguised salary’;

• Condition B: The individual member does not have significant influence in the running of the LLP; and

• Condition C: The individual member’s long-term capital does not exceed 25 per cent of their ‘disguised salary’.

Condition A: Identifying disguised salary

Condition A looks to establish whether a member truly has a profit share that directly varies with the profits of the firm. If it does not or elements do not, it will be classed as disguised salary.

Interest on capital varies with the level of capital contributed and with interest rates, not with the profit of the firm. Where firms have a tranche of profit allocated as ‘interest on capital’, this will be classed as disguised salary. Notional salaries deducted from profits before determining the allocation will also be disguised salary.

The legislation rules that variable profit shares that do not vary directly with the profits of the firm are again disguised salary. If a firm shares profits on an office or division basis rather than on a firmwide basis, its members will have disguised salary, as will those that grant specific bonus profit shares on billings, clients introduced, chargeable hours recorded and so on.

By contrast, if an individual member’s performance is assessed to determine what share he gets of a profit pool that directly varies with the level of profits of the whole firm, then that profit share is variable and is not disguised salary.

This leads to Condition A determining whether an individual member’s share of the firm’s profits is wholly or ‘substantially wholly’ made up of disguised salary.

‘Substantially wholly’ is not defined in the legislation – presumably it is left for the courts to decide whether the threshold is 75 per cent, 90 per cent or some other level. In the draft guidance, HMRC states that its view is that 80 per cent would be substantially wholly (but does not say that a lower percentage
is not).

Over recent decades, many firms have moved away from a simple lockstep method of allocating all profits between the members of the firm. As firms have designed more sophisticated profit-sharing matrices, many will find that at least 80 per cent of the members’ profit shares are not variable in the way that the proposed legislation and draft HMRC guidance envisage.

So, many members of many large firms will pass Condition A (and remember that, in this context, it is
failure that is good).

Condition B: Defining significant influence

Condition B considers whether the rights and duties of members of the LLP do not give the individual member significant influence over the affairs of the firm. Condition B is a short clause which does not further define ‘significant influence’ nor ‘affairs’.

The draft HMRC guidance suggests that ‘affairs’ includes routine operational decisions, not just major decisions. This contrasts with the concept of strategic management and control which is so important in determining the location of central management in residence matters, where the location of routine operational management of a business is not important.

We are back to the quaint concept of all partners meeting around the table, discussing and agreeing all matters from the colour of the teapot to the firm’s strategic plan. HMRC indicates that it expects that members in smaller firms will have significant influence, but it does not give an indication of where it might see the dividing line. In an example, it suggests that each member in a firm of three would have significant influence – would the same be true of a member in a firm with 10 or 20 partners?

HMRC also indicates that it believes that almost all members in a larger firm will not have significant influence over the affairs of a firm as a whole. It appreciates that most large firms have constitutionally-appointed management boards with significant delegated authority to make operational decisions for the firm, meaning that most members do not have a direct say in most operational management matters.

Whether having a vote in electing the management board, or indeed the power to call for a members’ meeting and table resolutions amount to significant influence over the affairs of the firm may be a decision for the courts. In HMRC’s view, such rights do not amount to significant influence. It suggests that, in large firms, it is only the members of the firm’s management board who have significant influence. It also dismisses the operational power of local office heads and divisional or practice area leaders, arguing that such positions control only parts of the firm, rather than the whole.

In HMRC’s view, members in very small firms will typically fail Condition B, whereas most members in larger firms are likely to pass Condition B (again, remember, passing is not good news).

If we look at Conditions A and B alone, it looks as though HMRC is potentially putting a ‘spanner in the works’ in the development of larger firms looking to build big successful businesses. Such firms have typically found that they can only be managed with delegated management structures. They have also looked to focus partner performance through personalised profit rewards, on top of the reassurance of a basic ‘notional salary’ fixed prior share. The government established UK LLPs just over a decade ago under pressure from larger firms – is it now about to take the structure away from larger firms by the
back door?

Condition C: Contribution to the firm

The question then for many members
of LLPs, particularly in larger firms, is whether Condition C will be the saving grace that will allow them to retain self-employed status.

Condition C looks at whether the contribution provided to the firm by the member is less than 25 per cent of his disguised salary (determined in the test for Condition A). Contribution is defined as long-term capital and so excludes undrawn current accounts, tax reserves or short-term loans made to the firm. Whether or not the member has personally borrowed the contribution does not matter, assuming he is personally liable for the loan – it is the fact that he has long-term funds personally at risk that is important.

For senior members, their level of capital may mean that they do not meet Condition C, but this may not be the case for more junior members.

HMRC’s historical view

It is worth reminding ourselves as to how partnerships operated 50 years ago, as it is this view of the traditional partnership world that seems to have driven HMRC in drafting the proposed legislation.

In the past, particularly when the 20-partner maximum rule was in place, it was understood that partners all met regularly to decide on all operational matters of the firm and all partners might consider that they had influence in the running of the firm.

Typically, there were no tranches or different slices of profits. All partners shared in the whole profits of the firm, either equally or through lockstep points. In most firms, the partners would have invested a reasonable level of capital. Indeed, 50 years ago, having family connections and wealth would often have been a key factor in choosing partners.

If you keep this quaint picture in mind, you will find it easier to understand and interpret the proposed legislation.

Actions to take

Given that firms will want all members to fail at least one of the three conditions on 6 April 2014, they will need to consider what they can most easily alter in their internal arrangements within the next couple of months to ensure members are not caught out by this new legislation.

In doing so, firms need to be aware of specific anti-avoidance legislation being introduced, through which arrangements put in place will be ignored if one of the main purposes is to prevent the salaried member conditions being passed.

Typically, it is easier for a firm to organise fresh capital from individual members than to consider, discuss and agree wholesale revisions to its profit-sharing matrix. Firms that anticipate that a number of members, or a wholesale class of members, will pass all three conditions are most likely to address their capital requirements in the first instance to establish the failing of at least one condition on 6 April 2014.

Over the next two months, firms that need to address the salaried member proposals will look to raise fresh capital from members, either to increase the firm’s working capital or to pay down existing firm debt levels.

Banks in the professionals sector will thus face a busy first quarter. Prudent firms will act quickly to raise this issue with their banks and discuss how it can be resolved.

Louis Baker is head of professional practices at UK accountancy firm Crowe Clark Whitehill
(www.crowehorwath.net/uk)