The Chancellor’s 2013 Autumn Statement confirmed what tax specialists had expected and feared – substantial changes to the way in which some partners and LLP members would be taxed. But, rather than provide the clarity that we had hoped for, the new rules – most of which will come into effect from 6 April 2014 – include references to important aspects, without defining what the criteria are. As a result, we know what the Chancellor is trying to achieve and have seen the proposed legislation but cannot be sure, for example, what the words “substantially” and “significant influence” mean in this context.
These changes are likely to give rise to an increase in costs for many LLPs and may result in the LLP restructuring its business and financing or transferring its business to a limited liability company.
There are two principal changes proposed; although they cover distinct issues, there is certainly a significant number of LLPs which could be adversely affected by both.
Mixed member partnerships
HM Revenue & Customs [“HMRC”] has for some time made known its dislike of partnerships in which the profits earned are not subject to income tax immediately but make use of the lower tax rates paid by, for example, companies to reduce the tax liability below what HMRC would regard a ‘fair share’. Typically in this situation, a partnership might have both individuals and companies as partners, though this can affect any partnerships whose partners are not all individuals The individuals’ profit shares might be what they need to live on, with any surplus allocated to the company. As corporate tax rates are currently much lower than income tax, this could yield significant savings – at least until the individuals want the money from the company.
The steps taken to combat this will affect situations where one or more partners have an interest (normally shares) in the ‘non individual’ partner (ie the company in the above example). In those cases – for tax purposes only – the company will only be allowed to receive certain prescribed amounts and types of income and the individual partner will be taxed on the rest, irrespective of whether he actually receives the profits.
This will throw up some very strange outcomes, as the following, very simplistic, example should illustrate.
The ABC partnership has three partners – A and B, the two individuals who run the business, and C Limited, a company owned and controlled by A, the senior partner. In the year to 31 March 2015, the partnership’s profits are £500,000, of which £150,000 is allocated to both A and B (the partnership agreement states that their profit allocations will be the same) – the remainder is allocated to the company. But the new rules ignore the allocation to the company for tax purposes and A is treated as having earned £350,000, meaning that his tax bill for the year potentially increases by more than £90,000, even though he does not receive the money.
There are steps that can be taken to reduce the impact of these new rules but partnerships need to think about introducing them now, before the legislation comes into effect and businesses are caught. The fact that there are anti avoidance rules in place with effect from last December makes it all the more important that any review is undertaken in conjunction with tax specialists able to advise on the potential impact.
Salaried LLP members
When the concept of Limited Liability Partnerships [“LLPs”] was introduced, the plan was to create a corporate entity that would be taxed as if it were a partnership – but the legislation contained a tax provision that did not apply to conventional partnerships. The relevant regulations stipulated that any individual who was a member of an LLP would automatically be taxed as if they were self-employed. This provision does not apply to partnerships – there are many firms with partners who, despite the title, are employees.
This distinction is important in terms of the amount of national insurance collected on those partners’ earnings – whereas an employee’s income will be subject to employer’s and employee’s NIC (at up to 25.8%) a self employed person’s profits will only suffer NIC at a maximum rate of 9%.
This mismatch has led to a number of LLPs making people members, possibly just to take advantage of the lower ‘employment’ costs. In many cases, the new members of the LLPs perform a role that most people would regard as typical of an employee.
In response to what it perceives as unacceptable avoidance, HMRC has proposed that ‘salaried’ LLP members will be taxed as if they were employees. In order for the new rules to bite, the following conditions must all be met:
1. The member performs services for the LLP in his or her capacity as a member, and is expected to be wholly or substantially wholly rewarded through a ‘disguised salary’ that is it is fixed or, if varied, varied without reference to the profits or losses of the LLP
The term “substantially” is not defined in the legislation but seems likely to be met if less than 20% of the member’s expected profit depends on the profits of the firm, as a whole, as opposed to the member’s own performance or the results of part of the firm (eg a specific division or department). This latter requirement could mean that ‘full equity’ partners who think they are safe fall foul of the new rules.
2. The member does not have ‘significant influence’ over the affairs of the partnership
Once again, an important term (in this case “significant influence”) is left to individual interpretation but it seems likely that very few members of a large LLP would meet this criterion, whereas it is possible that all members of a small firm – provided there is a genuine sharing of responsibility and not just one dominant partner who decides everything – would be regarded as having a significant influence over the LLP’s decisions.
3. The member’s contribution to the LLP is less than 25% of the ‘disguised salary’
The real point is whether the member stands to lose out significantly if the LLP fails. If a member has very little at risk, HMRC will argue that their position is akin to that of an employee – but it does not appear to take account of undrawn profits or short term loans to the LLP, which would represent just as much of a loss to the member as a loan intended to last as long as the member remained involved in the business.
The impact of these new rules, expected to come into effect from 6 April 2014, could be significant and the bulk of the costs will fall on the LLP, rather than the member involved. Not only will PAYE need to be operated – which will bring forward the payment dates for income tax – but the LLP will also need to consider benefits in kind, pensions auto-enrolment, and the onerous employment related securities rules.
It is disappointing that, given the scope of these new rules, there is a great potential for uncertainty; it is quite possible that a member’s status will change year on year, if the business’ results change significantly.
As with the mixed member partnerships, there are things that can be done to reduce the impact of these rules – but any action needs to be taken promptly, so that businesses fall into the new regime unprepared. It is equally important to make the point that the most obvious steps can have unforeseen consequences and that specialist advice in this area is essential.