Boulders on the beach: the dramatic effect of new partnership tax rules

The Finance Bill 2014, published on 10 December 2013, contains detailed proposals to change the UK's partnership tax regime. It seemed that huge boulders had been dropped from a great height onto a sandy beach.

Now just a month later, we are beginning to develop a sense of the new tidal flow around these boulders. It looks something like this:

• With more than £3bn of tax at stake over five years, we can expect HMRC to use all its might to enforce the new legislation.

• The rules relating to partnerships with corporate members, while understandable from the taxman's perspective, will impede the genuine commercial plans of firms which are striving to retain profits to invest in the future of their business, so reducing their reliance on banks.

• The new rules relating to salaried members of LLPs require firms to consider changing partner compensation arrangements, voting arrangements or firm finance. Tax should not distort genuine commercial arrangements in this way.

• Increasing LLP member capital requirements to escape the new rules looks like a retrograde step, forcing firms to make greater use of partner capital instead of organising firm-level medium-term finance with their banks.

• It is hard to escape the view that, with substantial short-term tax yield at stake, HMRC is imposing a similar short-term agenda on firms.

The draft Bill included some of the most significant changes to limited liability partnership and partnership taxation since the introduction of self-assessment in 1997.

The legislation will generally take effect from 6 April 2014, with anti-avoidance measures coming into effect from 5 December 2013 to catch any tax-motivated profit allocation structures.

HMRC has clearly listened to responses to its earlier consultation responses and amended some of the proposals to reflect this. Nonetheless, we fear that innocent arrangements will be caught. Firms should take time now to understand how the changes will affect them and decide what - if any - action is required.

There are three main changes for professional firms, concerning disguised salary, mixed-member partnerships, and revenue or asset transfers (see box below).

Unnecessary complexities

Because most of the changes come into force on 6 April 2014, rather than firms being allowed to implement the changes in the first accounting period following 6 April 2014, the Finance Bill imposes unnecessary complexities for firms. These could have been avoided.

In addition, HMRC has ignored profession-wide requests not to apply such a 'broad brush' approach which, as predicted, catches so many genuine partnership businesses using hybrid structures to accumulate profits for internal investment. This now gives the partnership model a very real disadvantage in comparison to the traditional corporate model.

HMRC has given businesses structured as LLPs and partnerships very little time to react to what will be a significant change to their business operations.

Prepare for change

While the legislation and guidance notes are being finalised, firms should:

• Evaluate the impact of the changes;

• Decide whether to reorganise their profit-sharing arrangements, voting entitlements or capital funding;

• Consider whether to escape the provisions by restructuring the firm's capital requirements. These LLPs must commence early conversations with their bankers to fund professional practice loans. Banks are already indicating that they will not be able to assess and respond to all such applications by 5 April 2014. As a result, HMRC may be forced to allow capital contributions to be completed within, say, six months of the required date;

• Partnerships and LLPs with a corporate partner must consider whether the profit share allocations exceed the permitted amount by measuring them against the notional allocations allowed by HMRC.

The measures introduced by the Finance Bill go beyond the original proposals and could result in operational and structural changes for both domestic and international law firms in the UK. Although there is now a further period of consultation on aspects of the draft legislation, there is a widely held view that HMRC will make few, if any, amendments to the proposed changes. The best we can expect is some further clarification and additional technical guidance on some of the more complex areas of the proposals. This period of consultation will end on 4 February 2014 with implementation still scheduled for 6 April 2014. It is expected that amended guidance notes will be published in the second half of February.

For now, there is a real risk that the broad-brush approach taken by HMRC leaves LLP and partnership businesses at a distinct disadvantage to competitors operating as limited companies.

 

THREE MAIN CHANGES

1. Disguised salary Under the draft legislation, an LLP member will be treated as an employee – for tax purposes only – if all the following conditions are met: If an individual performs services for the LLP and the amounts payable by the LLP in respect of the individual’s performance of those services are fixed or, if variable, the amounts are variable without reference to the overall profits or losses of the LLP (the ‘disguised salary’ element); The mutual rights and duties of the members and the LLP and its members do not give the individual significant influence over the affairs of the LLP; and The individual’s contribution to the LLP is less than 25 per cent of the disguised salary. The rules relating to salaried members of LLPs could present real problems for many firms, and virtually all partners in larger professional firms who have delegated management to a small management team. Under the rules as they currently stand, LLP members treated as employees for tax purposes will see their self-employment cease from 5 April 2014. Increased National Insurance bills will apply from 2014/15, along with the accelerated payment of income tax under PAYE. The changes could also result in a massive 2013/14 income tax liability for LLP members in firms which have a 30 April accounting date, if they are to be taxed as employees from 6 April 2014. This will further damage firm finances. US law firm start-ups in the UK, funded by guaranteed payment arrangements, could also be hit hard. We do not think that tax changes should force firms to modify commercially sound profit-sharing and management arrangements. We expect many professional LLPs to increase their capital requirements to ensure that the self-employed tax status of their partners is not prejudiced.This may make sense in tax terms, but for many firms it marks a step away from current best practice in law firm finance. Using a targeted anti-avoidance rule (TAAR) HMRC will, when determining whether an individual is a salaried member, pay no regard to any arrangements the purpose of which was to ensure that these salaried member rules do not apply. HMRC has confirmed that the TAAR was not introduced to catch genuine commercial changes that have real commercial effect (for example, capital contributions) even if the steps were taken to retain self-employed tax status that would otherwise be caught by the new rules. 2. Mixed-member partnerships New rules are to apply to LLPs and partnerships with individual and company members. The legislation will, for tax purposes, reallocate excess profits from a non-individual partner to an individual partner where the following conditions apply: A non-individual partner has a share of the firm’s profit; The non-individual’s share is deemed to be excessive; An individual partner has the power to enjoy the non-individual’s share or there are deferred profit arrangements; and It is reasonable to suppose that the whole or part of the non-individual’s share is attributable to that power of arrangement. HMRC has also restricted the ability to allocate income and capital losses between individuals and non-individual partners where it is tax-motivated. One response to this will be to incorporate the firm as a limited company.  Many have been concerned that HMRC somehow favours incorporated businesses over unincorporated businesses; the Finance Bill changes seem to mark another step in that direction. 3. Transfers of assets or income streams through or by partnerships Anti-avoidance measures are introduced to prevent individuals and non-individual partners transferring income streams or assets.

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George Bull is chair of the professional practices group at Baker Tilly

www.bakertilly.co.uk

 

 

 

 

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