Taxing partnerships: The impact of proposed new UK partnership taxes

As announced in the 2013 Budget, HM Revenue & Customs has issued a consultation on proposed new tax rules to counteract what they see as abuses of the tax regime for partnerships and limited liability partnerships (LLPs). These proposals, if enacted in the form proposed, could leave many professional practices facing some tricky choices over the next few months.

Stimulus for change

Before the advent of the LLP, partnerships were primarily used by professional service firms and not by the wider business community due to the potential for unlimited liability.

Partnerships and LLPs are uniquely flexible business vehicles and it is perhaps no surprise that those putting together ?tax schemes in recent years have used these partnership structures to achieve the 'tax magic' that they sell to participators. The danger of any changes is the impact upon those who have legitimately used these structures as the best vehicle for their business.

It is unsurprising that HMRC, fed up with having to challenge various tax schemes, has persuaded the government that this area of tax law needs an overhaul to block tax avoidance wholesale.

A written ministerial statement on ?5 December 2012 announced: "Due to the repeated use of partnerships and similar collective structures in tax avoidance schemes, the government will be considering the area of the taxation ?of partnerships and similar structures as part of its review of high risk areas of the tax code."

On 20 May, HMRC's proposals were published in Partnerships: A review of two aspects of the tax rules. HMRC has identified two key areas of perceived avoidance: disguising of employment relationships through LLPs and the artificial allocation of profit. The consultation runs until 9 August and legislation is stated to apply to profits and losses arising from 6 April 2014.

LLPs: Disguised employment

All registered members of an LLP are currently treated by HMRC for tax purposes as partners rather than employees. HMRC has no objection ?to this where the individual bears some of the traditional risks of a partner, but wants to remove the automatic presumption of self employment.

This was actually intended when the LLP legislation was originally enacted, as Clause 4 (4) LLP Act 2000 states: "A member of a limited liability partnership shall not be regarded for any purpose as employed by the limited liability partnership unless, if he and the other members were partners in a partnership, he would be regarded for that purpose as employed by the partnership."

However, the wording of this clause has given rise to some debate when tested in the courts. The drafting of the tax clauses of the LLP Act 2000 clouded the situation such that HMRC has felt obliged to treat all registered members as self employed. Therefore, theoretically, if everyone at a business (including cleaners) registers as a member, irrespective of other factors, they are all treated as self employed. This must be wrong.

The proposal is to replace the presumption of self employment with ?the presumption of employment, subject to the individual meeting two 'conditions' which could establish that the individual is self employed.

While the first condition will be ?based upon the original wording of ?Clause 4 (4) LLP Act 2000, considering the long-established case law relating to partners in partnership, it is disappointing that HMRC says it will use its non-statutory Employment Status Manual to determine whether an individual is employed by the partnership.

HMRC says this would apply where members have been "engaged on standard terms as part of a mass recruitment exercise or who having been employees of a company then become members of a successor LLP on essentially identical terms". This leaves the question of what happens when an individual is first promoted to partner.

If the first condition does not establish employment, HMRC would then apply the second condition to check if the individual is a salaried partner because he or she:

a) has no economic risk (capital or drawings) in the event that the LLP makes a loss or is wound up;

b) is not entitled to a share of the profits; and

c) is not entitled to a share of any surplus assets on a winding up.

If these conditions are failed, the individual will be classed as employed. A further specific rule will include looking at whether the level of economic risk is significant. An example in the consultation document states that a five per cent profit share on top of a guaranteed salary would be unlikely to be regarded as significant. Higher percentage shares may be ?classed as significant, but that may also depend on a combination of other factors for that member.

There will also be a targeted anti-avoidance rule (TAAR) to counter arrangements artificially inserting partnership terms to meet these tests, allowing HMRC to ignore such arrangements when applying the tests. This will, effectively, give HMRC the upper hand in any dispute and ensure that any question of self employment will be clear cut to avoid any dispute.

It is important to note that, at the end of the second part of the second condition, the current proposal uses the word 'and' rather than 'or', implying that it will only be necessary to breach one element of the second condition to achieve self employment. We will have to await the final draft legislation before being certain that this will remain the case.

Interestingly, the recent employment case of Tiffin v Lester Aldridge LLP [2012] ECWA CIV35 looked at this particular area by reference to established case law. In that case, the individual was held to be a partner because he had entitlements beyond a salary in a properly constituted partnership. Tiffin disputed its validity on practical points and on the basis that his level of risk/reward as a partner and involvement in the decisions of the partnership were so small as to be immaterial compared to his day-to-day role, which was effectively equivalent to that of an employee.

It is clear from the judgment that ?the rights of the partners need not be similar and even Tiffin's fractional entitlement to a profit share and assets ?on winding up were sufficient to establish him as a partner rather than an employee. It will be interesting to see if HMRC's proposal to ignore insignificant profit shares does appear in the final legislation, as it conflicts with the Tiffin judgment and previous cases.

As the new rules will apply to a partnership's profits or losses arising after 6 April 2014 (i.e. within the current accounting period for many firms) it is ?vital that all firms affected review their position now.

The consultation document makes clear that "there will be no grandfathering for arrangements entered into before ?this date", so arrangements for the ?current accounting period may be counteracted. Therefore, if no remedial action is taken, many firms will likely find that they have considerably larger PAYE and NIC liabilities from April 2014 than they do currently.

Profit and loss allocation

The ability that partnerships (including limited partnerships and LLPs) have to adjust their profit and capital-sharing ratios is a key element to their attractiveness as a business vehicle. Profit sharing and capital ratios can be changed at the discretion of the members and, controversially as far as HMRC is concerned, need not directly reflect the capital or practical contribution of each member.

The consultation acknowledges that it is necessary to create new anti-avoidance legislation to tackle this issue as, in many situations, this type of planning may not fall foul of existing tax legislation and could represent a 'reasonable' exercise of members' choices, as afforded by the law.

The proposals outlined in the consultation will affect partnerships where there are marked tax differences between the members and where it is perceived that the profit and capital-sharing ratio is arranged to secure a tax advantage for one or more members. The new anti-avoidance rule could therefore have a considerable impact on partnerships with:

• individual and corporate members;

• UK resident and non-resident members;

• exempt and non-exempt members;

• traders and investor members (e.g. film partnerships);

• banks and other (non-financial) traders as members;

• members seeking income and others seeking capital; and/or

• members with losses to use against profits and those without.

HMRC has grouped the arrangements that it will seek to counter into the following broad categories:

1. Partnerships with a mixed membership

- profits (sharing them between individuals and companies in ways that reduce or defer income tax)

- profit deferral/working capital

- losses (usually initial losses)

2. Partnership members with differing ?tax attributes (e.g. members paying tax at different rates, different types of legal entities).

These new rules will clearly affect firms that have used a limited company partner to assist with funding their business and this option seems likely to no longer be viable in future. This element of these avoidance rules is disappointing, as it puts those who conduct business through a partnership entity at a competitive disadvantage to those who undertake their business through a limited company, thus affecting the choice of commercial vehicle that is best suited to the majority of those within the professions.

Where counteraction takes place, HMRC would be allowed to reallocate profits for the relevant accounting period on a 'fair and reasonable' basis, taking into account all of the circumstances, with income tax and NIC liabilities recalculated accordingly.

Protecting your partnership

If your partnership agreements are all based on a clear business rationale and the financial arrangements flow from that, there seems little to be concerned about at this stage. In less clear-cut cases, building a robust well-documented case to prove the self-employed status of your partners or the commercial validity or profit-sharing ratios will be important.

Where remedial action may be required, planning for it now is prudent, as it may not be a straightforward process. For some firms, the method of profit allocation may be agreed in advance and therefore existing arrangement may already fall foul of the uncertain legislation. While it may be possible to unwind some arrangements fairly easily, in other situations, negotiations on reallocating profit shares or changing partner requirements may prove complex - especially where there is no net gain for the partnership as a whole.

Firms should consider the impact of the new proposals and how this may affect existing arrangements. Where the proposals affect normal commercial arrangements for your firm, a suitable submission in response to the consultation can only add weight to those seeking to influence the legislation, to ensure it is proportionate for those for whom the partnership structure is the best vehicle for their business.

Colin Ives and Anna Jarrold are partners in the professional services tax team at accountancy firm BDO (www.bdo.co.uk)

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