Kinetic Partners’ Michael Beart has been published in the recent Alternative Investment Management Association (AIMA) quarterly journal, writing a piece that looks at HMRC’s recent Finance Bill.
In December 2013 HM Treasury released the draft Finance Bill 2014 which contained the detail on the proposed changes to the taxation of partnerships in the UK following consultation earlier in the summer. This was recently followed by additional guidance on 21 February 2014 providing further practical direction as to how HMRC would be applying the legislation.
The proposals are far-reaching and go further than many anticipated. Despite what felt like a relatively long lead time when first announced last year, the commencement date of 6 April 2014 leaves taxpayers with a relatively short amount of time to take any appropriate action. Given the status of limited liability partnerships as the vehicle of choice for many in the sector, the proposals present one of the most significant changes to the basis of taxation in the industry for the past decade. Most concerning is the potential impact on the established commercial relationships between members and the need to revisit these merely to maintain the status quo from a tax perspective.
As an overview, the proposals focus on four areas:
- Salaried Members: Deeming an employment relationship (imposing PAYE/NIC obligations including the requirement to pay employers NIC at a rate of 13.8%) where three conditions (A to C) are met, such that an individual member:
- Condition A – receives a disguised salary by way of fixed or variable payment (variable without reference to the overall profits of the partnership) for services performed;
- Condition B – does not have significant influence over the affairs of the partnership;
- Condition C – does not have capital equal to 25% of their disguised salary contributed as capital to the partnership.
- Mixed Memberships: Placing restrictions on the allocation of profits to non-individual (e.g. corporate) partners such that individual members with ”power to enjoy” are taxed as if they had received them directly, or to put it another way, locking in profits at income tax rates.
- Alternative Investment Fund Managers Directive (AIFMD) Deferred Remuneration: Introducing a mechanism to defer profit allocations at the partnership level albeit at the additional 45% tax rate.
- Transfers of assets/income streams through partnerships: Restricting the ability to dispose of assets and income streams through a partnership.
The additional guidance released on 21 February 2014 focused on the Salaried Member proposals providing a range of examples, including some specific to the investment management sector, which will help taxpayers understand how the provisions apply to their business. In particular comments around the significant influence condition for regulated functions provide additional clarity and demonstrate a desire to respond to the needs of the industry. Furthermore, HMRC have stated that the non-statutory clearance procedure will be available from Royal Assent in the summer.
Much has been written summarizing the legislation, but with the implementation date fast approaching, the purpose of this article is to discuss some of the practical considerations taxpayers face and the action required.
Profit Shares – Partnerships will need to consider removing fixed non-repayable entitlements to members to meet condition A of the salaried member provisions, replacing them with an entitlement linked to the overall profits of the partnership. Partnerships operating individual or departmental profit pools may struggle as depending on the interpretation of the legislation sharing partnership profits as a whole is commercially a different proposal and runs contrary to the desire to remunerate personal performance. Equally some managing members may understandably be reluctant to give away a fixed share of partnership profits. One potential benefit, however, may be that a fixed profit allocation varied by reference to partnership profits as a whole is more likely to be considered akin to a dividend and therefore not variable compensation for AIFMD purposes. The recent additional guidance will mean for some partnerships only subtle changes to the LLP agreement will be required rather than a complete overhaul as was initially feared. More clarity is provided in the new examples around the meaning of ‘varied without reference to the overall amount of the profits or losses of the partnership’.
Significant Influence – The managing members of partnerships may consider diluting their control across all the members of the partnership to meet condition B of the salaried member provisions. In practical terms it may be difficult to judge at what level ‘significant influence’, a term used in the legislation, is actually achieved as it will be necessary to have significant influence of the partnership as a whole. Recent clarity discussing regulated functions and the example setting out that a portfolio manager could be considered to have significant influence is helpful.
Capital Call – To meet condition C, some members may be required to introduce significantly more capital to the partnership equivalent to 25% of their ‘disguised salary’. Thought will be needed as to what class of capital this should be and whether regulatory approval is required. A possible benefit may be that some founding members could seek a return of part of their capital. The introduction of a three-month delay in introducing this capital for existing members and a two-month delay for new members to the partnership from 6 April 2014 will be welcomed.
Working Capital – Partnerships have traditionally been able to allocate profits to a corporate member for working capital purposes. The restrictions will potentially charge such an allocation to income tax. This policy shift is particularly unwelcome as the equivalent in a limited company structure would be to tax shareholders on retained earnings as opposed to when a dividend is declared. Partnerships may want to consider funding corporate members for working capital purposes in advance of the legislation coming into force subject to any avoidance provisions.
Service Company – Many partnerships operate a corporate entity to support the partnership, providing employees, administrative support, etc. in return for a profit allocation or service fee. Given the potential restrictions around corporate allocations, partnerships should expect increased scrutiny of the amounts paid by HMRC. Noting that transfer pricing can also apply to UK-UK transactions, an arm’s length price should be substantiated going forward.
Deferrals – Some partnerships that have already adopted deferral mechanisms, either within the partnership or via a corporate entity, will need to consider how these will operate going forward and the implications of deferrals with vesting dates beyond 6 April 2014. For partnerships that do not currently defer, they may wish to consider using the statutory tax mechanism to achieve this going forward.
Operation of PAYE – Salaried members who have become accustomed to receiving drawings without tax deducted at source will be impacted by the cash flow impact of the new regime. Communicating the fact that it is a result of a change in legislation will be important and amendments to the partnership agreement will likely be required. More tricky will be the conversations surrounding employers’ national insurance contributions as these effectively reduce the profit pool from which to make awards. Consideration as to who will pick up the additional 13.8% cost may be a point of negotiation amongst members.
Employment Provisions – In addition to the PAYE and employer’s national insurance contributions, individuals who fall to be salaried members will also be subject to a wide array of far-reaching employment tax provisions that do not attach to self-employed partners. Thought will need to be given to equity-based awards around the group which could fall within the employment related securities provisions, or compensation pools that could potentially be subject to the disguised remuneration provisions. In addition, there is a developing issue for employees with a mix of UK and non-UK roles following the recent release of proposals to revise the dual contract provisions. From 6 April 2014, non-UK elements currently not assessable for non-domiciled individuals filing on a remittance basis could fall within the UK tax regime.
Corporate Structure – Naturally many partnerships will pose themselves the question whether retaining a partnership structure is still beneficial. The main advantages that companies have over partnerships going forward will be the ability to retain profits at a 20% corporation tax rate and pay dividends at a marginally beneficial blended rate compared to a profit allocation from a partnership. However, although somewhat reduced, the advantages of a partnership structure will still make sense for many, particularly with the ability to attract and reward key individuals with an equity stake. Whilst this is possible in a corporate structure, the employment related securities provisions make this a more costly affair. Furthermore, the disguised remuneration legislation and recently proposed changes to the dual contract arrangements can make partnerships a favorable choice for businesses with operations outside the UK, particularly for non-domiciled individuals.
Conversion – For those wanting to restructure, the conversion to a limited company is possible. However, replicating the commercial relationships established in the partnership agreement will require careful consideration. Legal input will be required as employment rights are likely to be introduced, noting that in the partnership structure a salaried member does not automatically obtain the legal rights of employment by virtue of the change to their tax treatment. There are a number of tax considerations to be made on restructuring as various exemptions for capital gains and VAT can prevent tax charges arising on restructuring. Timing from a regulatory perspective and the interaction between a change of legal status application and the AIFMD applications will be a concern for many – noting any drag could leave partnerships in an awkward position from 6 April 2014 until approval is granted. Unfortunately, certainty is not assured and unravelling the position could be a costly and time consuming position, so the best advice for all partnerships is to seek clarity with regard to their position as soon as possible.
Combinations – An attractive option could be to use a combination of both a partnership and limited company. A bespoke solution will work for some businesses to enable working capital retention; however HMRC do have a wealth of legislative provisions that will make it challenging for some to achieve a workable structure from an operational and regulatory perspective.
It is clear from a policy perspective that only partnerships with ‘true’ partners will continue to obtain the tax benefits afforded to partnerships and some of the planning opportunities currently available under the existing regime will cease. Those impacted by the changes, which are likely to be the vast majority of partnerships, should establish what the practical consequences of the legislation mean for them and take appropriate action before 6 April 2014. Difficult commercial conversations and negotiations will be required for some and, although unpalatable, should be undertaken sooner rather than later. Additionally, given the potential quantum of the tax at stack we would strongly recommend that partnerships approach HMRC to gain certainty under the non-statutory clearance procedure once available from Royal Assent in the summer.