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Proposed changes to partnership taxation

2 July 2013
Following the Chancellor's first "warning shot" at partnerships in the Autumn Statement 2012, this year's Budget delivered on the Government's promise to crack down on the perceived unfairness inherent in certain aspects of partnership taxation. The consultation document, published on 20 May 2013, set out the Government's proposed new approach to partnership taxation which, it believes, will address the unintended distortions in the UK tax system which the current rules allow. 

The two aspects of partnership taxation under scrutiny

The consultation covers two main areas: disguised employment, where individuals work for an LLP as members but on terms which are tantamount to employment; and profit and loss allocation schemes involving corporate members, which will apply to all partnerships (but are expected to affect corporate member tax planning involving LLPs in particular).

The consultation is open for comments until 9 August 2013 and the new rules are intended to come into effect from 6 April 2014. There is currently no proposal to include any grandfathering provisions.     

Disguised employment

Currently, under the automatic presumption of self-employment, individual LLP members are treated as self-employed for all tax purposes even where, under general common law principles, they would be treated as being employed.  Self-employed tax status brings several advantages, in particular:

  • the various anti-avoidance tax regimes applicable to employees do not apply
  • no employer's national insurance contributions (NICs), currently at 13.8%, are payable in respect of the individual's profit shares
  • there is a cash flow advantage for the LLP as income tax is not deducted at source through PAYE.

The availability of these advantages has resulted in a proliferation of certain arrangements which HMRC perceives to be unfair, such as low paid workers being made partners as a condition of obtaining work (where the resultant loss of employment rights is not coupled with the normal benefits of partnership), and early promotion to partnership for professionals who would normally be regarded as "high-salaried employees" in order to avoid employment taxes.

The proposed new rules seek, through the introduction of a new class of "salaried member", to remove the automatic presumption of self-employment for LLPs but also go further by positively deeming certain members to be "employees" for tax purposes. Under the proposed rules an individual will be treated as a "salaried member" and taxed as an employee if one of two conditions are met:

  1. where, on the assumption that the LLP was a traditional partnership, he would be regarded as being employed by that partnership
  2. where the first condition is not met, but the individual

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

  (b)  is not entitled to a share of the profits 

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

The first condition removes the presumption of self-employment and reverts back to the common-law definition of an employee. It is expected that this will only capture obviously artificial arrangements as most LLP members would still be regarded as self-employed under the common law tests. However, the second condition is expected to have a wider impact, potentially capturing junior partners on high fixed drawings. 

HMRC has said that the concept of a "salaried member" is not intended to capture members who take a real risk in the business and are rewarded on the basis of a share in the profits, or those who are promoted to partnership in recognition of their skills and who sacrifice their salary entitlement in exchange for an opportunity to participate on similar terms to a senior partner (even if rewarded by a fixed share). However, it seems likely that there will be a grey area into which many junior and fixed-share partners may fall.

A new anti-avoidance rule will also be introduced to counter attempts to circumvent the new rules by inserting provisions into the partnership agreement that have no practical effect other than to avoid allowing a member to fall within one of the conditions above.

Corporate member tax planning: profit and loss allocation schemes

The second aspect of the consultation aims to put an end to corporate member tax planning in all partnerships where one of the main purposes of the planning is to arbitrage the different tax rates payable by corporate and individual members so as to reduce or defer tax liabilities.

Profit allocation

The first group of arrangements under scrutiny involve partnerships which have corporate and individual members where profits are allocated to the corporate member (which pays a lower rate of tax), even though such profits are ultimately for the economic benefit of one or more of the individual members.

The new rules propose that, where profits are allocated to a corporate member and there is an "economic connection" between that corporate member and one or more of the other individual members such that one aim of the allocation is to secure a tax advantage, those profits will be reallocated on a "just and reasonable basis" to the individual members concerned. The most obvious "economic connection" will be where individual members have a shareholding in the corporate member, however HMRC have indicated that they will also consider side agreements or other arrangements which give rise to a direct or indirect benefit in the corporate member. 

HMRC claims that such arrangements create unfairness and market distortion by allowing taxpayers to get the best of both worlds, in that individual members are able to enjoy lower corporation tax rates on their profits whilst also benefitting from the other commercial and tax benefits of operating in partnership rather than within a company structure.

HMRC has also stated that working capital arrangements (where profits retained in the business to be used as additional working capital are allocated to a corporate member) and profit deferral schemes (typically where individual members are awarded profits subject to forfeiture within a deferral period such that the "retained profits" are initially allocated to a corporate member and taxed at a lower rate) will be treated in broadly the same way, despite the commercial reasons underpinning such arrangements.

The argument is that the high tax charges that would result from retaining profits in the partnership are a natural consequence of choosing to do business as a partnership rather than a company and these disadvantages should be accepted alongside the advantages. However, in relation to deferred profit arrangements, HMRC is considering allowing relief for individuals where profit allocations are forfeited at a later date or to allow affected members to elect to be taxed as employees on deferred amounts. 

It is anticipated that, due to established practice (and the investment manager exemption), these proposals will particularly affect the Fincial Services sectors (principally hedge funds) since many hedge fund managers receive most of their remuneration as fee income to an LLP. However, the proposed changes will also have an impact on PE general partners or managers that are structured as LLPs. It seems likely that HMRC will come under pressure from industry on these issues during the consultation process and, as a result, further concessions may be introduced.

Loss allocation

The second group of arrangements involve partnerships with mixed members where losses are allocated to a member paying a higher rate of tax, who may be exploiting the different tax rates applicable to corporates and individuals. There is no requirement for there to be an economic connection between the corporate member and individual members.   

In this case, the proposal is that the losses will simply be disallowed (rather than reallocated as is proposed for profits).

Other arrangements

HMRC is also proposing to take action against other arrangements which seek to arbitrage the different tax attributes of partners. In particular, the focus is on deterring arrangements where one partner (the transferor) contributes capital or makes a payment to another partner (the transferee) in return for the transferee receiving a new or increased share of profits in circumstances where the transferee is either not taxed at all on the profit or taxed at a much lower rate than the transferor would have been. In such a scenario, the receipt of any such payments will be taxed as income of the transferor.


Whilst it is expected that most of HMRC's proposals will remain in place in some form, there may well be changes to the new rules as a result of the consultation process. Firms which may be affected should review their governing agreements and practices once the proposals are confirmed and consider seeking advice by the end of the tax year, in particular to ensure that:

  • junior or fixed share members in an LLP will not fall foul of the new rules for "salaried members", so that the LLP is clear on its compliance and payment responsibilities, and
  • partnerships that have corporate members understand any changes to the taxation of the partnership once the final rules come into effect.

For more information please contact Tom Shaw, Partner

T: +44 (0)20 7427 6509