Odey and Hffx: partnerships with mixed membership
The First-tier Tribunal judgments in Odey Asset Management LLP and HFFX LLP concern interesting points of law relating to remuneration arrangements in partnerships with mixed (individual and corporate) membership. Both FTTs found that funds allocated to the corporate member of an LLP as part of deferred remuneration arrangements were not subject to income tax in the hands of the individuals under ITTOIA 2005 s 850 in the year of allocation, but the amounts were subject to income tax when received by the individual members under the ‘miscellaneous income’ rules in ITTOIA 2005 s 687. The FTTs took different views on the application of the sales of occupation income provisions in ITA 2007 ss 773–778.
The taxation of fund managers has been under HMRC’s spotlight for some years now, and there have been a number of targeted legislative changes between 2013 and 2016 (beginning with the salaried member and mixed membership rules and ending with the income based carried interest regime). That focus is now also evident in terms of litigation, with a number of recent cases challenging historic planning.
Two recent cases – Odey Asset Management LLP v HMRC  UKFTT 31 (TC) and HFFX LLP v HMRC  UKFTT 36 (TC) – address interesting points of law relating to remuneration arrangements in partnerships with mixed (individual and corporate) membership. Both cases concern deferred remuneration arrangements established by limited liability partnerships (LLPs) involved in fund management. And in both cases, the dispute related to planning subsequently targeted by FA 2014 (which inserted ITTOIA 2005 ss 850C–850E). In addition to the anticipated tax benefits, the planning also served a commercial function of ensuring that bonuses were aligned with the long-term interests of the business (in line with increased regulatory pressure in that respect) and incentivising the retention of key members, as entitlement was generally withdrawn for individuals who became ‘bad leavers’.
In Odey, the individual members of the LLP worked as fund managers. In each year, a proportion of the profit which would otherwise have been allocated to the individual members was deferred on certain conditions and paid to a corporate member of the LLP. The remuneration committee of the LLP made recommendations to the corporate member that it contribute the funds to the LLP on a discretionary basis as ‘special capital’ which would then be invested in the funds managed by each individual member. In turn, it would permit the individual member to withdraw the funds at specified dates over the following two to three years. Anyone who had left in the interim would not receive these payments.
There was a similar ‘capital allocation plan’ in HFFX. The individual members were researchers and developers working on software relating to a foreign exchange trading management business carried on by another LLP (GSA Capital) of which HFFX was itself a member. A Cayman company acted as the corporate member of the LLP. Under the arrangements, a proportion of profits which would otherwise have been allocated to the individual members was paid to a corporate member, which invested the amounts (net of corporation tax) in funds managed by GSA. The investments were then sold, and the amounts contributed to the LLP over the following three years. The corporate member then had discretion to allow the individual members to withdraw these funds. ‘Bad leavers’ departing in the interim would not receive payments.
In both cases, amounts allocated to the corporate member were liable to corporation tax rather than income tax, and the taxpayers argued they were not liable to any further tax when they were subsequently received by the individuals.
The three substantive issues
HMRC challenged the planning on three substantive bases:
- First, it argued that income tax was assessable on the individual members in the year of allocation under ITTOIA 2005 s 850.
- In the alternative, HMRC argued that the amounts should be taxable in the year of receipt under the ‘miscellaneous income’ provisions in ITTOIA 2005 s 687.
- Finally, if the miscellaneous income rules did not apply, the amounts fell within the sales of occupation income provisions (in ITA 2007 ss 773–778).
HMRC lost on the first ground and won on the second in both decisions. Although considered only obiter, the FTTs came to different conclusions on the third ground (with HMRC losing the point in Odey and winning it in HFFX). The facts and the issues were similar to those in BlueCrest Capital Management Ltd and others v HMRC  UKFTT 298 (TC), in which HMRC also won on the second and (in the alternative) third grounds.
ITTOIA 2005 s 850 is a generic provision which provides the link between the profits of a partnership and the amounts on which the partners are liable to income tax. It determines the share of the partnership’s trading profits treated as arising to a partner by reference to the ‘profit-sharing arrangements’ in force at the time. That term is, in turn, defined as the ‘rights’ of the partners to share in the profits of the trade.
HMRC made a number of submissions in relation to s 850. Its primary argument was that, on a realistic view of the facts and a purposive interpretation of the legislation, the individual members had gained immediate ‘rights’ to share in the profits in the year of initial allocation because the amounts were effectively earmarked for them.
It further argued that any discretion on the part of the corporate member as to the subsequent allocation of the funds was effectively redundant, because it could not appropriate the funds for its own purpose and it could only exercise its discretion rationally and in good faith (and, in Odey, taking account of a formal remuneration policy).
The taxpayers argued that the legislation required consideration of the rights of the members only in the period in which the initial allocation occurred. The subsequent use to which a member might put the amounts was not relevant to identifying the profit-sharing arrangements. The only person with a right to the amounts in the period of allocation was the corporate member.
HMRC was unsuccessful on this point in both cases. In particular, the judge in Odey concluded that ‘rights’ to share in the profits implied the need for the individual members to have a legal entitlement to those profits even if the amounts were not actually received. The individuals had, in practice, gained the much more limited right to be treated in accordance with the remuneration policy and, in some circumstances, they may have received nothing at all. It was clear that there was a real possibility the individual members’ expectations could be defeated. Accordingly, the ‘rights’ arose only once the corporate member had actually exercised its discretion.
HMRC also submitted that the individuals had in effect consented to the redirection of profits to which they were entitled in circumstances analogous to those in RFC 2012 Plc (in liquidation) (formerly Rangers Football Club Plc) v Advocate General for Scotland  UKSC 45, so that the amounts remained taxable on the individuals even if they had been allocated to the corporate member. This argument was also rejected in both decisions, as it had been in BlueCrest.
The charge on miscellaneous income (now in ITTOIA 2005 s 687) is a long-established ‘sweep up’ provision which taxes income from any source that is not otherwise charged to income tax. The taxpayers argued that the income did not have a source with a sufficient connection to the individual members and therefore it could not be taxable as miscellaneous income: in effect, it was paid voluntarily. HMRC argued that the source was the continued service by the individuals as members of the LLP or, in the alternative, the corporate member’s exercise of discretion.
The FTTs concluded that s 687 applied in both Odey and HFFX. Neither decision considers the question of whether the payments were income or capital in nature in much detail. In Odey, it was held that:
- the sums were income (analogous to employment or trading income);
- the source of the deferred payment was the work performed for the partnership and their ongoing fund management services; and
- the connection, if not contractual, still arose from an obligation and was ‘in no sense voluntary’.
It was not necessary for the sums to be paid under a contractual obligation enforceable by the recipient for there to be a sufficient link between the source and the recipient.
Similarly, in HFFX, the judge found that there was a connection between the activities of the individual members and the subsequent reallocation that was sufficient for the payments to have a source and be chargeable to income tax as miscellaneous income. The reallocation was not an entirely voluntary transaction.
Sales of occupation income
The sales of occupation income provisions (in ITA 2007 ss 773–778) have been relatively little-used to date, and HMRC’s decision to rely on them here is interesting in itself. Broadly speaking, the rules apply where an individual carries on a profession or vocation in the UK and is involved in arrangements to reduce or avoid income tax in which another person becomes able to enjoy the income they earn in exchange for a capital payment.
The consideration of the sales of occupation income rules was not strictly required in either case as their application is mutually exclusive with the application of the miscellaneous income rules. The FTTs reached differing conclusions: the taxpayers won the point in Odey but not in HFFX.
Both judges accepted, as the FTT did in BlueCrest, that the individual members were carrying on activities of a kind undertaken in a profession (and were therefore carrying on an ‘occupation’ for the purposes of ITA 2007 s 774). This is consistent with the increasingly broad meaning of the term ‘profession’ which focuses on the exercise of intellectual skill rather than the narrower meaning seen in earlier case law (and is discussed in some detail in Odey). The taxpayers argued, in HFFX, that the definition of occupation is intended to exclude activities of a kind undertaken in a trade and HMRC were incorrect to assume that every skilled activity constituted a profession. The FTT disagreed, finding that the activities were not precluded from being ‘of a kind undertaken in a profession’, even though they were actually undertaken as part of a trade.
It was also found as fact in both decisions that the arrangements in question had a main object of tax avoidance. The taxpayers in HFFX argued that to the extent tax was a factor in implementing the arrangements, it was only to address the prejudicial position of individuals being taxable immediately on deferred amounts (an issue that is, to some extent, addressed by the mixed membership legislation for AIFM firms), but this was rejected by the FTT. It is interesting that it was GSA and the managing member, not the other affected individual members, which were found to have the relevant tax avoidance object.
In determining that the sales of occupation income rules did not apply (contrary to rulings on this point in HFFX and BlueCrest), the judge in Odey drew on her earlier analysis that the individual members had no entitlement to allocations made to the corporate member. The judge concluded that because no such rights had arisen and consequently the corporate member had merely received income of its own, the corporate member had not been put ‘in a position to enjoy all or part of the income’ derived from the individuals’ activities as required by condition B (ITA 2007 s 777(3)). Rather, the corporate member had simply received its own income entitlement at that time. This point does not seem to have been disputed by the taxpayer in HFFX. If the conclusion on the point in Odey is correct, this could mean that the regime’s application is quite narrow.
We can probably expect more litigation in this area as a result of these decisions, which will have significant implications for those involved. More broadly, the cases demonstrate HMRC’s determination to challenge tax planning with long-established legislation, raising doubts about the need for the specific anti-avoidance provisions introduced in 2014. This does not provide any defence for taxpayers confronted with the old rules, as Lord Hodge observed in RFC 2012, but it adds force to concerns over HMRC’s ‘legislate first, litigate second’ approach which increases the length and complexity of UK tax legislation.
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