Following the consultation document, “Partnerships: A review of two aspects of the tax rules”, published in May 2013, the UK government has now issued draft legislation to target what it sees as:
In both cases, the proposals have been subject to substantial amendment since the consultation document. However, they still contain a number of ambiguities and remain potentially problematic in a number of areas.
The new legislation will apply from 6 April 2014, although limited anti-forestalling provisions took effect from 5 December 2013.
“Artificial” profit allocations
The changes primarily target arrangements that are viewed as diverting an individual member’s profit to a non-individual member, often a corporate partner. These arrangements were advantageous for hedgefund managers whose profits are “income” for tax purposes and therefore subject to tax at rates of up to 47% in the hands of the individual partners, but lower rates (currently 23%) if allocated to corporate partners.
Examples of where those arrangements are used include structures designed to meet regulatory deferral requirements. Part of the annual cash profit is retained by a corporate member for later distribution to the members if they meet performance conditions, and may in the meantime be invested in the funds under management. These structures vary in complexity with some achieving a reduction of the overall tax rate to the corporate tax rate.
A further example is where managers allocate cash profit which needs to be retained in the business for working or regulatory capital purposes, to a corporate partner. In that way, the cash suffers tax at the lower corporation tax rate allowing more cash to be retained in the business.
The basic proposal is that if arrangements are in place whereby an “excess” (non-arm’s length) amount of the partnership profit is allocated to the non-individual member, HMRC will have the power to reallocate the profit, on a just and reasonable basis, to the individual member(s) for tax purposes.
The detailed rules are complex, very widely drafted, and are likely to result in reallocations of profits for tax purposes to individual members in most of the structures for deferral or working/regulatory capital management outlined above. This will mean more tax payable up front, and thus less cash to be kept as capital or invested in the funds under management. In some cases, individual partners will be subject to tax on profits they may never receive (for example where deferrals are subject to conditions that may never be met), which seems unfair, especially compared to the equivalent provision for an employee which provides for relaxation from a dry tax charge for genuine deferrals.
To take account of this, the legislation permits AIFMD-regulated firms to elect for tax on the deferred profit to be borne by the firm in the year they arise at income tax rates. This avoids an up-front “dry” tax charge for the individual partners, but it exposes AIFMD-regulated firms to additional complexity and even more administration, so is likely to be considered a mixed blessing by the industry.
“Disguised employment” provisions
Currently, all members of LLPs are treated for tax purposes as self-employed. This provides a significant tax benefit as the LLP does not have to pay employer’s NIC (currently at a rate of 13.8%) and it was one of the main drivers for many managers setting up as LLPs.
As a result of this, there has been pressure to remove the automatic presumption of self-employment, and the new legislation provides that unless at least one of three conditions is met, a member will be re-classified as a “salaried member”. Salaried members will be treated as employees for tax and NIC purposes.
The first condition is that at least 20% of what the member receives from the LLP must not be “disguised salary”. A payment is “disguised salary” if it is a fixed amount, or a variable amount that is not affected by the overall profits or losses made by the LLP. Any guaranteed drawings will clearly fall within this definition. This will be an issue for start-up managers, who in the first few years of high risk often need to guarantee drawings so as to attract the right calibre of individuals.
Also, rather surprisingly, HMRC’s guidance states that remuneration linked to individual performance (rather than firm-wide performance) will be caught. This presumably means that “eat what you kill” models will be treated as disguised salary, despite arguably most resembling self-employment. The most complex discussions will occur where an individual member’s profit share depends both on the firm’s profitability and their individual performance. HMRC appears to envisage a slightly old-fashioned world where allocations either comprise guaranteed drawings or a simple residual profit share, but most profit allocations will now be based on a far more complex “waterfall”.
The second condition is that the individual must have significant influence over the affairs of the LLP. HMRC’s technical guidance suggests that actual participation in the management of the affairs of the LLP is required and that a mere acquisition of voting rights is not sufficient to suggest “significant influence”. We expect that in the context of asset managers only senior management (or the members of the management committee in the case of larger LLPs) will be considered to have significant influence over the affairs of the LLP. Senior management may not include some of the key portfolio managers who although responsible for managing one or more investment portfolios may not have management responsibilities internally.
The third condition is that the members’ capital or similar contribution must not be less than 25% of any disguised salary in the year under review. Some managers are considering whether further capital injections would be feasible so as to meet this condition, but even then it will still be necessary to wrestle with the uncertainties of what is, and isn’t, disguised salary in order to determine if the condition is met.
What should fund managers be doing?
Firms should review existing profit allocation structures and identify those individuals at risk of being treated as salaried members. They should then determine whether it is commercially possible and desirable to maintain the self-employed status of these individuals. Where it is decided that the self-employment status is to be maintained, firms should consider how their arrangements should be amended to achieve this.
Where corporate partners are used, firms should consider whether they should be retained and whether their profit allocation structures (for deferral or otherwise) should change. As part of this process firms should consider whether the current UK LLP structure is still the right one for them or whether it would be more appropriate to incorporate, or even move offshore.
Some of these decisions will not be straightforward, and there will be uncertainty about the characterisation of certain members and the tax status of some profit allocations. It is thus important for firms to start liaising with their advisers now so that they can plan their approach before the effective date.