In May of this year, HM Revenue and Customs (HMRC) published a consultation document proposing radical changes to two key aspects of the taxation of partnerships and LLPs. First, the government intends to remove the presumption that individuals who are members of an LLP are self-employed. The perceived misbehaviour here is that employment relationships can be disguised by using LLPs to reduce the employer’s National Insurance contributions (NIC) and avoid employment law matters, including minimum wage requirements. Second, it wants to counter the tax advantages that can be secured between partners with different tax profiles (“mixed partnerships”). One practice squarely in the government’s sights is the allocation of profits to a corporate partner in which individual partners have some form of economic interest. The concern is that this allows individuals to effectively benefit from lower corporation tax rates compared to income tax and NIC.
What does this mean for investment management partnerships? The proposed changes, in particular the challenge to mixed partnerships and the potential clash with the Alternative Investment Fund Managers’ Directive (AIFMD) remuneration rules, could have a profound impact on the tax position of partners. The opportunity to comment on the proposed changes ended on 9 August 2013 and draft legislation is not expected until late this year. In the meantime, it is a very encouraging sign that both HMRC and HM Treasury have engaged closely with advisers and industry representatives, including the Alternative Investment Management Association (AIMA), and with the Financial Conduct Authority (FCA), and the proposals are continuing to evolve through discussion. But we believe there is still some way to go before change can be effected without causing considerable and unwelcome uncertainty for the tax position of investment managers that operate through partnerships.
The government is concerned that members of an LLP should no longer benefit from an automatic presumption that they are self-employed. It believes that where the member is in reality an employee, the LLP enables the business to sidestep the 13.8% employer’s NIC. The proposal is that from 6 April 2014 two conditions will apply. If an LLP member meets either of these, they will be considered a “salaried member” with the result that income tax and employee’s NIC must be deducted by the LLP from their deemed salary. As the employer, the LLP itself must account for employer’s Class 1 NIC on that same amount. The salary and the employer’s NIC will be deductible in the LLP’s tax computation, but this could still represent a significant extra cost to firms. The two conditions are that:
• economic risk, through loss of capital or repayment of drawings;
• a variable share of profits; and
• any surplus of assets on a winding up.
We do not expect this change to impact the investment management industry as much as some other sectors. Our experience is that LLP members usually are genuine partners, with only a few exceptions where junior members are vested with few of the risks and rewards of being in a business in partnership. However, we are concerned that the factors to be applied under the first condition are not at all appropriate to investment managers, or indeed to professional partnerships more generally. The factors are set out in HMRC’s published guidance and are derived from case law over a long period and mainly relate to individual contractor relationships. While the decision will not be made on one single factor, the ability of a partner to provide a substitute worker and the requirement to supply their own equipment is a key consideration. These indicators might be appropriate to determine whether an IT consultant or a plumber is actually an employee, but they seem far from suitable when applied to a hedge fund manager, and have failed to keep pace with the reality of how modern professional partnerships operate. Thankfully, HMRC has indicated in discussion that it may drop the first condition altogether. Instead, it would place greater emphasis and further develop the second condition which looks closely at the economic fundamentals of what it means to be in partnership. We would welcome this, as it should reduce ambiguity for partners.
The changes proposed to the taxation of mixed partnerships are of far greater concern for the industry. The government believes that the discretion partnerships have to allocate profits and losses within the terms of the partnership agreement has been used to secure tax advantages. Its principal concern is with three kinds of arrangement involving mixed partnerships:
Unfortunately, the solution currently favoured by the government to address this concern is drastic and it has consequences that do not appear to have been thoroughly considered prior to consultation. It is proposed that where “it is reasonable to assume that the main purpose of the partnership profit-sharing arrangements … is to secure an income tax advantage”, all or some of the profits allocated to the corporate shall be allocated to partners liable to income tax on “a just and reasonable basis”.
Rather than define the hallmarks of an abusive arrangement and target the provision accordingly, the measure is very widely drawn and inherently subjective in its application. There is a clear danger that in order to tackle one perceived problem, the changes may create a number of more significant ones, including the spectre of an individual having to pay tax on income they will never receive. Our hope is that the government has started with a blunt solution but will rely on the representations made to it to refine the measures and eventually introduce something more workable.
There is significant pressure from investors and regulators alike to defer profit, show “skin in the game” through co-investment and increase levels of regulatory capital. Accordingly, the arrangement most likely to be seen in investment management partnerships is the allocation of profit to a corporate partner. HMRC considers that these arrangements are “clearly tax-driven” but it also acknowledges that such arrangements may exist for working capital reasons, or in order to provide a profit deferral mechanism. Perversely, it does not consider that these merit an exclusion or exemption.
Tension with the AIFMD Remuneration Code
The need for the industry to speak up is clear because the proposed tax changes are potentially in direct conflict with forthcoming regulatory changes that many investment managers must comply with. The AIFMD remuneration requirements will impose both share-based and variable compensation deferral requirements on many hedge fund managers for the first time. Up to 60% of remuneration must be deferred, 50% of the balance must be share-based and non-deferred shares must be retained for a period of time and cannot be disposed of immediately for cash. This means it is possible that a partner with a variable profit share is in a net cash loss position in the year of award. It is also conceivable that hedging of these deferral and share-based requirements through holding fund units increases the regulatory capital requirements of the business, thus requiring partners to make further capital contributions to the partnership. Table 1 illustrates how an individual partner subject to the AIFMD Remuneration Code could be taxed on a variable profit share.
In a series of discussions, HMRC has recognised this tension and the level of engagement by HMRC with investment managers, their advisers and industry representatives has been very high to date, perhaps even unprecedented. In September 2013, the FCA published draft guidance on the policies that must be followed by UK fund managers within scope of the AIFMD. The guidance refers to the possible introduction of a new statutory tax mechanism which, if adopted by a partnership, will mean that the rules will apply on a ‘net of tax’ basis. Details of the mechanism have not yet been released, but it should mean that partners should only be subject to deferral and share-based requirements on net of tax profit shares, providing a heavy incentive to adopt this statutory mechanism rather than adopt any alternative practice. We look forward to learning more in due course about how the mechanism will operate, but it would appear that HMRC and the FCA have recognised the tension between the AIFMD and the rules on the taxation of partnerships and reacted to the representations made by investment managers, their advisers and industry representatives. HM Treasury is currently charged with the wider policy objective of helping make the UK a more competitive place for investment managers, and this proposed mechanism will be important in this context so we await the outcome with keen interest. There is certainly a great deal at stake given the potential effect of the proposed changes.
Do partnerships have a future for investment managers?
The knee-jerk response might be to conclude that investment management partnerships should transfer their businesses to limited companies in the light of these changes. But we do not believe that is necessarily the right answer. Partnerships will continue to appeal to investment managers as the model that best reflects the ethos of their business and notwithstanding the final outcome of the consultation, it is likely that partnerships will still provide investment managers with valuable benefits; not least the ability to alter profit-sharing arrangements relatively easily and for one partner to dispose of a fractional interest in partnership assets to another partner without triggering a tax charge. Similarly, the consultation does not outline any proposals which would prohibit a partnership from entering into any commercial arrangement with a connected company, and thus make payments at an arm’s length for any services provided. Therefore, we would expect to see such relationships between partnerships and companies continue.
Ultimately, the decision as to whether restructuring or incorporation is the right answer can be made only on a case-by-case basis and we would encourage investment managers to review their structures once the final outcome of this consultative process is known.
Fiona Carpenter is a partner at EY. She co-leads EY’s EMEIA Asset Management Tax practice and specialises in tax advice for hedge funds and managers. Rob Osborne is a manager in the Asset Management Tax team at EY and serves a range of hedge fund clients. Before joining EY in 2010, Osborne was a tax inspector at HMRC for eight years.