The updated consultation on salaried members of LLPs that was released on 21 February by Her Majesty’s Revenue and Customs (HMRC) is the final process that started in the 2013 Budget. A consultation document was issued in May last year and HMRC responded in December. This document marks the final update on the topic. There are two issues which HMRC have sought to tackle:
Throughout, HMRC have been focused on changes to the taxation of LLPs starting on 6 April 2014. It has been a feature of this process that HMRC have shown a lack of commercial awareness of the issues affecting businesses. LLPs have been given a very short period of time to work out if and to what extent they are affected. It also gives LLP members the same period to work out the cash flows arising from a potential cessation.
When you consider the knock-on effects of ‘employment’ taxation (employment-related securities, benefits in kind, pension contributions), there is really no time, and for a government that is supposed to be pro-business, it is an embarrassment. Unfortunately, unlike in Armageddon there is no Bruce Willis to save the day, even when there is apparently ‘no time’.
There have also been no changes to proposals on the taxation of mixed member partnerships.
So what is the effect of the latest consultation?
The legislation has not been redrafted, but HMRC have issued new examples and guidance. For many in the regulated sector the revised guidance offers some helpful relaxation. To recap, a member of an LLP will be treated as an employee for tax purposes, and tax purposes only, unless they meet one of three conditions. (The legislation is written in the double negative – that they will be treated as an employee unless they fail all three conditions – however, it is easier to consider, and explain, in the positive).
The three conditions are:
As stated above, these rules start on 6 April 2014. HMRC state that the decision as to the status of the LLP member is as at that date, and will not be revisited unless circumstances change. However, each of the tests can be examined to test the reasonableness of that assumption as at 6 April. If the member joins post 6 April, it is the circumstances at that date that are relevant (with the same tests of reasonableness).
Interestingly, although income tax is an annual tax, HMRC take the view that you look at the overall arrangement for the foreseeable period in determining whether the ‘disguised salary’ test is met. In particular, two examples in the revised guidance (one of which is a start-up fund management venture) look at a three-year period, and given expected profits in year three, the individual member does not have a ‘disguised salary’ even in years one and two, although he or she receives a fixed draw.
LOOKING AT THE THREE CONDITIONS IN TURN
Condition A – Disguised salary
HMRC are only considering payment for services in the status as a member of the LLP. Payments to companies, investors and former partners during a ‘sunset’ phase are not at risk. Equally, payments that aren’t for services as a member, e.g., rent for a property, are not in point.
Also the ‘disguised’ salary element must be at least 80% of the total expected remuneration. If the ‘disguised salary’ part is less than 80%, then the member will not be a ‘salaried member’.
‘Disguised salary’ is defined in the draft legislation as being remuneration that:
HMRC then take 14 pages to give examples of the above. The hoops that HMRC have forced themselves into with this legislation can be seen from examples 14 and 22 in the draft guidance. These are repeated in full below:
This example looks at bonuses and remuneration committees.
J works for the ABC LLP. He will receive a salary of £100,000 plus a bonus determined by a remuneration committee, at their discretion. For the purposes of this legislation, the question is about the terms governing the remuneration committee’s exercise of its discretion in determining the bonus payable. If the bonus paid is genuinely a share of the profit of the business, it will not be considered as disguised salary.
In this case, more information is needed to determine whether the award is determined as an additional share of the overall profits of the firm or not. What are the terms of reference for the committee?
If the bonus is an additional share of the overall profit of the business, the next question is how realistic is it that any profit share will be 25% or more of the fixed salary of £100,000 (such that less than 80% of the total rewards will be disguised salary). As stated above, those rewards that are unrealistic and are unlikely ever to be triggered are ignored.
This example looks at how a team leader can be rewarded for the results of their team by the way the profits are allocated.
Towards the end of the year, the performance of the members is assessed and additional profit share units are allocated to members based on their performance during the year. This also takes into account the performance of the team for which they are responsible.
Condition A is not satisfied. Although the profit share units are allocated partly on the basis of personal performance, all that is happening is that the proportion of the profits going to each member is being set. How much each member will receive depends upon the amount of the overall profit.
To return to the cake analogy, their performance partly determines how large the slice is, but the actual amount of money depends on the size of the cake. A bigger slice of a smaller cake may be smaller than a larger slice of a bigger cake.
So as long as LLPs are profitable overall, then it should be possible to demonstrate that the sharing of that profit is not a ‘disguised salary’. However, this will require careful documentation and communication with LLP members.
There are likely to be issues where some LLP members have fixed draws where the LLP makes losses, or indeed where a priority draw causes other LLP members to be allocated losses (subject to the point on projected profits mentioned earlier).
Cost plus arrangements
Worryingly, HMRC have suggested that UK LLPs that operate on a ‘cost plus’ basis may not be capable of meeting the ‘disguised salary’ test. They have included as an Annex examples of ‘global structures’ and the issues these businesses may face with the ‘salaried members’ tests. Para 1.4 of the Annex deals with a ‘cost plus’ basis of profit allocation.
1.4 Cost plus basis
If the profits of the UK LLP are calculated on a cost plus basis, then Condition A is satisfied (i.e., the LLP member will be treated as a ‘salaried member’ asthe level of profits vary with the rewards to the members rather than the members receive a reward that varies with the profits of the LLP).
This is illustrated in the following example.
P and Q are members of P&Q LLP which is a fund manager associated with a US firm. All fund management fees are paid directly to the US firm.
P and Q provide services to the US firm and agree at the end of the year that based on the profits of the US firm, £300,000 will be allocated to P&Q LLP as their remuneration, in addition to an amount equal to the costs of the business of £500,000. The LLP has agreed a ‘costs plus’ basis with HMRC and therefore the profit taxable in the UK will also include an additional £80,000 (i.e., a 10% mark-up on costs including the members’ remuneration).
The £300,000 is not in practice variable by reference to the overall amount of the profits of the UK firm because it is set according to the profitability of the associated firm. Therefore it is disguised salary. Similarly, the additional £80,000 varies according to the members’ remuneration and other costs, not the profits of P&Q LLP. P and Q meet Condition A.
This seems both concerning and also logically incorrect. P and Q do not provide services to the US firm. Rather P&Q LLP provide those services. The reward for those services in the above example is £880,000 and has been agreed as a proper calculation of the split of profits of the combined businesses. The split of the £380,000 profit would seem to be relating to the profits of the UK LLP’s business. However, LLPs in this position would be wise to ensure that the members are exempted from being ‘salaried members’ by one of the other criteria.
There are other examples in the guidance with profit-sharing in global businesses that are also not helpful. HMRC are taking a hard line where an LLP member may take a relatively small fixed sum from a UK LLP, but where they do truly share in the profits of a worldwide LLP. In this situation, HMRC suggest that in respect of the UK LLP, the member will be a ‘salaried member’.
Condition B – Significant influence
There has been little change in the updated consultation for most businesses as regards the definition of ‘significant influence’. Those members that are involved with the strategy and key decisions of the LLP as a whole will have ‘significant influence’ and not be ‘salaried members’. This is not a reflection of voting rights necessarily, or indeed professional qualifications, but rather the role the member plays in the running of the LLP. HMRC equate this to be broadly a member of an executive or management committee.
In a small partnership, this may be the easiest and cost-effective way of ensuring that LLP members are not caught by the ‘salaried member’ rules. Meetings should be held regularly, at least quarterly, and minuted.
One important change is that HMRC now accept that for businesses that are regulated by the FCA, the definition of ‘significant influence’ includes those with investment authorisations.
The section is worth including in full:
2.5.3. Significant influence functions of financial businesses regulated by Financial Conduct Authority (FCA)
The Financial Services and Markets Act 2000 says that a significant influence function, in relation to the carrying on of a regulated activity by a firm, means a function that is likely to enable the person responsible for its performance to exercise a significant influence on the conduct of the firm’s affairs, so far as it relates to the regulated activity.
A person carrying out such a function in relation to an authorised firm must be an FCA-approved person.
The context of the FCA significant influence function test is different from that of the significant influence rule in the salaried member legislation. However, HMRC would accept that the following FCA “significant influence functions” are likely to result in the individual exercising them having significant influence for the purposes of Condition C: CF3 (chief executive function) and CF8 (apportionment and oversight function).
On the other hand, CF4 (partner function) merely means that the individual has to be FCA-approved by virtue of being a member of the LLP (and as a result of which the FCA presumes the individual to have influence). Whether this in practice results in the individual having significant influence over the affairs of the LLP as a whole is a question of fact. In cases where the firm’s activities consist wholly or almost wholly of regulated activities and the individual in question significantly contributes to the firm’s major decisions (management, strategic or investment-related), then it is likely that HMRC would accept that this constitutes significant influence for the purpose of Condition C.
This example looks at an example of whether someone who fulfils a function required by a regulatory body can satisfy Condition B.
X is a member of XYZ LLP, a regulated asset manager. X is a key portfolio manager, but not on the managing committee of XYZ LLP.
X is authorised by the FCA and holds Controlled Function CF4 for FCA purposes, which is listed as a ‘significant influence’ function. In addition, X makes significant investment decisions in relation to one of the funds under management.
X fails Condition B because of his significant influence over the LLP.
Capital contributions to the LLP
Where an LLP member contributes as a capital contribution at least 25% of the amount that would be considered to be disguised remuneration, then they will not be considered to be a ‘salaried member’. Capital contribution includes all amounts invested as capital (including long-term loans) but not a current account or short-term loans.
One change in the updated consultation is that an LLP member has three months to organise the capital, although they will be required to give an unconditional commitment to make the contribution. This will need to be given by 6 April 2014 for existing LLP members.
HMRC take the view that it is only capital in the UK LLP that can be considered for these purposes. Capital invested worldwide will not count. Businesses in this situation may need to move capital around to ensure that partners are not caught. This may not be easy (or even possible) in the timescale.
The analysis above is at a very high level. Every LLP will have different structures and processes, and what may be relevant and appropriate for one, may not be for another. Therefore, no LLP should act, or refrain from acting without seeking specific advice on their situation.