The Draft Finance Bill 2014 - Economic Affairs Committee Contents


Chapter 3: The Consultation And The Draft Legislation

42.  This chapter sets out the background to the legislation which appears in the draft Finance Bill. It starts with a brief overview of the Limited Liability Partnerships Act 2000, then moves to the announcement in Budget 2013, followed by the consultation document published in May 2013. It describes the consultation responses and the Government's reactions as evident from the legislation in the draft Finance Bill. All four elements of the partnerships package are described, followed by a brief section on the estimated yield from the package. For the proposals concerning salaried members of limited liability partnerships, the chapter examines the evidence that the proposed legislation is radically different from what preceded it and offers conclusions.

Limited Liability Partnerships

THE LIMITED LIABILITY PARTNERSHIPS ACT 2000

43.  As discussed in Chapter 2, the Limited Liability Partnerships Act 2000 introduced into UK law limited liability partnerships with limited liability for their members. This was in response to concerns at the risks associated with large legal claims for professional firms set up as general partnerships.

44.  When the LLP Act was introduced, the broad policy intention was that members of a LLP should be treated in the same way as partners in a general partnership; this was achieved by section 4(4) of the Act. The precise drafting of this sub-section has been criticised in various employment law cases where the point at issue has been whether the LLP member had been an employee of the partnership, with the rights and protections that go with that status.[12] However, the courts have been prepared to take a purposive approach to its interpretation by addressing the question of whether the member would have been treated as a partner or an employee if the LLP had been a general partnership.

45.  It was also intended that there should be equivalence of treatment between LLPs and general partnerships for tax purposes. As HMRC put it in their consultation document of May 2013 "The original tax policy aim was to place members of LLPs in the same position for tax purposes as partners in a traditional partnership."[13] However, the provision which is now at section 863 Income Tax (Trading and Other Income) Act (ITTOIA) 2005, results in the tax legislation going further than the original intention by deeming an LLP member to be a partner for all the activities of the LLP. This is the legislative basis for treating LLP members as self-employed in all cases.

46.  Many of our witnesses confirmed this understanding of both the intention and the outcome. For example, the Law Society of England and Wales (LSEW) wrote:

    "[The LLP Act] intended that the status of a person who is a partner in a general partnership and a person who (although he may purport to be a partner in a general partnership) is in law an employee of the partnership, should not change if the general partnership converts to an LLP … However, this policy misfired."[14]

47.  The result is that the case law tests, based on court decisions which apply to determine whether a person is an employee of, or a partner in, a general partnership, do not apply for tax purposes to members of a LLP. Put simply, membership of a LLP is sufficient to produce the result that the member is self-employed with the attendant tax and national insurance savings. This presumption of self-employment has been increasingly exploited to disguise employees as self-employed partners. Mr John Whiting, OTS, told us "We were cited one so-called LLP partnership that had 20,000 partners in it … Equally, I was told by one practitioner of occasional fruit pickers being officially partners in an LLP."[15]

THE BUDGET ANNOUNCEMENT AND THE FIRST CONSULTATION

48.  Budget 2013 announced that "the Government will consult on measures to remove the presumption of self-employment for limited liability partnership (LLP) partners, to tackle the disguising of employment relationships through LLPs." [16]

49.  The consultation document which followed in May 2013 stated that "The policy aim is to prevent a member of an LLP benefiting from the default partner status if the terms of his or her engagement with the LLP are tantamount to an employment."[17] Baker Tilly reminded us how the Exchequer Secretary had written in his foreword to the consultation document "Fundamentally, this consultation is about levelling the playing field. It will have no impact on those partnerships or LLP members that use partnership structures as Parliament originally intended."[18]

50.  The consultation document set out how the Government was intending to achieve its policy aim. An individual LLP member who met either of two conditions would be classified as a "salaried member" and would be treated as an employee of the LLP. An employment status test would form the first condition and determine, by reference to the tests set out in HMRC's Employment Status Manual, whether the member would be treated as an employee if the LLP were a general partnership. The second condition would be an economic risks test which would treat the member as an employee if he did not meet the first condition but carried no economic risk, was not entitled a share of the profits and was not entitled to a share of any surplus assets on winding up the partnership.

THE RESPONSE TO THE FIRST CONSULTATION AND THE DRAFT LEGISLATION

51.  The consultation closed in early August and HMRC published a Summary of Responses on 10 December 2013 alongside the draft Finance Bill.

    "A large number of the respondents objected to the use of traditional employment status rules (the first of the two conditions proposed in the consultation document). They did not think that the self-employed and employee tests described in HMRC employment status manuals would be appropriate to determine the status of large professional LLP members."[19]

Those tests had been "devised to differentiate between self-employed consultants and employees rather than between partners and employees."[20]

52.  The Government's response to these views was to withdraw the first condition (the employment status test) and rely instead on strengthening the second test (the economic risks test). The option that had been pressed by many respondents, of simply repealing the presumption of self-employment and relying on general case law, was rejected on the basis of general uncertainty over the meaning of the case law.

53.  The revised second test is included in the draft legislation. A LLP member is to be treated as an employee if all three Conditions A to C are met:

Condition A: the member is to perform services for the LLP in his or her capacity as a member, and is expected to be wholly or substantially wholly rewarded through a "disguised salary" that is fixed or, if varied, varied without reference to the profits or losses of the LLP;

Condition B: the member does not have significant influence over the affairs of the partnership; and

Condition C: the member's capital contribution to the LLP is less than 25% of the annual, disguised salary.

54.  HMRC announced in its Summary of Responses document that "The original start date of 6 April 2014 will not be deferred given that there has been a long lead time for customers to prepare for these changes following the Budget 2013 announcement."[21]

55.  In chapter 4, we discuss the evidence concerning the merits of adopting these legislative tests compared with the general partnership case law tests and the extent to which they deliver the policy objective of aligning the tax treatment of LLP members with partners in a general partnership. In this chapter we focus on the evidence as to whether the Conditions in the draft legislation are a natural development of the earlier round of consultation or whether they constitute a radically different approach.

VIEWS ON THE DRAFT LEGISLATION

56.  There is a widespread view that the legislative proposals are very different from those in the May consultation document. Baker Tilly thought that "the policy objective has changed significantly since the original consultation".[22]The view of the Confederation of British Industry (CBI) was that

    "The consultation process which took place between May and August 2013 sought responses to a much narrower set of proposals than those published on 10 December 2013. Had businesses known these parameters, many more may have responded and those that did respond may have responded differently."[23]

57.  The LSEW were more strident in their criticism: "This is a fundamentally different approach from that set out in the May 2013 consultation … HMRC said that Conditions A to C were a strengthening of the second condition. We do not agree as we believe that they are a fundamentally different proposal."[24] The Association of Partnership Practitioners (APP) agreed.[25] Mr Frank Haskew, Institute of Chartered Accountants in England and Wales (ICAEW), thought that "Somewhere along the line, it seems as though that view was changed in favour of these totally different tests."[26] Mr Gary Richards, LSEW, described them as "radically different."[27] Herbert Smith Freehills[28] and Mazars[29] added their support.

58.  In her evidence Ms Judith Knott (HMRC) stated that

    "the text in the draft legislation is different from that proposed in the original consultation, but that is because of the views we heard during the consultation. Views differed, as you heard in the hearings, but there was a strong view that a clear set of rules was required, which is what we have tried to provide in the draft legislation. We were persuaded that the case-law tests would not suffice and would not work well in the context of LLPs."[30]

59.  The failure of the Limited Liability Partnerships Act 2000 to achieve its policy objective of aligning the tax treatment of LLP members with that of partners in a general partnership is at the heart of the problems that have arisen with LLP members all being treated as self-employed.

60.  We accept the evidence of our private sector witnesses on the provisions concerning salaried members of LLPs, and agree that the December proposals are significantly different from those proposed in the earlier consultation.

61.  This change of direction in December has implications for the way in which this consultation should have been handled and the way in which consultations generally should be handled. We return to this in Chapter 6.

Mixed Membership Partnerships

THE BUDGET ANNOUNCEMENT AND THE FIRST CONSULTATION

62.  This is the second main element of the tax package proposed for partnerships in Budget 2013. The Budget announced that "the Government will consult on measures to counter the artificial allocation of profits to partners (in both LLPs and other partnerships) to achieve a tax advantage."[31]

63.  The May 2013 consultation document explained what was intended here:

    "A partnership may involve different types of entity, for example, it may include both company and individual members … HMRC has seen an increasing number of arrangements involving such mixed structures where the profit-sharing ratios are calculated in such a way as to minimise the overall tax paid by the partners."[32]

64.  The proposals in the May consultative document were that HMRC could reallocate to individual partners profits allocated to a corporate[33] partner where the partnership comprises individual(s) and company(ies), there is an economic connection between those partners, and it is reasonable to assume that the main purpose or one of the main purposes, of the partnership profit-sharing arrangements is to secure an income tax advantage for any person.

65.  In such circumstances the profits could be reallocated on a just and reasonable basis, taking into account all the circumstances. The proposals would also target the situation where losses are allocated to individual partners where loss relief can be claimed at a higher effective rate of relief.

THE RESPONSE TO THE FIRST CONSULTATION AND THE DRAFT LEGISLATION

66.  Many respondents noted that the proposals were a departure from traditional anti-avoidance measures. Others argued that at least some of the arrangements targeted were commercial, for example, to enable working capital to be taxed at a lower rate. We return to this point in Chapter 5 and describe the very similar points that were put to us. Others thought that only a timing advantage was gained by allocating profits to a company; some considered this legislation an over-reaction.

67.  In their Summary of Responses document, HMRC stated that their analysis showed that

    "arrangements involving partnerships with mixed members give rise to permanent tax loss, and that any later tax attributable to dividend income is significantly less than the tax lost at the point of allocation. The Government considers that blocking excessive allocations at the start is the only certain way to stop this tax loss".[34]

As discussed in chapter 5, HMRC was unable to give us any further idea of how this permanent tax loss was achieved, when such arrangements were first introduced or the amount that had been foregone as a result of them.

68.  However, the Government did make some changes to the proposals including replacing the main purpose test with a more objective test. The provisions included in the draft Finance Bill give HMRC the power to reallocate, on a just and reasonable basis, profit shares where a partnership or LLP makes a profit for tax purposes and a profit share is allocated to a corporate partner, and either

(a)  the company's profits represent the deferred profit of an individual member and in consequence the individual's profits and the overall tax liability are lower than they would otherwise be, or

(b)  an individual partner has the power to enjoy the company's profit share and it is reasonable to suppose that both the individual's profit share and the overall tax liability are lower that they would have been in the absence of that power to enjoy the company's profits.

69.  HMRC's draft guidance issued on 10 December 2013, stressed the need for an economic interest between the individual partners and the non-individual partner: "The legislation does not apply to mixed membership partnerships in which the individual and non-individual partners are genuinely acting at arm's length."[35] And it applies only if it is reasonable to suppose that the profit allocated to the corporate partner is excessive and that allocated to the individual partner is correspondingly reduced.

70.  The issue of profit deferral arrangements, which occur mainly in the banking and investment fund sectors, received most comment. These arrangements are where an amount

    "may be awarded to particular executives but during a deferral period be subject to forfeiture depending on the performance by the executive or a wider group over that time …The aim of these deferral arrangements is to align incentives with long-term performance and discourage the taking of risks which may yield short-term profits but long-term losses."[36]

71.  It is clear that, with many partnerships, deferred profits are allocated to a corporate partner so that the tax immediately payable is correspondingly reduced and the individual partner does not have to pay tax on monies that he has not yet received. Generally, the Government's view remains that the allocation of the deferred profits of an individual partner to a corporate partner does not justify special treatment whatever the reason and that is why profit deferral arrangements have been included in the draft legislation. However, the Government was prepared to relax this stance in one situation which emerged during the consultation, the treatment of Alternative Investment Fund Managers (AIFM) partnerships.

VIEWS ON THE DRAFT LEGISLATION

72.  Whilst we have received much evidence on the scope and drafting of this legislation on mixed membership partnerships, no-one has contended that it is not a natural progression from what was proposed in the first consultation document, or that it should be delayed.

AIFM Partnerships: Profit Deferral Arrangements

A NEW MECHANISM TO TAX DEFERRED PROFITS

73.  In the May consultation document, HMRC set out its "understanding that at present it is exceptional for partnerships to be subject to any regulatory requirement to operate either profit deferral or clawback, but that this may change in the future."[37] This turned out to be incorrect in one area, the AIFM sector which is subject to regulation under the AIFM EU Directive (AIFMD).[38] The aim of the AIFMD is to improve investor protection across Europe and promote efficiency and cross-border competition. It came into force on 22 July 2013 and was implemented in the UK through secondary legislation and FCA rules. It requires certain firms to defer 40-60% of the variable remuneration of key staff by 3 to 5 years and pay at least 50% of that variable remuneration in units or shares of the funds they manage, rather than cash. Full application of the AIFMD is subject to exceeding certain thresholds. These apply to the total net assets that the manager has under management across all funds, rather than the size of the individual funds that he manages.

74.  The allocation of profits to corporate partners has been very prevalent in this sector and the mixed membership proposals would affect these partnerships very significantly as the individual partners would be required to pay tax on monies that could not, as a regulatory requirement, be paid to them. Accordingly, in discussions with representatives of the sector, HMT and HMRC developed proposals which would ease this difficulty by including a new mechanism for taxing the partnership (not its partners) at the additional rate of 45% on profits allocated to the partners but deferred in accord with the AIFMD. Under the mechanism, an election may be made to allocate certain restricted profits to the partnership, rather than any partners, and the partnership will pay the tax of 45%. When the profits are paid out subsequently, the individual partner pays tax and NIC at their marginal rates with a credit for the tax paid by the partnership.

Transfers of Assets and Income Streams Through Partnerships

75.  The proposals in the May consultation document and the resulting legislation cover schemes which seek to exploit the differing tax attributes of members of a partnership. The respondents to the consultation document were in favour of this being tackled and the draft legislation is as proposed in the May document.

Estimated Yield From Draft Legislation

76.  At the time of the Budget, the estimated yield from the package of measures was estimated at £1345 million for the 5 years from 2014-15. It turned out that this greatly under-estimated the yield from the AIFM sector. The discussions with the AIFM sector showed that the mixed membership proposals would have a much greater impact on that sector than had been anticipated. As a consequence it was announced in the Autumn Statement that the estimated yield was increased by £1920 million. In chapters 4 and 5 we return to discuss these yield figures in greater detail.


12   See for example Tiffin v Lester Aldridge LLP [2012] 2 All ER 1113. Back

13   Partnerships: A review of two aspects of the tax rules, Consultation document, HMRC, 20 May 2013, paragraph 2.8. Back

14   LSEW, paragraphs 7 and 8. Back

15   Q 8. Back

16   Budget 2013, HMT, March 2013 (HC 1033) paragraph 1.209. Back

17   Partnerships: A review of two aspects of the tax rules, Consultation Document, HMRC, 20 May 2013, paragraph 2.12. Back

18   Baker Tilly, paragraph 10. Back

19   Partnerships: A review of two aspects of the tax rules, Summary of Responses, HMRC, 10 December 2013, paragraph 1.7. Back

20   Ibid., paragraph 3.8. Back

21   Ibid., paragraph 3.20. Back

22   Baker Tilly, paragraph 39. Back

23   CBI, paragraph 4. Back

24   LSEW, paragraph 16. Back

25   APP, paragraph 4.2. Back

26   Q 44. Back

27   Q 71. Back

28   Herbert Smith Freehills, paragraph 3. Back

29   Mazars, paragraph 10.1. Back

30   Q 118. Back

31   Budget 2013, HMT, March 2013 (HC 1033) paragraph 1.209. Back

32   Partnerships: A review of two aspects of the tax rules, Consultation document, HMRC, 20 May 2013, paragraphs 3.9, 3.10. Back

33   Strictly a non-individual partner, but since this situation arises most frequently with a corporate partner, this report refers to a corporate partner from here on. Back

34   Partnerships: A review of two aspects of the tax rules, Summary of Responses, HMRC, 10 December 2013, paragraph 4.11. Back

35   Partnerships: A review of two aspects of the tax rules, Technical Note and Guidance, HMRC, 10 December 2013, paragraph 3.1.a). Back

36   Partnerships: A review of two aspects of the tax rules, Consultation document, HMRC, 20 May 2013, paragraph 3.16. Back

37   Partnerships: A review of two aspects of the tax rules, Consultation document, HMRC, 20 May 2013, paragraph 3.18. Back

38   2011/61/EU. Back


 
previous page contents next page


© Parliamentary copyright 2014