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
|