House of Lords - The Draft Finance Bill 2014

The Draft Finance Bill 2014 - Economic Affairs Committee Contents

Chapter 4: Salaried Members Of Limited Liability Partnerships

77. This chapter examines the evidence on the proposed changes to the tax treatment of members of LLPs. It opens by considering the Government's proposals and an alternative that was pressed on us. It then examines the scope of the proposals: whether Conditions A to C achieve the policy intention and the business implications of applying those Conditions. There then follow some more detailed points on the draft legislation. Finally, the chapter examines the evidence on the difficulties in implementing the provisions with effect from 6 April 2014 and the consequences of delaying the introduction of this part of the legislative package. The chapter ends with an overall recommendation of the best way forward.

The Draft Legislation

78. As has been seen in chapter 3, the proposals are designed to change the presumption in existing legislation that all LLP members are self-employed partners in the LLP. They seek to do this by incorporating into the existing legislation (Income Tax (Trading and Other Income) Act (ITTOIA) 2005) three new sections.

79. The first section (section 863A) directs that an individual LLP member is to be treated as an employee if Conditions A to C are met for that member. The detail of Conditions A to C is contained in section 863B. Section 863C contains an anti-avoidance provision. Where the proposals apply to make the LLP member an employee of that LLP, there are then supplementary consequential provisions.

The Approach of the Legislation: Case Law or Legislative Tests?

80. The problems with salaried members of LLPs stem from the failure of the LLP Act 2000 to achieve its policy objective of aligning the tax treatment of LLP members with that of partners in a general partnership. As discussed in chapter 3, the provision which achieves this for general law purposes, particularly employment law, is considered not to apply for tax purposes, given the wording of the tax provisions.

A CASE LAW APPROACH

81. It might be thought therefore, that the most obvious way to rectify the situation is to amend the legislation so that it does directly align the tax treatment of LLP members with that of partners in a general partnership, and indeed, this was proposed in the May consultation document. This would be done by removing the presumption of self-employment from tax legislation thus allowing the case law that applies to general partnerships to apply to LLP members.

82. This approach was favoured by most of our witnesses. The ICAEW wrote "The existing rules for determining an individual's employment status could be used for an LLP."[39] Mazars[40], the APP[41] and Deloitte[42] all agreed, as did Mr John Dixon, EY: "In our analysis we would agree with the Deloitte point of view."[43] Mr Kevin Nicholson, PwC, expressed his view that "You can see why you might think a mechanical test is a good one. Unfortunately this does not create certainty at all. It creates anything but certainty …"[44] He reinforced this later in his evidence "That is why, I am afraid, I would not try to come up with a mechanical test. I would go back to basics … because you will be sitting here in 14 years saying, 'Why did somebody not shout louder, and why did we just allow this to happen?'"[45] Mr Bill Dodwell, Deloitte, could see why "Bright line tests can be easy for administrators … but they do not hit the qualitative approach, which we think is the right answer for assessing partnerships."[46]

83. The British Private Equity and Venture Capital Association (BVCA) and the LSEW agreed and the latter commented that

This view is strongly echoed in the other oral evidence. For example, Mr Chris Sanger, Tax Professionals Forum (TPF), said "We do absolutely believe it would have been simpler to reinforce the [general partnership law] tests."[48] Mr Ashley Greenbank, LSEW, rejected the suggestion that the drafting difficulties with section 4(4) of the 2000 Act were sufficient to justify the alternative approach taken by the Government.[49]

THE LEGISLATIVE TESTS

84. Although there was a very considerable weight of evidence in favour of a case law test from the private sector witnesses, there was some understanding of HMRC's position and a willingness among some witnesses to try to make a legislative approach work. Mr Steven Whitaker, BVCA, was "realistic, in that it is unlikely that we can move to a case-law determination of what a partner is".[50] The LSEW too, notwithstanding their preference for a case law approach, did not object to the alternative approach "provided that in essence they replicate the case law test and respect the tax principle underlying the case law test."[51]

85. In their evidence KPMG supported the policy objective and, while not necessarily preferring the approach taken in the legislation, were more comfortable with it, believing "that the three factors used in the draft legislation of profit sharing, management and capital are, on balance, those most prominently featured in previous case law."[52]

86. The apparent difference between the KPMG view and that of Deloitte, who favoured the case law approach, was discussed by Ms Jane McCormick, KPMG, and Mr Dodwell at one of our witness sessions. They agreed that there was not that much between them. It was common ground that with the legislative tests it was essential that they achieved an outcome equivalent to the case law approach.[53]

HMRC'S VIEW

87. HMRC's reasons for rejecting the case law approach were set out in the Summary of Responses document: "The main concern here was that normal self-employed vs. employee tests as described in HMRC's employment status manuals would not be effective tests in this context."[54] Notwithstanding the fact that in the Overview of Legislation in Draft,[55] these measures are brigaded in a section entitled "Anti-Avoidance", Ms Knott told us that the partnership measures were not purely about anti-avoidance: "These are structural changes, designed to ensure that the taxation of partnerships and LLPs is fair and consistent and to prevent significant tax loss."[56]

88. Invited to explain why the Government did not restore the position to what was intended in 2000 by removing the presumption of self-employment Ms Knott outlined the answer given in the Responses document:

RECONCILING VIEWS

89. It is difficult to reconcile the views expressed by private sector witnesses with those expressed by HMRC. It appears to us that there may have been a misunderstanding about the nature of the objections submitted by respondents to the original consultation concerning the case law approach. They seem to have been objecting to the use of the tests in HMRC's Employment Status Manual, not to the use of the case law tests in general.

90. This point was put to us in evidence. The LSEW wrote:

Mr Greenbank summarised the position as "It was just applying the tests in the wrong context, and so it made it difficult to apply."[59] Others had the same thoughts.

91. It is not clear to us how significant this apparent misunderstanding might have been in HMRC's decision to reject the case law test. However, the Summary of Responses document, having acknowledged that many respondents wanted the case law test, went on to say:

92. It is clear that there are alternative ways of achieving the policy outcome of aligning the tax treatment of LLP members with partners in a general partnership. One approach would be to remove the presumption of self-employment from the tax legislation and to rely on partnership case law to determine whether a LLP member is an employee or a self-employed partner. Another approach would be to adopt legislative tests designed to achieve the same outcome.

93. In our view, it is still open to question which is the better approach. We agree strongly with those who stressed that, if legislative tests are adopted, it is vital that they achieve the intended policy outcome of aligning the tax treatment of members of LLPs with that of partners in a general partnership.

94. If our recommendation on commencement of the provisions on salaried LLP members (paragraph 142 below) is accepted, it will provide time to enable a reassessment of both approaches and for HMT and HMRC to have further discussions with all interested parties.

Do the Three Conditions Achieve the Desired Policy Outcome?

95. In this section we examine the evidence concerning the legislative tests in Conditions A to C and particularly whether they achieve the policy outcome of aligning LLP members with partners in a general partnership. We also consider their business implications as the legislation is currently drafted.

96. As discussed in Chapter 3, the draft legislation provides that a LLP member will be treated as an employee if all three Conditions A to C are satisfied:

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.

We find the negative way in which the conditions have been drafted surprising. It sets out conditions which, if satisfied, would make the LLP member an employee for tax purposes. We would have expected the legislation to set positive hurdles which, if satisfied, would make the member a partner. If our recommendation for delay is accepted, this approach might be revisited.

THE GENERAL SCOPE OF THE CONDITIONS

97. It will be clear from the preceding section that some of our private sector witnesses were more comfortable than others with the principle of having tests in the legislation. However, there was unanimity of view that the three Conditions as drafted failed to achieve the desired policy outcome. The widespread feeling was that the Conditions went further than desired, had the potential to affect many, if not most, partnerships and would reverse the present relatively advantageous position of LLPs compared with general partnerships. In this report it is possible to mention only a selection of the evidence we received on this point. Viewing the evidence directly will confirm the weight of opinion that we received.

98. Baker Tilly made their point in this way:

"So if the new legislation has achieved its intended outcome, existing professional partnerships who are continuing to use a pre-LLP framework for their partnership agreement should be able to say 'we are using a partnership structure as Parliament intended: this legislation will have no impact on us'.

This is manifestly not the case

It is our experience, based on very extensive discussions with our own clients, that the legislation will have an impact on virtually every professional partnership in the UK which operates as an LLP

99. The City of London Law Society (CLLS) considered that "the current proposals demonstrably go further than treating as an employee for tax purposes an LLP member who would otherwise be an employee as a matter of general law and change the policy fundamentally in that they clearly and explicitly place the LLP at a positive disadvantage."[62] Grant Thornton[63] agreed, as did Herbert Smith Freehills[64] and Mazars[65].

100. KPMG, after accepting the objectives of the legislative tests, wrote: "However, as currently drafted we do not believe that the legislation achieves its aim … In effect it does have the capacity to impact significant numbers of genuine equity partners."[66] The CBI "support the stated objectives but are not convinced that they are achieved by the proposed legislation."[67] The LSEW, concluded that "the objective tests set out in Conditions A to C completely fail both to replicate the case law tests and to respect the tax principle that they embody."[68] Others, including Mr Patrick Stevens,[69] Chartered Institute of Taxation (CIOT), Mr Magnus Spence,[70] New City Initiative (NCI), and Mr Louis Baker,[71] APP, made the same point, shaded to reflect the sectors that they represent.

101. Mr Richard Murphy, Tax Research, gave us his perspective on this:

However, Mr Murphy thought that "The ideas are pretty poorly structured inside the new legislation … We are creating new tests that are inappropriate."[73]

102. Having reviewed the evidence on the scope of the three conditions, which strongly suggests that they fall well wide of their target, we now examine in turn the objections that have been raised with regard to each of the conditions.

OBJECTIONS TO CONDITION A

103. The main concern with Condition A was that, by focusing on the profits or losses of the whole LLP, it excludes those members who are remunerated by reference to the performance of part of the business, a division or a line of business. The Professional and Business Services Council (PBSC) wrote "In a large and complex business, it would not be unusual for a partner to be given a variable profit share over the profits of a single service line or geographic location for which they have some responsibility."[74] This concern was supported by many others. Whilst the PBSC referred to large and complex businesses, we think this could equally be an issue with smaller LLPs.

104. The ICAEW had a slightly different slant on the same theme "The definition of disguised salary in new s 863B(2) will catch profit pools comprising bonuses that are to be allocated on different bases."[75] The LSEW had a slightly wider point: "Condition A does not address the correct question, namely, whether the individual's remuneration results from a division of the LLP's profits or represents an expense in arriving at those profits. It merely addresses the computational aspects of the payment."[76] The oral evidence that we heard supported the large amount of written evidence that we received on this aspect.

OBJECTIONS TO CONDITION B

105. There was also much concern about the significant influence test in Condition B. Herbert Smith Freehills outlined the problem as they saw it:

106. Again many others agreed, and we heard the same complaints in the oral evidence. Mr Stephen Herring, Institute of Directors (IoD), thought there was a very significant misapprehension about how large professional firms are run.[78]

OBJECTIONS TO CONDITION C

107. Our witnesses thought that Condition C would cause many partners to increase their capital contribution to the LLP to satisfy the 25% test when the partnership did not need the increased amount of capital. There was concern as to the capacity to arrange such funds on the requisite timescale. There was also concern as to how 'capital contribution' was defined in the legislation. HMRC's Technical Note and Guidance states that "it does not take into account undrawn profits unless by agreement they have been converted into capital."[79]

108. Mr Nicholson commented:

109. Amongst others, Herbert Smith Freehills clarified the point about the definition of capital contributed: "while the definition of contribution for the purposes of Condition C is technical, and complex, it is broadly restricted to capital contributed to the LLP, so does not include retained or undistributed profits which many times fulfil the same purpose as capital, nor is it clear that loan accounts would constitute capital for these purposes."[81]

BUSINESS IMPLICATIONS OF THE THREE CONDITIONS

110. Many of our witnesses commented on the business implications of applying Conditions A to C, making a number of different points. Most partnership agreements would have to be reviewed by 6 April and perhaps amended. Many were concerned about damaging UK competitiveness. The read across to foreign LLPs carrying on a business in the UK was a source of puzzlement. And there was concern about the potential absence of employment rights if LLP members were reclassified as employees for tax purposes.

111. The need to review partnership agreements and the attendant difficulties came from many witnesses. Professor Freedman commented

Mr Gammie agreed[83] as did Baker Tilly who wrote "This is not a one-off requirement. It will need to be done in respect of each individual member of the LLP every year and every time a new member joins or leaves the LLP."[84]

112. A number of our witnesses were concerned about the effect on UK competitiveness. Mr Greenbank identified some disadvantages: "It is the employer national insurance contribution that is the most direct cost. …Your tax reserves will have to be paid out effectively month after month, so you cannot use them to fund the working capital of the business, as most partnerships do. There is then general compliance."[85] The CBI's view was that "It appears that this economic impact may not have been fully assessed in advising the Ministers, perhaps underestimating the number of firms impacted if the test 'thresholds' are set as proposed."[86] The ICAEW were concerned about the "additional compliance cost for LLPs."[87]

113. The LSEW were particularly strong in their criticism: "what started as a moderate and sensible proposal to counteract obvious tax avoidance (e.g. potato pickers being corralled into LLPs) has become a widespread attack on a business model which is of central importance to the legal profession and an increasing number of other businesses."[88] Grant Thornton contested[89] the statement in the Tax Information and Impact Note that the measure will have a negligible impact on businesses.

114. Not only would UK general partnerships be outside the scope of this legislation and therefore be treated differently from UK-registered LLPs, but so would be LLPs which were formed outside the UK and carrying on a business in the UK. This was drawn to our attention by a number of witnesses. Mr Richards said "Which makes it interesting that HMRC is perfectly happy to accept the tax consequences of those foreign LLPs, as when someone is an employee or partner, but cannot accept those consequences when it comes to our own home-grown LLPs."[90] Others saw this as an anomaly.

115. One other consequence that was brought to our attention was that those LLP members who would be treated as employees for tax purposes under this legislation would not necessarily acquire employee rights under employment law. A number of our witnesses thought it wrong that the tax consequences should be altered without looking more widely. The ICAEW saw the resulting uncertainty as important "The increasing divide between employment law and tax law leads to more uncertainty, complexity and unfairness as individuals are taxed as employees, but without equivalent employment rights."[91] Others were also concerned at this difference. We explore this aspect in Chapter 6 where we examine evidence from our witnesses on the desirability of looking at tax changes in a wider, more holistic context. We note that these partnership measures are one example of this not happening.

OFFICIALS' RESPONSE

116. We put all these points on scope and business implications of the proposed legislation to HMT and HMRC. Ms Knott argued that the three conditions achieved the same outcome as case law tests:

"We have chosen these three tests because in essence we think that, with the three elements, they capture what it means to be in partnership. We think they are quite clear tests, so people should be clear about their application. Together, they should produce an appropriate outcome. Only if somebody fails … all three tests, will they be regarded as an employee. We think that collectively it is quite a good test. …

117. Commenting specifically on the three Conditions, Ms Knott made the following points on Conditions A and B:

"Coming back to your first point on the partnership share, the specific point about it relating to part of the business was raised during the consultation. This is draft legislation, so we are still in the process of tightening the test…

118. Responding to a question that additional capital might have to be contributed that might not be needed and that the test does not take into account undrawn profits, Ms Knott said:"Again, there will be different circumstances for different partnerships, but with the three tests we think that broadly it should be possible to apply it in all circumstances."[94]

119. Asked whether she agreed with the widespread view that LLPs would go from being in an advantageous position compared with general partnerships to being disadvantaged, Ms Knott responded "Again, we do not think that that is the case, because we do not think that the test is any tighter than the case-law test."[95]

120. Ms Knott was asked about claims that many partnership agreements would need to be reviewed. She said "We were certainly aware that certain reviews would take place. We would be surprised if all LLPs had to review their arrangements in that way, but we are certainly aware of some of that. It is quite common when tax laws are changed for people to review their structures in that sense."[96] Asked about concerns that the measures would have the effect of reducing working capital and "could sound the death knell for investment management partnerships",[97] she responded "Those statements are certainly quite concerning, but we have consulted widely on this measure and do not believe that the impacts will be as serious as suggested by those statements."[98]

121. Ms Knott was asked about the position of foreign LLPs and responded:

122. Nearly all the evidence that we received supported the view that the proposed legislative tests to determine who is a partner for tax purposes do not achieve their policy objective. If the Government continues with the approach in the draft legislation, it is vital that they address all the points made and amend those tests so that they place members of LLPs in the same position as partners in a general partnership.

123. The Government should also consider the position of non-UK LLPs carrying on a business in the UK with a view to aligning their treatment with that of UK LLPs.

The Three Conditions: Other Points

124. In addition to the issues concerning the scope and business implications of the three conditions, various other important points were put to us which could be dealt with in revising the draft legislation

125. The first concerns the detailed wording of the provisions which some considered to be so subjective as to lead to significant uncertainty. The PBSC were concerned about the words 'reasonable to expect'.[100] Grant Thornton focused on 'significant influence' and 'wholly, or substantially wholly'.[101] KPMG were similarly concerned.[102]

126. Others were concerned at the length of the guidance and the function it was performing. KPMG wrote: "The guidance supporting the draft legislation is 56 pages long … we do not believe that the guidance as currently drafted performs its correct purpose. This should be to clarify the legislation rather than to extend it … Despite its length the guidance itself does not clarify certain key points."[103]

127. Another cause of complaint from a number of witnesses was that the three Conditions were based on the fiscal year, rather than the period over which the partnership draws up its accounts. Mr Dodwell explained this: "There is a huge practical problem that the Revenue has given everyone here, which is that instead of applying the test from the beginning of the partnership's accounting period, or the end, they are applying it from a tax year."[104]

128. Asked about these points, Ms Knott recognised

105

129. We expect that many points on the detailed drafting of the legislative tests will have been made to HMRC. It is essential that the drafting of the legislation is tightened so that, as far as possible, any subjectivity and resulting uncertainty is minimised. We recommend that this be done in close consultation with all interested parties so that, where possible, consensus is reached.

130. We recommend that the guidance should then be redrafted so that it performs its proper function of clarifying rather than extending the primary legislation.

131. We recommend that the Government consider with interested parties the case for changing the basis of the tests decided on so that they operate by reference to the accounting period of the partnership rather than over a fiscal year. This would avoid some administrative difficulties that would otherwise arise.

Salaried Members' Provisions: Commencement

132. Finally in this chapter we focus on the evidence we have received on the start date for these provisions. The Government's proposal is that they should operate from 6 April 2014. However, we have received much evidence that because the provisions announced on 10 December were so different from those that had been consulted on previously, it is unfair and impractical for that April timetable to be maintained.

133. The CLLS's first recommendation was "that the implementation of the proposals should be delayed until 2015."[106] They make a number of points in favour of this recommendation which others echo in their evidence: the proposals are detailed and still relatively undeveloped; they will not be finalised until Royal Assent; business needs time to consider properly how the provisions will apply to them; and, as we shall discuss further in chapter 6, the way the consultation has been handled.

134. Others would settle for a shorter delay. The ICAEW wrote "[6 April] is too short a period to make any necessary changes given that at that date many LLPs will be part way through an accounting period. … We believe any change should apply from the start of the first accounting period after 6 April 2014."[107] Deloitte took a similar view.[108]

135. We asked HMRC about the consequences of delay of a year in the introduction of the salaried members' provisions. Ms Knott focused on the Exchequer implications "it would cost the Exchequer a considerable amount of money because the measure raises a considerable amount."[109] When challenged that there had been significant changes in December, she said "we think the tests should be clear to operate, so people ought to be able to apply this from 6 April."[110] Challenged again that an April deadline does not give businesses very much time to get themselves organised, Ms Knott said

111

136. Given the change of approach to the provisions that took place in December, we conclude that there is too little time to settle all the outstanding issues, get the legislation right and enable businesses to adapt to that legislation in time for a 6 April start.

Exchequer Consequences of Delay

137. Ms Knott was asked whether she could make an estimate of the yield from the salaried members' provisions. She replied

112

138. There is no doubt that, as Ms Knott contended, any delay would have an effect on the profile of the yield from these measures. The yield figures for these measures is estimated by HMRC to be as set out in the following table.[113]

TABLE 1

Partnership Taxation Package: Estimated Yield

£m	2014/15	2015/16	2016/17	2017/18	2018/19
Budget	125	365	300	285	270
Autumn Statement Addition	nil	680	430	410	400
Total	125	1045	730	695	670

As Ms Knott confirmed, none of the additional yield in the second line of the table is attributable to the salaried members' provisions so it would be unaffected by any delay in their introduction. The original (Budget) yield in the first line comes from a combination of these salaried members' provisions, the mixed members provisions as they apply to partnerships (which was known about at the time of the Budget) and the anti-avoidance provision preventing the transfers of assets and income streams through partnerships.

139. HMRC seems unable or unwilling to disaggregate the respective contributions of the three measures to the Budget estimates, but the yield from the salaried members' provisions must be a proportion of the figures in the first line of the table. That suggests that deferring the introduction of the salaried members provisions by a year would mean deferring the proportion of the first-year yield of £125m attributable to this measure to 2015/16, with commensurate consequences for the rest of the Budget row. Even if all the yield estimated at the Budget were a result of the salaried members' measure, that would mean a loss, over the scorecard years, of £270m (the 2018/19 figure), or 8 per cent of the total yield of £3,265 billion from the whole package. But, of course, since the measure accounts for only some of the Budget yield, the loss would be smaller than 8 per cent. Precisely how much smaller we can know only when HMRC chooses to tell us; we have asked for these details and not received satisfactory answers. In any case, whatever the amount is when estimated more precisely, the Exchequer effects of a delay would have to be balanced by the benefits of achieving better targeting of the legislation and giving businesses time to adapt to the provisions.

140. As discussed earlier, some commentators argued for the provisions to commence from the beginning of the first accounting period of the partnership after 6 April. For some, those with a 30 April accounting date, this would not be a very significant delay, though such a change would bring the administrative benefits that we referred to earlier. The Exchequer yield would clearly be affected by less than for a delay of a whole year. This more limited delay would provide businesses with more time to adapt, particularly those with an accounting date later in the fiscal year. However, crucially in our view, it would not give any more time to get the legislation right. The legislation would still have to be included in the Finance Bill 2014.

141. We recognise the importance to the Government of the tax yield from these measures. However, taking the time necessary to target these provisions more precisely would ensure that the resulting legislation was more robust and effective and that the new rules gained greater acceptability amongst taxpayers.

142. Accordingly, we recommend that the Government give urgent consideration to delaying these provisions until next year. That would give time for a reassessment of the alternative approaches to achieving the policy outcome and, if the present approach in the legislation prevailed, to target that legislation more accurately.

143. A delay would also give time to make a proper assessment of whether these provisions should apply for the accounting periods of partnerships rather than for the fiscal year in order to reduce the administrative burden on partnerships affected.

39 ICAEW, paragraph 26. Back

40 Mazars, paragraph 7. Back

41 APP, paragraph 3.4. Back

42 Q 105. Back

43 Q 105. Back

44 Q 105. Back

45 Q 109. Back

46 Q 105. Back

47 LSEW, paragraph 20. Back

48 Q 25. Back

49 Q 70. Back

50 Q 87. Back