In December 2013 and following the Autumn Statement, HM Treasury and HMRC published draft legislation and guidance in relation to, among others, the tax treatment of individual members of limited liability partnerships (LLPs).
As previously reported (see our July update) HMRC launched its initial consultation in May 2013 on proposals in respect of certain tax treatments of LLPs. The proposals consulted upon were chiefly focused on:
- 'disguised employment', where LLP members are in reality employees (the subject-matter of this article); and
- profit and loss allocation in mixed membership partnerships (not just LLPs) (generally individuals and corporate members).
Findings published following the initial consultation period made clear that, while the Government may have revised its stance somewhat in light of the responses received, there is clear intent to introduce changes in the law with effect from April 2014, and draft legislation has now been published for further consultation, accompanied by extensive guidance notes1.
The provisions discussed below apply only to LLPs, and not to common law partnerships.
Disguised employment
The original consultation document included a proposal to use the traditional tax test for employment status when determining whether an individual is in reality an employee or self-employed. This has now been abandoned in favour of a more stringent version of the second proposed condition concerning financial risk.
The draft legislation sets out three conditions and states that, where all three are met, an individual will be treated as being an employee (a 'Salaried Member') of the LLP rather than a self-employed member.
The three conditions
- Condition A. An individual (M) performs services for the LLP in her capacity as a member, and it is reasonable to expect that payment for those services will be wholly, or substantially wholly, disguised salary.
'Disguised salary' is income which is either fixed or, if variable, determined by reference to factors other than the profit or loss of the whole LLP (so, for example, it might be varied depending on personal or team performance). HMRC consider that 'wholly or substantially wholly' will mean more than 80% of the amount payable to M.
- Condition B. M does not exercise 'significant influence' over the affairs of the LLP. It will be very difficult in practice for this condition not to be satisfied.
- Condition C. M's capital contribution to the LLP (not including amounts that are in some way temporary or can be withdrawn, or loans made (and repayable) by the LLP on behalf of the member) is less than 25% of the disguised salary expected to be payable to M for the tax year.
There are provisions for pro-rata calculation of both the contribution and the annual disguised salary in the event that M becomes or ceases to be a member part-way through a tax year.
Consequences
Where all three conditions are met, M will be considered an employee for tax purposes (and, conversely, failure to satisfy just one condition will mean that M will be considered to be self-employed). Clearly this could amount to considerable costs to the employer LLP. Certain benefits may become taxable, and PAYE for salaried employees will be collected monthly which may have cash-flow implications. In addition, applying PAYE to an income that is not fully determined until profit can be declared may cause some difficulty. It should be noted that members of an LLP are jointly and severally liable for PAYE and NICs.
Timing
One further area of practical difficulty is likely to be the timing of applying and reapplying the conditions to determine M's status: The tests in relation to all three conditions need to be applied on 6 April 2014 (with respect to individuals who are members at that time) or the date the member joins (if later), and thereafter whenever there is a change of circumstances (for instance, in relation to Condition C, an increase or decrease in the member's capital contribution) that may affect the result. In addition, Condition C is to be applied at the start of each tax year. Relatively minor changes to salary or other conditions could mean that members move back and forth from partner to salaried member status even where there is no deliberate attempt to avoid losing preferential tax treatment, and the additional administrative burden of this will be obvious, particularly for larger firms.
Anti-avoidance
The draft legislation also contains anti-avoidance provisions. Arrangements whose main purpose (or one of their main purposes) is ensuring that an individual is not deemed by the legislation to be an employee for tax purposes will be disregarded, with obvious consequences. The use of intermediaries is also covered, such that if M works for an LLP but via another (typically corporate) member, M will nevertheless be treated as a Salaried Member of the LLP for tax purposes and any sums received by M will be treated accordingly.
Further, HMRC guidance makes clear that, when considering whether all of the conditions are met, the reality of the situation will be important and not just any rights and duties set out in LLP or other agreements (such as variable elements of income which appear to be linked to LLP performance but are in fact dependent on unachievable levels of profit, with no reasonable expectation that they will ever be paid).
Firms are well advised to review their current arrangements in light of the upcoming changes and consider how they will impact on their members and what steps might be taken now.
Footnote
1 The draft legislation for inclusion in the Finance Bill 2014 and guidance notes are available at https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/264620/4._Partnerships.pdf.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
