By Steven Whittaker and Nicholas Fagge, Schulte Roth & Zabel LLP
In May 2013, HM Revenue and Customs (“HMRC”) consulted on proposals in two areas to tackle perceived tax avoidance via partnerships. The first area was disguised employment in Limited Liability Partnerships (“LLPs”) and the second was the tax-motivated allocation of business profits and losses in partnerships (including LLPs), especially profit allocations to the corporate member of an LLP. The consultation has ended and HMRC issued final legislative proposals and a detailed draft Technical Note and Guidance (“Guidance”) in December 2013. The final form of the Legislation and Guidance is expected to be published in March 2014.
The new legislation will be effective from 6 April 2014 and, in substance, will: (1) tax individual LLP members who are treated as salaried members under the tests in the new legislation (“Salaried Members”) as employees; and (2) remove in most cases the tax advantages gained through profit allocations to corporate partners (“Corporate Members”), loss allocation to individual partners, and transfers of assets or income streams through partnerships. The Salaried Member rules [and allocations of profits to Corporate Members] are explored in this Memorandum.
Timing and Content of LLP Agreements
Note that for individuals who are members as of 6 April 2014, the Salaried Member tests need to be applied at that point. For individuals who become members after 6 April 2014, those tests need to be applied at the date on which they become members. There are a number of areas where the content of the LLP Agreement will have a direct impact on how the new legislation applies. Some LLPs will wish to make changes to their LLP Agreements before 6 April 2014 as a result.
The Salaried Member Test
The Salaried Member test will deem certain individual members to be employees for tax and national insurance purposes, resulting in the requirement for tax and national insurance contributions to be deducted from compensation under PAYE and liability to employer’s national insurance contributions (13.8 percent) for the LLP as the deemed employer and to tax for the individual on any benefits provided by the LLP under the employment “benefits-in-kind” rules.
In order for an individual member to be taxed as an employee, all three of the following conditions must be satisfied (or, put another way, failure of any of these conditions is sufficient for an individual not to be treated as a Salaried Member):
Condition A requires that, at the relevant time the individual is to perform services for the LLP, it is reasonable to expect that the amounts payable to him by the LLP will be wholly, or substantially wholly (HMRC interprets this to mean 80 percent or more), disguised salary. An amount is disguised salary if it:
• Is variable, but is varied without reference to the overall amount of the profits or losses of the LLP; or
• Is not, in practice, affected by the overall amount of those profits or losses.
Condition B requires that the terms of the LLP Agreement do not give the individual “significant influence over the affairs of the LLP”.
Condition C is that, at the relevant time, the individual’s capital contribution to the LLP is less than 25 percent of the total amount of disguised salary it is reasonable to expect will be paid in the relevant year.
The Salaried Member test is not concerned with experience or professional qualifications. It looks at the role that the individual plays in the business and the affairs of the LLP. The Guidance acknowledges that provisions in an LLP Agreement whereby each member is entitled to an equivalent to statutory sick pay, maternity/paternity leave, holiday entitlement and termination rights are not taken into account in the Salaried Member test. Even though they may make the partner look like an employee, they can remain and are ignored.
The Guidance also gives a useful general example of an LLP in which each member receives a profit share, which varies from member to member, but everyone knows that if the business makes less profit they will have less income and if it makes a loss they get nothing. In this example, the Guidance acknowledges that all the members, from a secretary to a founder, know that their income from year to year depends on the level of profit. If the firm makes a loss, then they have no income for the year. This would mean that Condition A is not satisfied and no member of the LLP is a Salaried Member and no further action is needed.
However, see the commentary below on Condition A and the scope of what constitutes disguised salary, especially a bonus based on a member’s personal performance, guaranteed profit and non-refundable (advance) drawings.
This is the most significant of the three conditions that determine whether an individual is a Salaried Member. It is intended to identify those members who, at first sight, are working for the LLP on terms that are like those of employees; that is, they are paid for their services without reference to the overall profitably of the firm. Condition A considers the manner in which the individual is rewarded for his or her performance of services to the LLP.
In order to avoid triggering Condition A, it must be reasonable to expect that more than 20 percent of the individual’s remuneration will be through a share of the profits of the overall business (i.e., not be caught by the broad definition of what constitutes “disguised salary”). The Guidance provides some further colour on this and provides that “disguised salary” includes:
• Payment on a piece work basis — by the number of units produced or jobs done;
• A bonus based on a member’s personal performance rather than the success of the overall business;
• Guaranteed profit; and
• Non-refundable drawings.
The last three of these examples are likely to be the most relevant to hedge fund manager LLPs.
It is important to note that Condition A is framed in terms of the amounts that it is “reasonable to expect” the LLP to pay to the member. This is a question that should be answered by reference to the substance of the matter taking a realistic view of the facts. Those rewards that are unrealistic and are unlikely to be triggered will be ignored.
This is designed to ensure that those individuals who have, as the Guidance puts it, a “significant say in the running of the business as a whole” rather than individual components of the business (effectively, who operate like the partners of the overall business) are permitted to enjoy the tax benefits of being an LLP member. Junior members of an LLP who do not participate in a day-to-day management committee or group are at risk of meeting this condition. Condition B is likely to be particularly important for members of smaller LLPs, particularly new or recently established hedge fund managers with a small number of members.
A junior member would not have “significant influence” and would meet Condition B (and be a potential Salaried Member) if he or she only has the right to vote on certain reserved matters along with all other members (e.g., to approve the accounts, on material changes to the business, appointing or removing the auditors etc.).
This is based on the assumption that a partner in a traditional partnership risks losing money if the business fails. To reflect this, an individual will not be a Salaried Member if he has invested money in the LLP that is at least 25% of his disguised salary (i.e., his expected income from the LLP, which is fixed or variable income for the relevant tax year as described under Condition A).
Historically, many individual members of hedge fund manager LLPs will have made very small capital contributions (often between £5,000-£10,000) and, for some of those members, that is unlikely to amount to at least 25 percent of such expected income and they will potentially be Salaried Members (unless they fail to satisfy one of the other two conditions).
The capital contribution for this purpose is the amount that the individual has invested as capital in accordance with the LLP Agreement. The Guidance recognises that certain types of long-term loans by a member to the LLP (if the terms are comparable to capital, e.g., only repayable on resignation or winding up) may also qualify as a capital contribution.
A capital contribution does not however include: (1) sums that the individual may be called upon to pay at some future date; (2) undrawn profits unless by agreement they have been converted into capital; or (3) sums that are held by the LLP for the member (e.g., sums held in a taxation account).
The legislation contains an anti-avoidance provision which applies to ignore any changes made to the terms on which an individual is a member of an LLP where the “main purpose” or “one of the main purposes” of those changes is to ensure that he is not a Salaried Member.
In contrast, the Guidance acknowledges that “it is not avoidance if the terms under which an individual is a member change and they become a member on genuine terms comparable to a partner in a traditional partnership”.
If any changes are to be made to the terms of an existing LLP Agreement in light of the new legislation, they must be implemented with caution and an eye to this test.
Specific Comments on Examples in the Guidance
Please refer to the Examples in the Annex to this note (which have been extracted from the Guidance) when considering the commentary below:
The statement that a discretionary bonus paid out of a share of the firm’s profit is not caught as disguised salary is helpful (albeit partly stating the obvious), but note the forward-looking aspect of what it is reasonable to expect will happen subsequently when assessing whether more than 20 percent of total rewards is likely to be out of profit share.The test depends on what it is reasonable to expect at the time the LLP Agreement is entered into by the relevant individual. The test is not revisited with the benefit of hindsight based on actual numbers. In making an assessment, HMRC will look not only at the terms of the LLP Agreement itself, but also any separate Deed of Adherence or Admission and the minutes of any relevant committee or body which exercises the discretion.
This theme could be applied to a marketing person within a hedge fund manager who is remunerated at least partly based on the level of assets raised in a particular year. Whilst payment by reference to assets under management/fee revenues procured during the relevant year is variable, it is “varied without reference to the overall amount of the profits or losses of the LLP” and would be disguised salary.
By analogy, a bonus paid by reference to the success of a portfolio manager’s or analyst’s particular fund (where there are at least two funds and/or managed accounts), or the success of part of the assets within a fund (even where it is the only fund/account managed by the business), would be likely to meet Condition A (i.e., not be regarded as a share of the profits of the business as a whole and would be regarded as disguised salary).
In the hedge fund manager context, it has been relatively common for an LLP Agreement to provide that the advance drawings of junior members are not repayable in the event that a subsequent loss arises or the LLP does not generate sufficient profits to “match” these drawings. Non-repayable drawings will be regarded as disguised salary. In this scenario, consideration should be given to changing the terms of the LLP Agreement if this would otherwise cause the individual to fail the more than 20% of total rewards out of true profit share test.
The examples suggest that if there is a management committee (or equivalent) which effectively runs the LLP on a day-to-day basis, then if a member or members are not on that committee, he or they will not have significant influence (and will potentially be Salaried Members). This will be the case even if, as is very common in hedge fund manager LLP Agreements, they have a right to vote with all members on certain reserved/exceptional matters where the management committee does not decide.
Hedge fund managers should consider, and, where appropriate, pursue the following action points prior to 6 April 2014:
© 2014 Schulte Roth & Zabel LLP
This is an extract from a longer memorandum which has a section titled “TAX MOTIVATED ALLOCATIONS IN MIXED MEMBERSHIP PARTNERSHIPS”. See the whole memo at http://www.srz.com/Do_You_Need_to_Make_Changes_to_Your_UK_LLP_Agreement/
For further information please see the SRZ website at http://www.srz.com or contact the authors.