From Daniel Lewin of Kaye Scholer
On May 20, 2013, HM Revenue & Customs (HMRC), the UK Revenue authority, published a consultation document that proposes significant new anti-avoidance tax measures aimed at UK partnerships, and in particular at English limited liability partnerships (LLPs). This consultation document continues to be the subject of controversial discussion between HMRC, HM Treasury, the Financial Conduct Authority (FCA) and, on behalf of the hedge fund industry, the Alternative Investment Management Association (AIMA). HMRC have since also come out with anti-avoidance measures targeted at Hedge Funds and Private Equity funds.
The significant scope and impact of these proposed changes, and what businesses should be doing in order to prepare, will be covered.
Could you sum up the changes proposed by this new UK partnership consultation document?
In a nutshell, regarding partnerships, to achieve its stated fiscal aim of collecting additional revenue, HMRC, the UK Revenue authority have proposed complex and fairly extreme measures, reversing or tweaking areas of tax law that have been in existence for a long time, in some cases over a century. Broadly, the UK Government is targeting two areas, referred to as “disguised employment” and “profit and loss allocation schemes,” both of which will significantly curtail ways in which UK partnerships and LLPs are currently operating. The changes are right around the corner, and I believe their impact will be enormous. But many LLPs are still unaware of the magnitude.
What is a consultation document? Does it have the legal effect of a law?
No. It is just the first step of something becoming a law, the beginning of a conversation on this topic if you will. Comments on the partnership consultation were invited by August 9, 2013. However, frankly, for the most part, it’s not much of a “consultation.” The feedback sought is in many instances limited to the design of the proposed anti-avoidance changes to the current tax rules. There doesn’t seem to be any real question that, whatever the ultimate design, these new measures will fundamentally be introduced. We urged the Government to defer introduction of the second measure, the “profit and loss allocation scheme,” so that meaningful consultation with HMRC can take place to avoid harming the UK disproportionately as a place in which to do business, but this has been rejected.
What does the partnership consultation address specifically?
The first aspect of the partnership consultation concerns “disguised employment.” Under current law, individual members of an LLP are by default taxed as self-employed partners, subject to a slightly more favorable income tax and National Insurance Contributions (NICs) regime. Profit allocations to partners (or members, as partners of LLPs are called) aren’t subject to employers’ NICs—currently 13.8 percent (or perhaps closer to a net 11% as the NICs are tax deductible; still a significant amount). Here, HMRC are proposing to remove the existing legislative presumption of “self-employment” status for individual members of LLPs, meaning the firm will have to pay employers’ NICs for all partners who are deemed “employees” or “salaried members.” This will increase the tax cost, and therefore the cost of operating businesses set up as LLPs.
Will this affect all individual LLP partners?
No. Under the original proposals, an individual member of an LLP (such as a hedge fund manager) will only be classified as a “salaried member” if s/he is regarded as “employed” under the employment tests set out in HMRC’s Employment Status Manual. It is likely that this test will be dropped. However, such member will still be classified as a “salaried member” if s/he is on a fixed salary, does not bear real economic risk and is not entitled to share in the profits and surplus assets of the LLP on a winding up. This is specifically targeted at non-equity partners, for example.
The proposed partnership test for English LLPs will be significantly stricter than those that exist for all other types of English partnerships. Crucially, in my view, the consultation failed to take account of the first tax test that should have been considered – whether the individual concerned is a partner under the existing partnership tests. There is also the question of the wisdom of being an “employee” for tax purposes, but not for employment law purposes. Arguably one should follow the other.
What will be the practical effect of these changes becoming law?
It is difficult to give precise numbers. However, by my admittedly non-scientific estimates, if this goes ahead as planned, I would think a very high number, including the majority of hedge funds, private equity funds, law firms, consulting firms etc. will be affected with at least some partners being treated as employees, and the businesses will have to pay these significant additional taxes. In short, an enormous number.
For example, for hedge funds , the effect will be that many partners, other than, e.g., the “Founders” or very senior managers, are likely to be treated as “salaried members” and therefore liable for income tax and primary (Class 1) NICs. Crucially, and this is the crux of the issue, the employer, i.e., the LLP, will then be liable for secondary (Class 1) NICs of currently 13.8 percent on all remuneration paid to the salaried members. In short, the cost of operating as a UK based hedge fund manager through an LLP will increase materially.
Or consider yet another possible—and likely unanticipated—outcome. Currently, non-equity or fixed rate partners might be members in a partnership that is operating at a loss. No big deal—they still get paid. But under the new system, if they are suddenly employees, their payments in a temporarily loss-making partnership will suddenly be considered an employment-related loan—and one they haven’t paid interest on. So, suddenly under UK tax law, there’s a new deemed 4% income tax charge on “zero interest loans”, and a corresponding tax obligation for the individuals and the LLP. I could go on and on about the possible frightening side effects of this proposed “medicine” to remedy unfairness in the tax system. Basically, the law of unintended consequences is huge here, especially when it comes to the second target described below.
What or who is the second target of HMRC’s partnership consultation?
This one is, in my view, of even greater concern, as the consultation proposes highly penal measures regarding profit and loss allocation scenarios that will have a significant impact on structures in which an LLP or other partnership has a corporate member in addition to individual members (which is very common).
How will this new regulation be triggered?
Most hedge funds established as LLPs are set up with a corporate member, either because the fund’s head office is in the US, for example, and controls the UK entity via a UK subsidiary, or to benefit from lower corporation tax rates for certain purposes, e.g., working capital. For UK tax purposes, a partnership (or an LLP) is transparent in most circumstances, and it is the partners (or members) who are liable for tax on their share of the partnership’s profits in the year in which the profits arise as allocated under the partnership or LLP agreement. As part of the new proposals, the government is seeking to counter scenarios whereby profit and loss allocations made by partnerships with “mixed partners,” i.e., individual and corporate members, are used to achieve a “tax advantage.”
How broadly will these anti-avoidance proposals be applied?
They are extremely far-reaching, extending even to standard working capital or deferral arrangements. In those scenarios, monies are typically initially allocated to a corporate member to benefit from the lower corporation tax rate (currently 20-23 percent). HMRC consider these corporate member arrangements to contribute towards the “unfairness and market distortion” existing within the UK tax system. For example, a corporate member used for working capital retention purposes of an LLP is deemed abusive if income is allocated to it to benefit from the lower corporation tax rate (leaving a greater amount available for reinvestment, compared to allocating income to individual members at higher income tax rates, e.g., 47 percent). However, the same benefit, i.e., the use of the lower corporation tax rate of 20-23 percent, would be available to any business operating as a limited liability company, so it is difficult to understand where the “evil” lies with LLPs. No partnership would choose to route its working capital through individual members with higher tax liabilities. Allocating working capital to the corporate member is basic, common-sense tax planning; nothing to do with “market distortion.”
How will deferred compensation be handled under the new proposed scheme?
This is still under discussion, not least because the FCA and Alternative Investment Fund Managers Directive (AIFMD) deferral requirements also come into play. HMRC acknowledge that certain investment managers are currently subject to, or in the future will be subject to, regulatory rules on deferred remuneration, e.g., the FCA’s Remuneration Code and the AIFMD. Under the present FCA provisions, depending on the size of the fund manager, up to 60 percent of variable remuneration of an individual member of an LLP must be deferred and 50 percent received as fund equity. There also has to be a risk of forfeiture, i.e., that an individual does not get the full deferred amounts. . To date, investment managers who sought to align their remuneration practices with investor requirements or the potential (and now incoming) FCA/AIFMD requirements have often used arrangements involving allocation of deferred amounts to a corporate member in some capacity, so as to avoid double taxation (should the deferred amounts be forfeited). This is sensible tax planning. The concern for HMRC is that through appropriate structuring, it was in certain circumstances possible to keep the applicable tax rate at the corporation tax level even when the money was subsequently taken out by the individual member. To give some credit to HMRC, this is an area where the tax provisions have been abused, by some accounting firms in particular.
However, HMRC have so far been unwilling to deviate much from their stance of any income subject to deferral being allocated (and taxed) upfront and at the highest income tax rates, whatever the deferral circumstances (although it is proposed that a tax credit will be available later, on allocation of the net income amounts where the deferral conditions are met). On this issue, many difficulties remain unresolved – and so far the consultation process has not provided a truly satisfactory response. It is, of course, possible that HMRC’s hands are simply tied by the Government. In any event, this area remains one of the core areas of focus in the discussions between HMRC, HMT, FCA and AIMA.
What will be the impact of these tax changes?
In a word, huge. In the UK, the LLP is the most popular form of incorporation, encompassing especially hedge funds, but also PE firms, law, accounting and many other consulting companies. I would say about 90% of UK hedge fund businesses operating as LLPs could be affected.
Was the consultation created because of abuses in the system?
My guess is it was a mixture between abuse, and the Government’s need to raise more monies. There may admittedly have been some people stretching the existing scheme beyond its original intent—for example, abuses in mixed partnerships, where in order to avoid their 47 percent taxation, individual partners had income moving through the corporate entity, and being taxed at only 20 percent. But there were other ways these abuses could have been addressed. The government could have implemented specific and targeted anti-avoidance rules but not change the treatment of every partnership in a way that will have significant and perhaps very considerable unintended consequences that will only come to light once the new rules are used. The consultation potentially damages the UK as a business location. It also makes the partnership tax laws considerably more complex.
What is the stated intention of the partnership consultation?
The stated intention of the partnership consultation is not to affect those persons entering into arrangements that are not tax-motivated, but rather to deter arrangements that seek a tax advantage. However, despite these arguably “good” intentions, the reality is that HMRC’s proposals are so far-reaching that it is difficult to imagine many LLP scenarios in which the new anti-avoidance rules would not apply. Further, the almost draconian nature of some of the present proposals arguably creates some unfairness in the UK tax system itself. And all this before you get to the perennial difficulty of defining the boundaries of “tax advantage.” Basically, HMRC and HM Treasury have chosen to use a howitzer to hunt rabbits and the consequences may be dire.
So what’s next in terms of the approval process?
As a next step, HMRC will publish a summary of responses, which are expected shortly. Subsequently, on December 4, the so-called “Autumn Statement” (a “preview” of the UK’s March 2014 tax budget) will take place where we expect to receive the draft legislation – so we can finally see exactly what we are dealing with. Thereafter, there will be about three months for people to submit further comments, but it is likely that they will only be taken round the margins. Many aspects don’t really seem to be open to much debate. The Government has made it clear that these significant changes will happen; it is just a question now of details and exact scope.
What should firms be doing now?
We have clients that are contemplating withdrawing all of their money from the partnership and corporate members in particular. However, in most cases, I wouldn’t recommend that. After all, making changes before we’ve seen the actual proposed legislation in December may be too hasty; you won’t know what kind of specific changes you need to make.
However, businesses should definitely start preparing to respond, by “dusting off” their partnership agreements, profit arrangements, LLP set-ups and documentation, and starting to meet with their advisors to see if and to what extent they are within the scope of the consultation. There is also the very important question as to which businesses will become subject to mandatory deferral rules under the AIFMD or FCA. By now, people have a fairly good view of the regulatory implications, as well as the likely partnership tax law changes (given the lack of flexibility of HMRC). This will allow us to start working on bespoke solutions — for example, subsidiaries of LLPs are currently not caught by the new tax rules, so there is an area of use one could develop. Once the draft legislation is out, businesses will have only a few months to react—that’s a very short time in which to make potentially many big changes, e.g., to their partnership agreements, and most importantly, their variable profit deferral arrangements which may be mandated by the regulatory authorities. This is, arguably, an entirely counterproductive way of legislating, but businesses simply have no choice. They can’t really start running until the gun officially sounds.
What is the second initiative, regarding private equity fund managers and transfer pricing?
Most recently, in addition to the above mentioned partnership consultation, the UK Government has also announced the introduction of anti-avoidance measures that can affect UK-based private equity (PE) fund managers. These changes would be in relation to (i) loans made by principals to UK PE manager entities at vastly excessive interest rates, and (ii) under-remunerating the UK management company.
The key in all these cases is transfer pricing that HMRC are now proposing to counter-act: the individuals got a favourable “compensating adjustment” where the UK corporate entity was denied an interest deduction, or subject to a higher income amount as a result of transfer pricing limits, and that “compensating adjustment” then offset the increased liability of the UK corporate entity as a result of the transfer pricing position in a mirroring fashion—for the benefit of the individual lenders / owners in the form of a reduced personal tax liability. This was arguably very aggressive planning.
So overall, we are talking about a broad initiative across the spectrum of the investment management industry. However, unlike the partnership consultation, the UK anti-transfer pricing challenge, is much narrower and therefore clearer in ambit (essentially, like a targeted anti-avoidance rule). So clearly this can and needs to be looked at now.
Kaye Scholer is part of the team of representative AIMA member firms which is engaged in direct discussions with HMRC, HM Treasury and the Financial Conduct Authority (the successor to the Financial Services Authority).
About the author: Daniel Lewin’s practice is broad-based and covers the full range of U.K. tax issues. He advises corporate, institutional and private clients on the U.K. and international tax aspects of a wide variety of transactions including financings, acquisitions and divestitures, joint ventures, investment structures, derivative transactions and employment matters. He has particular expertise in the taxation of investment funds and the structuring of management entities. He can be reached at firstname.lastname@example.org.