Partnerships with mixed membership
Following the consultation process on partnerships which took place in the summer of 2013, draft legislation has been published in the Finance Bill 2014 covering a number of important changes affecting partnerships and LLPs.
Included within these changes are provisions aimed at countering tax-motivated allocations of business profits or losses. These apply to both partnerships and LLPs, where the partners/members include both individuals and companies (partnerships with mixed membership).
For the purposes of this article the reference to “partner” also include a “member” of an LLP, reference to “partnership” also includes “LLP” and vice versa in both instances.
Under current partnership law, it is not necessary for profit sharing ratios to be in proportion to contributions, effort or capital introduced. It is also not necessary for profits or losses to be shared in the same proportion and sharing ratios can alter from year to year. High – earning individuals in a partnership pay income tax at 45% plus national insurance whereas a corporate member would only pay tax at 20% on profits where the small companies rate applies. It is often the case that the individual members are also shareholders of the corporate member and HMRC’s perception is that this flexibility in profit sharing arrangements enables partnerships to take advantage of the differential in tax rates by arranging for profits to be paid to the corporate member which can be enjoyed by the individuals at a later date.
In essence what these new anti-avoidance rules seek to counter is the perceived artificial allocation of profits to a non-individual member subject to tax at a lower rate.
The non-individual partner in most instances will be a company and this is assumed for the purposes of the remainder of this article.
Despite calls to delay the implementation of the partnership changes it is unlikely that the mixed partnership rules will be postponed. The changes take effect from 6 April 2014, with accounting periods straddling this date split. Full guidance has yet to be published but the indications are that anti-forestalling provisions in relation to profit allocation will apply from 5 December 2013. It is vital therefore that anyone affected by these rules considers these rules and takes the appropriate action now.
When and how do the rules apply
The provisions will be included within new sections in ITTOIA 2005 as S850C, D and E. The main provision s850C applies where a profit share is allocated to a corporate partner and either condition X or Y is met.
Condition X – applies where an individual partner‘s deferred profit (remuneration and benefits e.g. profits deferred upon meeting performance criteria) has been included as profits of the corporate member and as a consequence the individual member pays less tax;
Condition Y – applies if
- The corporate member’s profit share exceeds an “appropriate notional profit”;
- The individual member has the power to enjoy the profits of the corporate member;
- Both the individual member’s share and the relevant tax are lower than they would have been in the absence of the individual member’s “power to enjoy”.
“Appropriate notional profit” is the sum of the appropriate notional return on capital and the arm’s length remuneration for services performed. The appropriate return on capital is simply a commercial rate of interest on the capital contributed. This is not a specific rate and HMRC acknowledge that the commercial rate will reflect the level of risk involved. In their initial guidance, HMRC highlight an example using a rate of 2%, but this is not set in stone. In terms of services, these should be calculated at arm’s length and HMRC’s view is that in almost all cases the notional consideration should be no more that the cost to the company providing the services plus a modest mark up.
There will therefore be a need to review capital contributions made by corporate partners and the services they provide to the partnership to gauge whether the profit share exceeds the appropriate notional profit.
By way of example where the corporate member has contributed say £10,000 to the partnership and provides no services to the partnership, the appropriate notional profit could be as low as £200 assuming a rate of interest of 2%.
The “power to enjoy” profits provisions have been broadly drafted and captures arrangements where
- The individual partner is connected with the company as a director/shareholder of the company (the most common scenario);
- The individual partner can control (directly or indirectly) the application of the company’s profit share;
- The individual receives/ is entitled to receive benefits provided out of the company’s profit share.
Section 850D exists to counter the situation where individual partners seek to avoid the charge under s850C by holding their interests via a company so no individual partners exist. These provisions effectively look through the company structure and seek to reallocate deferred income upon which the individual has the power to enjoy even though that individual is not directly a partner.
Thankfully, compensating adjustments, subject to conditions can be made under s850E. These apply where amounts paid to the corporate member are reallocated and taxed on the individual and these amounts are subsequently paid by the company to the individual.
Restriction for losses
The provisions will also deny relief for income and capital losses for an individual member where tax avoidance arrangements are in place to ensure that excess losses are allocated to the individual rather than the company.
Action needed now
It is vital that practitioners review their own business structure if it is likely it will fall within these rules and consider any restructuring to mitigate the adverse impact the changes will have. It is also equally important that these changes are discussed with all partnership clients to ensure that they are aware and prepared for these important changes. In some instances it may be possible to justify the existing structure based on capital introduced and services provided. However, in most instances, consideration to eliminating the corporate members and installing an alternative business structure or simply moving to full incorporation may have to be considered. The deadline for these new changes is fast approaching, so this issue should be at the top of every practitioner’s agenda.
If you require any further information or assistance in respect of these provisions or any of the other changes affecting partnerships please ring the TaxDesk on 0845 4900 509 and ask for either Martin Mann, Paul Howard or Paula Tallon.