Consultation to review partnership tax and close loopholes

We recently blogged about HMRC’s current initiatives to introduce further legislation surrounding the way partnerships and limited liability partnerships (LLPs) are taxed. This is aimed at reducing tax avoidance in a notoriously complex area; because partnerships and LLPs are flexible entities, tax planning in recent years has focused on the interaction of these with limited companies in order to reduce the burden of the 50% level of income tax.One of the most recent HMRC developments we highlighted is the introduction of new legislation governing loans made by close companies (which are small limited companies with 5 or fewer shareholders, or in which all shareholders work in the company) to partnerships or LLPs in which one of the partners is also a shareholder in the company. This has been a widely used commercial strategy which can also have tax planning benefits, but will now result in a tax charge of 25% of the amount of the loan, payable by the company making the loan, and repayable only once the loan has been repaid.

Tax on partners with ‘disguised employment’ status

In addition, HMRC issued a new consultation on 20^th May to review two more aspects of partnership tax. Firstly, what it classes as disguised employment and secondly, the allocation of profits and losses between partners. If the changes proposed in this latest consultation are legislated, they will become effective in April 2014.

1. Disguised employment

Members of a partnership or LLP are currently automatically classed as self employed. However it is often the case that certain, perhaps more junior members will receive the majority of their income from the partnership as a fixed amount, with little or no opportunity to participate in higher profits, and will not receive a lesser income if business profits fall. HMRC view this as potentially disguised employment rather than genuine participation in the business, and consider that such individuals should pay PAYE on their fixed income as salaried employees, rather than being taxed as self employed individuals. This of course has a number of benefits for HMRC – they receive the tax more quickly under PAYE, the partnership is liable to pay employers’ NICs on salaries, and there are certain expenses for which a self employed person can claim a tax deduction but an employee cannot.

The changes being proposed by the Government will remove automatic self-employed status for LLP members and introduce a number of factors to be considered in deciding whether a member should be treated as self employed or as an employee. The criteria it is proposed be applied to ascertain whether a partner is a salaried partner and not a business partner, is whether there is an ‘employment relationship’ in place. This will include for example situations where there is no real commercial risk to the partner of not receiving a regular level of remuneration. In this sense the changes being proposed are in part consistent with IR35 and will bring the taxation of partnerships in line with limited companies, which face an equivalent level of scrutiny from HMRC.

2. Allocation of profits

This concerns the allocation of profits when a member leaves a partnership and has arisen as a result of a number of disputes brought before the tax tribunal. Partnership profits are generally shared amongst partners in accordance with a Partnership Agreement. In the absence of such an agreement between the partners, either written or unwritten, HMRC will assume an equal share of profits between all partners. When a member leaves a partnership it can of course become more difficult to reach an agreement, hence the involvement of the tax tribunal in a number of cases. As a result, HMRC have revised their guidance to enable a partner to make a formal appeal if he or she does not agree the share of partnership profits which has been allocated to them. This will avoid incidences where individuals have to pay tax on more than their share of profits because an automatic apportionment has been made. To make a formal declaration of profit actually received, a partner can complete the relevant section on their personal self-assessment.

Restrictions for partners sheltering profits in companies

In addition to the above two areas, HMRC is looking to address the practice of creating a hybrid structure in which a company is introduced as a partner to either a partnership or LLP. Because of the flexibility available to partnerships and LLPs in allocating profits, this practice can result in profits which would be liable to tax in the hands of the partners being sheltered within a limited company partner at the more beneficial rate of corporation tax. HMRC is seeing ‘increased use’ of these structures and is concerned at the loss of tax. Where this occurs for tax avoidance purposes, the consultation document proposes that the profits which have been allocated to a company partner should instead be allocated amongst the members who are chargeable to income tax. HMRC has asked for comments on the proposals and the final legislation will become available in due course.

It is clear that the taxation rules which apply to partnerships are becoming more complex as a result of the use which has increasingly been made of flexible partnership structures to reduce the rates of income tax payable, and that this has become an issue since the introduction of the 50% rate of income tax. It is also clear that we can expect many changes to the tax legislation surrounding partnerships and LLPs in the coming months. We will report on the changes as they occur but if you are concerned about the potential impact of this consultation on your own tax liability, please contact Lesley Stalker at las@rjp.co.uk.