FBA0012/13-14

HMRC—Written evidence

OTS PARTNERSHIP REVIEW

Taxation of partnerships

1.          Partnerships are transparent for most tax purposes.  Partners are liable to tax on their share of the profits of the business on essentially the same basis as they would be taxed on profits of a business carried on alone.
    
2.          This means that businesses have a choice between using a structure where tax liability rests with the business entity (e.g. a company), or a tax transparent partnership or Limited Liability Partnership (LLP).  When the Limited Liability Partnership structure was introduced, tax transparent treatment was provided in response to business views. 
    
3.          Partners are taxed on the full amount of the partnership profits, just as sole traders or companies are taxed on the full amount of business profits. 
    
4.          Partnerships make their own decisions on how much of their profits they wish to retain or distribute (subject to any relevant company law provisions applicable to LLPs), just as sole traders decide how much drawing to take from their business and companies decide distributions to shareholders.
    
5.          Where an individual partner incurs an allowable business expense, this is taken into account for tax purposes in calculating the taxable profits of the partnership business. 
    
6.          HMRC believes that the current basis of taxation of partnerships is fair.  It follows from the principle of tax transparency and the general approach to taxation of business profits.
    

Partnerships and partners as customers

7.          To meet our objectives, HMRC has developed a ‘Customer-Centric Business Strategy’.  This means developing a deep understanding of our customers, so we can deliver services which are based on their needs and positively influence their behaviours.

8.          HMRC treats partnerships in the same way as all our other customers – we are committed to helping partnerships and partners get their tax right and treating them fairly.
    
9.          HMRC Customer Survey results indicate that over 80% of those carrying on business in partnership reported being well treated by HMRC staff in their dealings with HMRC, the same high score as for sole traders.

Organisation

10.      HMRC has a Business Customer and Strategy Directorate, led by a Senior Civil Servant, which works with other parts of HMRC and external stakeholders to build our customer understanding and improve the customer experience for all our business customers, including partnerships.

11.      For the largest partnerships, HMRC invests in a resource-intensive, relationship-managed service, because the money and complexity involved make this the most cost-effective way of getting the right tax agreed early with these customers.

12.      HMRC also has a dedicated, specialist Partnership unit in our Local Compliance area of the business, with the capability to deal with complex issues and provide advice and support to operational and compliance colleagues on issues in connection with our partnership customers’ tax affairs.

Tax administration

13.      HMRC is committed to reducing administrative burdens on our business and other customers, and improving our service to them.  HMRC intends to build on the Autumn Statement 2012 investment in digital services, expanding these services so that it is easier and cheaper for customers to deal with HMRC as well as reducing costs for HMRC. 
     
14.      To make the tax system more efficient, transparent and less burdensome HMRC will significantly expand the online services it offers over the next three years.  An example of a current digital project is “Your tax account” – an online tax dashboard which will be available to individual partners to help them manage their tax affairs.

15.      One of the aims of investing in information technology is so that we only have to ask for information once, for use across our systems.  For partnerships, our strategy for the future is to make the fullest use of data from partnerships and collect less information from individual partners.  (Just as by collecting information from employers through the Pay as You Earn system, we have reduced the information we need from individual employees).

Compliance

16.      Most partnerships and partners want to get their tax right, and HMRC is committed to helping them to do so.  But, at the same time, HMRC is also relentless in pursuing the minority who bend or break the rules.

17.      HMRC undertakes comprehensive risk assessment (including to identify inconsistencies between partnership and individual partner returns).  Enquires and other interventions are pursued to collect the right amount of tax.

Tax simplification

18.      The Government is committed to simplifying the tax system to ensure that taxpayers can understand and comply with their obligations.  HMRC is actively supporting implementation of the Government’s priorities on tax simplification by working closely with the Office of Tax Simplification (OTS) on their reviews.  The Tax Assurance Commissioner and second Permanent Secretary, Edward Troup, sits on the OTS Board.

19.      HMRC believes that working together with the OTS, and in consultation with our customers, tax professionals and other stakeholders, it will be able to deliver simplification for customers; tackle legislative complexity; and simplify and streamline tax administration.

The OTS Interim Report on the taxation of partnerships

20.      The Government is grateful for the work the OTS is doing to further the simplification of the tax system.  The OTS have put forward a number of proposals in their interim report on the taxation of partnerships which the Government will be considering in detail.

21.      The Government will make a formal response to the report in the 2014 Budget.

TAXATION OF PARTNERSHIPS: DRAFT FINANCE BILL 2014 PROVISIONS

Origins

1.              The possibility of conducting a formal review of certain aspects of the tax rules on partnerships (including limited liability partnerships (LLPs)) was first mentioned at Autumn Statement 2012 as part of a Written Ministerial Statement (WMS) announcing the closure of a tax avoidance scheme involving partnership tax rules. The WMS stated that the Government would consider partnership taxation as part of its review of high risk areas of the tax code. 

2.              This was followed by a formal announcement at Budget 2013 indicating that the Government would consult on introducing legislation effective from April 2014 to:

• remove the presumption of self-employment for “Salaried Members” of LLPs; and 
• prevent tax-motivated allocations of business profits or losses in partnerships (including LLPs), particularly in relation to partnerships with both individual and company members (“mixed membership partnerships”).

Consultation

3.              HMRC consulted stakeholders informally between the run-up to Budget 2013 and the publication of the formal consultation document in May 2013.  The evidence gathered at this stage informed the consultation proposals and the Government’s decision to introduce legislative changes. The formal consultation ran for 12 weeks ending in early August, attracting about 110 written responses.

4.              Autumn Statement 2013 reaffirmed that the Government would take forward the proposals as modified following consideration of the consultation responses and that the changes would take effect from April 2014 as previously announced.

5.              Draft Finance Bill 2014 clauses and guidance were published in December for technical consultation, which will close on 4 February 2014.  

6.              Associated changes to the National Insurance contributions (NICs) legislation in relation to Salaried Members and alternative investment fund managers are being introduced under the NICs Bill 2013 and these will take effect from 6 April 2014. 

Costings

7.              The Budget 2013 announcement stated that significant tax revenues were at risk from these tax-motivated arrangements.  Information obtained during the consultation showed that the use of mixed membership structures was far more widespread amongst the alternative investment fund managers (typically hedge funds) who operate as a partnership than originally expected. The costings certified by the Office of Budget Responsibility and published at Autumn Statement (AS) 2013 were accordingly increased as follows (with all extra yield attributable to the investment fund manager sector):

Objectives of the review

8.              Ministers have made clear that the objective of the review has been to secure tax revenue and achieve fairer taxation, primarily by:

• reducing the difference in the tax treatment between LLPs and partnerships generally in relation to the Salaried Member strand of the review;  
• changing the long-standing structural flexibility of partnership profit and loss allocation rules to achieve tax advantages on the profit and losses allocations strand.  The main focus has been on mixed membership partnerships where profits earned by individual members are allocated to a company that they control.

9.              The first issue reflects the fact that individual members of LLPs are currently taxed as self-employed partners even if they are engaged on terms closer to those of employees.  This can produce unfairness in the tax system as an individual member of an LLP who is treated as a partner receives more favourable treatment than a member of a traditional partnership. The difference results in significant loss of tax and NICs, much of it attributable to individuals who would normally be regarded as employees in high-salaried professional areas such as the legal sector.

10.              The second issue reflects the fact that under partnership and tax law, it is not necessary for profit-sharing ratios to be in proportion to contributions, effort or capital, or to be the same from year to year. This flexibility has been used to generate tax advantages. For example, profits may be allocated to a low tax entity, such as a company, while individual partners taxable at higher income tax rates ultimately receive the benefit of those profits in low-taxed or even non-taxable form. 

Detail of the proposals

Salaried Members

11.              The draft legislation sets out 3 conditions, all of which must be met before an LLP member can be classified a Salaried Member. These conditions are that the member:

A) is to be wholly (or almost wholly) rewarded for services by a fixed amount or, if variable, by an amount that does not vary according to the profitability of the firm;

B) does not have a significant influence over the firm’s affairs; and

C) has not contributed a significant amount of capital (25% or more of the fixed payment entitlement).

12.              Where all 3 conditions are met, then from 6 April 2014, the individual member will be treated as an employee of the LLP for tax and NIC purposes. Failing to meet any one of these conditions will mean that the member continues to be treated as a partner.

Tax-motivated allocations of business profits or losses in mixed partnerships

13.              The new rules will reallocate excess profits from a non-individual partner to an individual partner where:

• the individual partner has the power to enjoy the non-individual's share or there are deferred profit arrangements in place;
• it is reasonable to suppose that the whole or part of the non-individual's share is attributable to that power or arrangements; and
• the profit-sharing arrangements result in an overall reduction in tax. 

14.              In certain circumstances, profits may be reallocated to an individual who performs services for the partnership through a non-individual partner (for example, a personal service company) if it is reasonable to suppose that the individual would have been a partner but for the new rules.

15.              The new rules will also deny individuals income tax loss relief and capital gains relief for partnership losses allocated to an individual partner as part of arrangements, the main purpose of which is to secure the allocation of some or all of the loss to the individual, instead of a non-individual, with a view to the individual obtaining relief.

16.              The mixed membership proposals will not be relevant to traditional partnerships consisting wholly of individuals (or wholly of corporates), nor where profit and loss allocations are made on a basis that properly reflects the contribution made to the partnership by the relevant members.

Tax-motivated disposals of income streams through partnerships

17.              The legislation will impose a charge to tax on income where a person disposes of all or part of an income stream by or though a partnership if the main purpose, or one of the main purposes, of the disposal, or any of the steps by which the disposal is effected, is to secure a tax advantage in relation to the charge to income tax or the charge to corporation tax on income. 

What do these changes say about the overall state of partnership taxation?

18.              The tax rules applicable to traditional partnerships (those established under the Partnership Act 1890 or the Limited Partnership Act 1907) respect the fact that in English law the partnership is a transparent entity. The tax rules likewise treat them as tax transparent. Any profits of the partnership are attributed to the partners according to their profit shares and tax is then levied at that level through the income tax self-assessment (or corporation tax self-assessment) system. Partners who are individuals rather than companies are also charged NICs.

19.              The salaried member proposals relate only to LLPs and do not have any wider significance for partnership taxation. The LLP is a body corporate and has little in common with a traditional partnership apart from its tax treatment.  In most areas, it is subject to the same rules as a company. Like a limited company, it gives members the benefits of limited liability.

20.              In the absence of specific tax rules, the LLP would be taxed as a company. However, the tax rules introduced for LLPs in 2000 for most purposes treat it like a traditional partnership.  Individual members are taxed as self employed partners and company members are liable to corporation tax according to their respective profit shares.

21.                            These tax rules go further than intended and result in all LLP members being classified as self-employed. This outcome was never intended and given rise to significant risk to the loss of employment taxes which will be prevented by the proposed rules.

22.              The proposals relating to partnerships with mixed membership reflect the fact that the flexibility of partnership profit and loss allocation rules combined with differentials between income tax and corporate tax rates currently gives rise to significant loss of tax.  This is not exclusively a partnership issue but reflects a wider issue about rate differentials.

23.              The proposals relating to transfers of income streams through partnerships respond to a particular issue involving tax legislation introduced in 2009 to deal with sales of income streams. These rules do not always work effectively where the transfer is achieved through or by a partnership (for example, by means of a change in profit-sharing ratios), and the changes now proposed will correct this.  Again, this is not primarily a partnership issue.

24.              The Government has been clear from the start of the review that the FB2014 measures are not only about avoidance, but about making structural changes to tax rules to prevent loss of tax. HMRC and the Government stated in the consultation document and during consultation meetings that the vast majority of partnerships do not engage in avoidance or in the types of tax-motivated activity that will be affected by the proposed changes. 

January 2014