The UK’s mixed membership rules came into force on 6 April 2014 as anti-avoidance measures to prevent profits and losses of a limited liability partnership (LLP) being allocated to corporate members instead of individuals in an attempt to reduce the overall tax liability. Introduced alongside the salaried member rules, they had a fundamental impact on the way LLPs operate from a tax perspective. Whilst the Government’s tax rationale was clear, the commercial implications of the rules were questionable as they inhibit LLPs from taking the prudent step of building up reserves. For a business with regulatory capital requirements this is particularly painful and the financial shock of COVID-19 is likely to be the first real test since the introduction of the legislation.
By way of background, the mixed membership legislation aimed to prevent tax advantages arising from partnership profits and losses being allocated to corporate members. Prior to 2014 planning in relation to profits was commonplace and typically involved awarding capital to individual members funded by profits taxed at corporate tax rates some years earlier. Where incorporated as part of a genuine incentivisation structure to retain partners in the long-term this planning had merit and importantly operated within the confines of tax legislation. Planning around losses was somewhat more convoluted with the proposed result often being quite detached from the reality (to keep matters focused on reality we’ll refrain from discussing loss restrictions further in this article). Understandably HMRC took action as the boundaries were pushed further and further.
The mixed membership rules operate by taxing individual partners on excess profits allocated to the corporate member where they may benefit – regardless of whether they do or not! These profits are simply re-allocated and taxed on the individuals where the power to enjoy exists. However, the legislation does not apply where both the company and individual members are acting on an arm’s length basis such that the profits allocated are commensurate with services and goods provided. A corporate member can still be expected to receive a notional return on their investment as profit allocation without the rules applying, even if an individual member meets the power to enjoy condition.
In January 2020 the rules were first tested in the courts, in Nicholas Walewski v. The Commissioners for Her Majesty’s Revenue and Customs (2020), with HMRC proving successful. The business in question is a successful asset manager focused on the European equities markets. But the fact pattern of the case is fairly unique and it is unclear whether or not this will have much wider application. The case relates to the 2014/15 tax year when the rules were first implemented. In brief, a corporate partner (through which Mr Walewski argued he provided his services as the sole director) had made capital contributions (which constituted regulatory capital) in two different partnerships in which he was also a member. The corporate partner received substantial profit allocations from the partnerships but HMRC argued that those profit allocations should be re-allocated to Mr Walewski instead as they relate to profits arising to him personally in his capacity as a partner.
It should also be noted that there was no sense that the taxpayer involved actually received any of the amounts assessed under the legislation – meaning a dry tax charge applies. This seems somewhat counter to the original intention of the legislation to prevent individual partners receiving profits at reduced tax rates, noting the same business operating as a company would not have given rise to any such charge.
The legislation does allow for an allocation for an appropriate notional return on capital, however in the case it was concluded that a reasonable return on capital invested was a mere 5%. This is a somewhat odd conclusion given the context. Regulatory capital is a fixed amount that cannot be retracted at whim and its reduction requires approval from the Financial Conduct Authority (FCA). It is essentially invested to enable the orderly winding down of the business in a crisis situation to protect investors (fund investors not the partnership’s investors) by covering all of the anticipated costs. In short, the capital is there to be eroded in such a situation. Where this happens partners often lose the vast majority of the capital invested as such a 5% return seems somewhat low.
COVID-19 will place the first big test on the industry since the introduction of the legislation in 2014. Performance across the asset management sector was generally good in 2019 meaning most managers will have had very positive financial position for 2019/20. Given that performance fees generally crystallise in December businesses are likely to have made commitments in terms of remuneration and recruitment in early 2019 ahead of the pandemic. However, the outbreak may well place significant financial burden on businesses that would naturally lean on reserves to weather the storm.
There could be scope within the current legislation to justify allocating more profits from 2019/20 to the corporate member where businesses anticipate a fall in revenue inflow. Independent parties would arguably look to renegotiate terms where their ability to cover operational expenses and retain key employees comes into question. Logically engaging with HMRC in advance may be a sensible step, however, any attempts to rely on such arguments where actions are primarily tax motivated are likely to be dismissed.
As the COVID-19 crisis took hold, the UK government provided an array of support packages to both businesses and individuals. HMRC has even postponed new legislation, such as the IR35 rules, to next year to give people more time to be better prepared for it. While this is all helpful, the uncertainty and subsequent economic impact of the pandemic will continue to affect businesses in the short to medium term.
Given the exceptional circumstances a relaxation of the mixed membership rules, or at least HMRC’s interpretation, for the 2019/20 tax year would be a welcome step. Arguably the disguised remuneration rules for the self-employed introduced in 2017 would counter attempts to abuse LLP structures, noting asset managers would also need to contend with the disguised investment management fee rules introduced in 2015. Given the context allowing LLPs to build up reserves in their corporate partner would be a welcome step all round. Helping businesses to prop themselves up by strengthening their balance sheets as opposed to utilising government backed loans or furloughing schemes certainly makes economic sense and far better positions the economy for a recovery.