HMRC has published draft legislation which sets out the tests that will be applied to determine whether a member of an LLP will, from 6 April 2014, be treated as an employee for tax purposes.
The criteria are such that we anticipate that many LLPs with fixed share members will need to change their arrangements for remunerating those members prior to 6 April 2014. Some will also need to change how senior equity members are rewarded.
The consequences of members being taxed as employees are
- employer’s national insurance contributions will be payable by the LLP at 13.8% of remuneration, significantly increasing the cost of remunerating such individuals
- other employee tax issues will arise such as PAYE and income tax on benefits in kind
- international firms will need to consider particularly carefully the UK tax status of members as there may be a difference between the UK and overseas tax treatment and, consequently, scope for double taxation.
If all of the following conditions are met, a member will be taxed as an employee:
- at least 80% of the individual’s reward is a “disguised salary”, i.e. a sum that is fixed or, if variable, is varied without reference to overall profits of the LLP or not, in practice, significantly affected by overall profits;
- the member does not have significant influence over the affairs of the LLP; and
- the member’s contribution to the LLP is less than 25% of the disguised salary.
Examples of “disguised salary” for Condition A include: fixed amounts, amounts paid by reference to personal performance or performance of the individual’s portfolio or practice or performance of an office or business unit (rather than the success of the firm as a whole), guaranteed profits and drawings. LLPs which engage senior equity members with promises of guaranteed remuneration in their initial years of membership may fall within Condition A. Care is also needed when members receive a fixed profit entitlement in their final year.
Condition B seems likely to be met for many members in large firms, where management is often delegated to a small group.Even in smaller firms, some members will not qualify as having “significant influence” over decision making.
Thus, for firms or individuals unwilling to restructure their remuneration or management to deal with the changes, the only way to be sure to avoid classification as an employee for tax purposes will be a substantial increase in typical capital contributions from members, particularly fixed share members. Amounts payable in the future,undrawn profits (unless converted into capital), tax reserves and loans repayable before the member leaves do not qualify as capital contributions.
Any arrangements with a main purpose of circumventing the new rules, where they give rise to no economic risk to the member, will be disregarded.Capital funded by “soft” or limited recourse loans therefore will not count.
HMRC does not consider that taxing a member as an employee will cause that member to be treated as an employee for employment rights purposes. However, it remains to be seen whether employment tribunals will increasingly view tax treatment of a member alleging unfair dismissal as a factor in their determinations.
All LLPs should now review their remuneration arrangements. Any necessary changes will need to be in place by 6 April 2014. Time should be allowed for full discussion with members of the implications of any proposed changes and adoption of any necessary amendments to members’ agreements.