HMRC published its Consultation Paper on partnerships a few weeks ago. In Part One, we looked at the proposals concerning disguised employment. In this part, we shall look at profit allocation schemes and what the Government is intending to do about them.
What is a profit allocation scheme?
Unlike the proposals concerning disguised employment, the new rules governing profit allocation schemes will cover all types of partnership, not just LLPs.
The following principles are useful in understanding how and why profit allocation schemes have come about:
- Partnerships are tax transparent. The earnings of the business bypass the partnership and are imputed directly to the partners in accordance with their profit sharing agreement;
- The way in which profits and losses are allocated between partners doesn’t have to coincide with their capital contributions – it simply depends on the agreement between the partners;
- This agreement isn’t fixed in stone. Profit sharing ratios can be adjusted from year to year, depending on circumstances.
This is very advantageous, especially when the partnership consists of a mixture of individual and corporate members all taxed at different rates:
- Members who are individuals subject to the higher 45% rate can minimise their tax burden by allocating their share of the profits to the corporate partners taxed at the lower 20-23% rate;
- Conversely, losses can be allocated to those members who are taxed at the higher rates. So individual partners receive a higher tax refund when setting these losses against their other earnings (though the general set-off is now subject to a cap);
- Alternatively, a member can sell his profit share to another member who may be able to make use of lower tax rates or other reliefs to minimise his overall liability.
The first two cases are two sides of the same coin and will be dealt with together. We shall then go on to look at the third case concerning profit transfer arrangements.
Profit allocation – adjusting profits and losses between partners
In this diagram, we see that the individual partners don’t have a profit share – all the profits are allocated to the corporate member who is taxed at a lower rate. Note that the diagram doesn’t disclose the respective capital contributions – these are not relevant. All that matters is what the profit sharing agreement says. The individual members could have contributed up to 50% of the capital, but if they agree that their respective profit shares are to go to the corporate member, then to the corporate member they will go.
However, since they are all shareholders in this company, they haven’t actually lost control of the cash. Any individual member can draw on the money any time he needs it, and this can be done in a tax efficient manner. See the examples given by HMRC in their technical note on close company participators.
Not surprisingly, HMRC doesn’t like it. There are two particular areas that have been highlighted:
- Profit deferral arrangements which are relevant to those working in the fund management and banking industry. The idea is that where part of a person’s pay package is contingent on certain conditions being achieved, profit allocation schemes can be used to minimise the impact of having to pay tax on an award that won’t be actually paid until a few years down the line;
- Working capital arrangements where part of the partnership profits are retained within the business for the purposes of reinvestment. Since these profits are not being drawn by the business owners, it is more tax efficient to reallocate them to partners with a lower taxation rate.
Both these arrangements highlight one of the disadvantages of a partnership as a business vehicle. Profits are taxed as they accrue, irrespective of whether they are paid out to the partners. The consequences are that unless all the earnings are paid out, the partners are taxed on money that never goes into their pockets.
So a fund manager working within a partnership structure still has to pay tax on his bonus even though he may never actually receive the money due to targets not being met. The same applies where business profits are reinvested – which is the case with even the most mature businesses. The partners still have to pay tax on the money even though it eventually ends up in Davy Jones’ locker.
These considerations arguably give support to the view that not all profit allocation schemes are bad. The profit deferral and working capital schemes both provide a viable solution to the problem of how to deal with funds that are not currently required by the owners of the business.
However, as stated previously, HMRC doesn’t like it.
What are the profit and loss allocation proposals?
If the following conditions apply, profits and losses are re-allocated in the appropriate manner:
- The mixed membership condition – the partnership consists of some members who are subject to income tax and some members who are not. The idea is that the latter class of members are taxed at more favourable rates, as is the case with corporate members, or perhaps they are exempt from UK tax altogether;
- The profit condition – it is reasonable to assume that the current profit allocation is motivated by the need to secure an income tax advantage. For this condition to apply, there must be an economic connection between the members involved in the profit allocation. The idea is that the partner whose profit share is being diverted, still has the means of accessing the cash;
- The loss condition – it is reasonable to assume that the current loss allocation is motivated by the fact that the partner to whom the losses are transferred intends to utilise these losses against his own tax liability. There is no need for an economic connection between the parties in this case.
Note that the profit and loss allocation has to be motivated by tax. This would be the case if the only reason for having a corporate partner is to take advantage of the lower rates, especially where this partner has contributed neither capital nor expertise to the business.
Profit transfer arrangements
This measure is targeted at a wider class of transaction than is involved in simply rearranging the profit sharing ratios.
Profit transfer arrangements involve one partner assigning an income stream or other tax asset to another partner who is able to make better use of this asset than the original owner. In return, the transferring partner receives a payment which is not taxed as it might have been under a straightforward transaction.
The difference with the profit allocation schemes is that the partnership need not be mixed. The acquiring partner need not be a corporate body benefiting from lower tax rates, or benefit from an exempt tax status, though this situation is included.
The key is that the acquiring partner has some attribute that ensures that in his hands, the tax asset is more valuable than in the hands of the original owner. For example, the acquiring partner may have losses to use against the transferred income, or the income is treated differently due to the latter’s status. For example, banks and financial institutions engage in transactions that are treated differently for tax purposes than for other taxpayers.
Whatever it is, the overall tax liability is lower as a result of the profit transfer arrangement. It is proposed to introduce new rules that will counter such arrangements. These rules will apply in the following circumstances:
- There must be a profit transfer arrangement which results in one partner receiving an (increased) share of the partnership profits;
- In return, the transferring partner must receive some sort of “payment” – whether in cash, or in kind, whether directly or indirectly – this will include cases where connected parties are involved in the transaction;
- It is reasonable to assume that the main purpose, or one of the main purposes of the arrangement is to secure a tax advantage;
- This tax advantage must come about as a consequence of the fact that the partners involved have different tax attributes.
This diagram explains the situation. This is one of the examples given in HMRC’s Consultation Paper. Note that the profit transfer and the payment are all undertaken through the partnership.
If the conditions apply, the transferring partner will be taxed on the “payment” received for giving up his income stream. This will be on the same basis as the transferred profits are taxed – so if the asset transferred consists of property rentals, the payment will be taxed as rent – if the asset involved consists of IP royalties, the payment will be taxed as a royalty.
These rules will not apply if the payment is already taxed under another part of the legislation, such as the structured finance rules (though these rules rarely apply to partnerships). In particular, these rules will not apply if the profit transfer arrangement is already caught by the mixed membership rules.
The consultation period ends on 9 August 2013, and the aim is to have the new rules in place for April 2014. This is quite a short timeframe, so it is important that interested parties to get their say in as quickly as possible.
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