My VIP Tax Team question of the week: Mixed Partnerships
My new client is an LLP that has 5 members made up of two individual members, A and B each owning 30% and 20% interest respectively. The third member is a company (VC Ltd) which owns the remaining 40% interest in the LLP. Individual members C and D each own 5% of the LLP’s interest each. C and D are the only directors and shareholders of VC Ltd. VC Ltd provides the LLP with various services such as marketing, accounting admin and office space, for which they do not charge a fee to the LLP. The LLP is currently making a profit, are there any tax issues for me to consider?

All references below are to ITTOIA 2005 unless stated otherwise.

This LLP is a mixed partnership as it has individual members and a non-individual member (VC Ltd) and as required by s.850 ITTOIA 2005 and s.1262 CTA 2009 profits (or losses) have to be allocated to each of the partners in accordance with the firm’s profit-sharing ratio during that period.

Prior to the enactment of specific anti-avoidance legislation brought in by Finance Act 2014, which came into force on 6 April 2014, it was easier to manipulate the allocation of profits and losses so that:

  • profits could be diverted to the company from the individual and thus be liable only to corporation tax, rather than the higher income tax rates, and;
  • in a loss situation, the company’s share of the loss could be diverted to the individual who has greater flexibility over the use of the losses and potentially saving higher rates of income tax.

As C and D are shareholders of VC Ltd you need to consider if excess profit is being allocated to VC Ltd.

The anti-avoidance legislation does not apply to mixed partnerships in which the individual and non-individual members are genuinely acting at arm’s length and not intending to secure a tax advantage. The legislation aims to treat the individual as the recipient of the entire profits but to fall foul of the legislation- s.850C, we need to see if the entry conditions are met.

The conditions are as follows and apply for a ‘relevant period of account’.

  • a partnership must make a profit as computed under s.849;
  • an individual, ‘A’, must have a profit share or no profits allocated to him for the period under s.850 or s.850A;
  • a ‘non-individual’ partner ‘B’ (e.g., a corporate body such as a company or limited liability partnership, or indeed a body of trustees) has been allocated a profit; and
  • one of two conditions, X or Y, is met (s. 850C).

As C and D are members of the LLP and controlling shareholders/directors of corporate member VC Ltd, the rules of s.850C need to be considered. HMRC’s guidance can be found at PM217000. We then need to consider Conditions X and Y separately.

Condition X applies where VC’s profit share includes or comprises amounts that represent deferred profits of all the individual members and, as a result, the profit share for the individual or individuals is reduced, as is the overall tax bill. “Deferred profits” is defined in s.850C(8) and includes “any remuneration or other benefits or returns” which would be provided to the individual members but has been deferred including remuneration, etc. HMRC have provided their views and some useful examples on the concept of deferred consideration in their manual– see PM218000.

Condition Y applies where VC’s profit share is more than appropriate notional profit defined in s.850C(3)(a) (PM220000) and C and D have the power to enjoy (s850C (18)-(21)) VC’s profits (PM224000) and it is reasonable to suppose all or part of company VC’s profit share is based on C and D’s power to enjoy the profits (PM228000) and C and D’s profit shares (5% each) are lower than they would be without the profit share to VC Ltd (PM229000).

s.850C(10) defines the appropriate notional profit as “…the sum of the appropriate notional return on capital and the appropriate notional consideration for services”. s.850C(15) then defines the appropriate notional consideration for services. Broadly, this is the arm’s-length consideration which the non-individual member (VC Ltd) would receive for any services that it provides to the firm during the relevant period, on the assumption that it is not a member in the firm, less any amounts actually received for such services (nil in this case) (s. 850C(15) and (16)). HMRC’s guidance (PM222000) suggests that this will usually only involve the cost to the non-individual in providing those services plus a modest mark-up, although HMRC evidently also accept the possibility of an arm’s-length charge for services.

Any services provided by members C and D to the LLP via VC Ltd are excluded from the calculation of the appropriate notional profit for services (s.850C (17)). It is also worth noting that the services provided via intermediaries using VC Ltd will not get the LLP out of the provision in s.850C (17) as HMRC may still challenge such arrangements “no matter how long the chain or how complex” these are- see PM223000.

It is important to note that the application of the provisions needs to be considered every year, even if the partnership arrangement appear not to have changed from one year to the next – i.e., it must be self-assessed. It is also advisable for you to request to see sight of any commercial agreements between the LLP and VC Ltd to provide the services they currently offer such as marketing, accounting admin and office space. These agreements are crucial to understand how VC Ltd has earned its profits from the LLP.

Walewski (2020) TC 07554 is the first case to examine the anti-avoidance and the FTT ruled against the taxpayer. One of the reasons the taxpayer lost was because they were unable to convince the FTT of the commercial arrangements between the corporate member and the firm. The FTT, who took a forensic approach to the facts, noted that “we were provided with little evidence of either substance or form to support the Appellantʼs arguments about what W Ltd did to earn its allocated profits”. Although this case was appealed, the Appellant lost their appeal in the Upper Tribunal [2021] UKUT 133 (TCC).

Once you have reviewed the agreements (if these exist) and you are satisfied that neither Condition X nor Y apply, then the partnership allocation of profits does not need to be adjusted to allocate a profit share to C&D. As stated above and from Walewski the test which you should apply is in determining whether VC Ltd has earned its share of attributed profits is a test of substance and not just form. HMRC can of course challenge the profit allocations and may disagree with your conclusions and so, to avoid potential penalties in addition to any further tax liability, full details of the annual review should be recorded and retained.

Finally, if it is decided that the best way forward is for members C and D to resign as members whilst VC Ltd remains a member of the LLP, then you will need to be wary of the application of the anti-avoidance provision in s.850D. This is aimed at catching arrangements entered into, post 5 December 2013, to circumvent s.850C. There are five gateway provisions for s.850D to apply but the critical requirement of s. 850D is in subsection (1)(d) which broadly states that it is reasonable to suppose that the individual (s) members would have been partners directly had it not been for the provisions in s.850C. HMRC’s commentary on s.850D can be found at PM234000.

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Tax Adviser
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Prior to joining the team, Ibrahim worked in boutique wealth and tax advisory firms where he dealt with owner-managed businesses and high net worth individuals. He also spent over three years managing the operations of a leading fiduciary firm in Cyprus, specialising in offshore trusts. Ibrahim is a member of the Association of Tax Technicians and is a qualified Chartered Tax Adviser.

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