Partnerships: A review of two aspects of the tax rules 2) Profit & Loss Allocation Schemes Response by the Chartered Institute of Taxation

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1 Partnerships: A review of two aspects of the tax rules 2) Profit & Loss Allocation Schemes Response by the Chartered Institute of Taxation 1 Introduction 1.1 The Chartered Institute of Taxation (CIOT) sets out its comments on HMRC s proposals for certain arrangements involving the allocation of partnership profits and losses amongst members of mixed partnerships. 1.2 The consultation document published on 20 May 2013 aims to tackle schemes where partnerships allocate profits or losses in order to reduce tax and that the objective is that tax advantages will not arise where there are inappropriate partnership allocations to a company or similar vehicle. 1.3 We understand, however, that in meetings HMRC have indicated that the main intention is to increase the tax yield rather than tackle aggressive tax avoidance schemes. If that is the primary purpose of these proposals then that should be stated openly and not dressed up with the more acceptable label of anti-avoidance. 2 Executive summary 2.1 We think the focus of any legislative changes in this area should be on tackling abusive arrangements where tax avoidance is the main purpose. The proposals are much wider than they need to be to tackle abusive schemes. We feel the proposals are being driven by vaguely-articulated generic concerns about avoidance without regard for the adverse consequences for ordinary commercial businesses. Such a policy-driver invariably results in poorly-drafted legislation that serves principally to increase uncertainty and complexity within the tax system. 2.2 If implemented as proposed in the consultation document the new rules will put many partnerships at a distinct disadvantage to competitor companies. The broad brush approach is likely to have an impact on the ability of persons to choose the best commercial structure for operating a business in accordance with tax and general commercial considerations. The new rules should not apply to working

2 capital finance arrangements or profit deferral arrangements, where these arrangements are similar to those adopted by companies. 2.3 The proposals in respect of mixed member partnerships are vague, poorly targeted and, as they stand, uncertain. The proposed approach will only add to the complexity of the UK s tax system. Those in respect of partnerships with differing tax attributes can be addressed through amending existing legislation, as the consultation document identifies. 2.4 HMRC already have a wide range of Targeted Anti-Avoidance Rules (TAARs) and the General Anti-Abuse Rule (GAAR), which is aimed at exactly the sort of abusive tax avoidance schemes the consultation document refers to and it is intended to apply to any arrangements entered into to exploit any loophole or shortcoming in legislative provisions. We suggest that the GAAR is used to tackle the perceived abuse, rather than introduce another layer of legislation which brings with it the prospect of greater uncertainty and adversely affecting commercial arrangements. 2.5 If the Government deems that new legislation is required, the new rules need to be more appropriately targeted so that they deal with tax avoidance motivated arrangements and not genuine commercial structures. As they stand, the proposals will add to the administrative burdens faced by partnerships, including those whose structures are very unlikely to result in additional revenue for the Exchequer. 3 Allocation of partnership and LLP profits and losses 3.1 Avoidance Schemes Paragraph 1.15 explains that HMRC are seeing increasing exploitation of partnership structures, but the consultation does not go into detail on this point. While some examples of tax avoidance schemes are included in Annex C there is no indication as to why these arrangements might work. On the contrary, HMRC state that they would challenge them. This suggests to us that in most cases the avoidance schemes alluded to would not succeed on a proper application of existing legislation. Indeed HMRC have had some success in recent cases involving partnerships While we agree that abusive avoidance should be stopped, HMRC s proposals go well beyond tackling tax avoidance. We think that what is needed is for existing legislation to be clarified to put beyond doubt that those schemes, which should in any event fall foul of the new General Anti-Abuse Rule (GAAR), do not achieve their alleged advantages. 3.3 If new legislation is needed it should be tightly focused to tackle the perceived abuses and not normal commercial behaviour. 3.4 Levelling the playing field As the consultation document acknowledges at paragraph 3.2 there are a range of structures available when setting up a business, each with differing tax and commercial consequences. The potential tax advantages of using one structure 1 Eg in the case: Vaccine Research LTD v HMRC [2013] UKFTT 073 P/tech/subsfinal/OMB/2013 2

3 verses another, or a combination of structures, are merely one set of commercial issues considered when setting up a structure, and derive from the inherent differences in tax rates on corporate and non-corporate structures. If the government is intent on levelling the playing field and making tax fairer, a better option would be to address this underlying issue. Otherwise, the government should accept that businesses will utilise a range of structures to try to prevent their competitors from gaining a commercial advantage over them. 3.5 Valve Partnerships We have previously raised the subject of valve partnership arrangements where a partnership has international activities in the context of the cap on income tax reliefs. These arrangements are a simplified way of holding interests in the activities being carried on overseas, whereby profits and losses are channelled through two or more partners and then, in effect, shared with the other partners through adjustments to profit sharing ratios. Can HMRC confirm that as these types of arrangements are commercially driven, they would not be caught by the profit and loss allocation proposals? 3.6 Policy rationale We note that the proposed new rules will only apply where the partnership is a mix of individual and corporate members. Thus, it would seem that where the individuals have exchanged their interests for shares in companies that are or become the members of the partnership, such arrangements will be unaffected. It is not clear what the policy rationale is for this. 3.7 Issue 1: Partnerships with mixed membership profits We are not convinced that this is as big an issue as the consultation implies and that the consultation document fails to see it through a sensible commercial lens. The arguments set out in paragraph 3.14 of the consultation document point to taxpayers failures to plan correctly and organise their affairs in the most efficient manner, rather than to unfairness and market distortion. This can only be valid if the opportunity is restricted. The proposals ignore commercial considerations and economic reality in order to increase tax revenues rather than tackle avoidance schemes, and will put mixed member partnerships at a disadvantage over other structures. 3.8 The focus appears to be on the lower tax rate paid by a corporate member but ignores the eventual extraction cost. The combined cost of corporation tax and income tax on the extraction of profits from the company is, broadly, similar to that paid by an individual partner. The main advantage is in timing but there are often good commercial reasons for this. The proposal also ignores the fact that a lower rate of tax could be achieved anyway through the use of a corporate structure or all corporate members. The chief advantage of mixed member partnerships is the ability to stream profits to the member that earned them (something that is far more difficult in a purely corporate structure). 3.9 For new fast-growing businesses a partnership structure offers a dynamic balance to encourage investment and new workers while allowing easy extraction for those that want to withdraw from the business. This flexibility should be encouraged as it is essential for economic growth. P/tech/subsfinal/OMB/2013 3

4 3.10 Profit deferral arrangements We would take issue with the use of these rules where corporate members are used for commercial and regulatory profit deferral (potential forfeiture) arrangements For example, there can be geographical differences between the use of corporate partners in mixed partnerships arising from the commercial requirements of some lenders for the purpose of obtaining business financing for partnership structures. We understand that this has been a requirement for many firms in the North of England In regulated sectors, particularly the financial sector, the use of deferred remuneration arrangements is simply good governance. The use of a corporate partner simply defers the tax until the deferred profits can be released why should an individual pay tax on something he or she has not, and might never, receive? Inflicting a large upfront tax charge on such remuneration arrangements, even with the prospect of recovery in the event of forfeiture (which in some cases could be limited by the new cap on income tax reliefs), seems to us to be a disincentive for partnership structures compared to purely corporate structures. It risks bringing the tax system into disrepute Working capital arrangements We would also take issue with the proposed application of the rules to mixed partnerships where the profit allocations of corporate members finance partnership working capital requirements There is a tax advantage from a working capital perspective for using a corporate vehicle from which to trade. This arises from inherent differences in the tax treatment of corporates, as highlighted in the consultation document ie corporation tax at 20% compared with 45% income tax. Therefore, it is not surprising that, in order to level the playing field, some partnerships will introduce a corporate partner so as to give the partnership access to working capital on the same terms as is available to corporate competitors. The crime here is not that mixed member partnerships may receive a tax advantage over other partnerships but that partnerships generally have less-favourable access to finance than corporates A corporate partner has an important function here to help partnerships have a more long term funding vehicle. Making financing more expensive for partnerships, when tax does affect commercial viability, compared to other business structures, is not good economic policy and potentially inhibits UK PLC s economic recovery Family partnerships Paragraph 3.1 of the consultation document states that the proposals are not intended to cover cases where family members use structures to allocate profits between them. The implication is that only applies to situations similar to the Arctic Systems case. Is that correct? It would also be helpful if HMRC could clarify whether family means spouse or civil partner or extends to lineal relatives and siblings? 3.17 Often a mixed partnership is introduced in a family situation because of succession planning issues, as it can be easier to admit new partners to a partnership than new shareholders in a company. It is unclear whether such arrangements are intended to be caught by the new rules? P/tech/subsfinal/OMB/2013 4

5 3.18 Farming partnerships It is common within farming partnerships for only part of the business to be incorporated (eg because of land tenure arrangements). We assume that as these types of arrangements are entered for commercial purposes and, often, the limited company carries on the farming business, or part of it, in its own right, that such arrangements would not be within the new rules. Can HMRC confirm that this is the intention? 3.19 Disguised employment Can HMRC confirm that an individual, who is a member of an LLP, and who is deemed to be a salaried member, but is not an employee, would not have part of the profits of a corporate member reallocated to them, on the basis that they are employed and not self-employed for tax and NIC purposes? For example, what would happen where primarily all the partners are companies but solely for compliance of professional regulatory bodies (and assuming this does not constitute sufficient economic risk to prevent him being a salaried member) there is one individual as a partner in person (but is also the director/shareholder of one of the company members). As recompense for carrying out that aspect of the managing partner s duties receives a flat rate fixed profit share before the allocation of profits to his and the other corporate members. Could he fall foul of the regulations and be deemed to receive the whole of his company s profit share as if an employee s salary? 3.20 The profit condition The any person nature of the test is too broad, given the minor involvement some people might have, and this could lead to genuine commercial transactions being caught. We would suggest that a de minimis exclusion may be needed. Otherwise a clearance system will be needed. Also, how will the profit earned by the corporate member from its own activities be determined so as to decide what share of the profit is to be reallocated? 3.21 Issue 2: Partnerships with mixed membership losses Again, we are not convinced that this is as big an issue as HMRC suggest and that any tax avoidance motivated schemes would not, in any event, be countered by existing legislation (including the GAAR). We are not in favour of HMRC promoting further legislation to duplicate the effect of existing legislation. Complexity, uncertainty and unfairness will result Partnerships with mixed membership: Proposed changes The consultation document does not explain how the rules will apply. The proposal is for a just and reasonable basis of reallocation that takes into account all the circumstances but we have a Self-Assessment basis of taxation, so who will decide what a just and reasonable reallocation of profits is? The all-encompassing nature of the proposal will inevitably result in disagreements, which will undoubtedly then lead to litigation Of particular concern is that HMRC, when faced with a mixed partnership, might conclude that one of its main purposes is to secure a tax advantage. Mixed partnerships are a common arrangement for special purpose vehicles (SPVs) established to undertake a new project as they provide flexibility. Usually there will P/tech/subsfinal/OMB/2013 5

6 be no economic connection between the parties and therefore this will be outside the intended scope of the new rules but unless the legislation is carefully worded a member applying his share of the profits for the partnership s benefit might constitute an economic benefit Where a corporate member s profit share is reallocated to individual members would the partnership s profit allocation be recomputed on income tax lines or the corporate computation of profit reallocated? 3.25 How would the transitional rules work? For example, if the partnership has a 30 April year end, would the reallocation only apply to that portion of the profits arising to the corporate member from 6 April 2014? 3.26 How would the rules work for the purposes of Universal Credit and the high-income Child Benefit charge? While profit may be reallocated to an individual that does not mean the company will distribute the profits to that individual: they may, for example, retain their profit share or distribute them to other individuals Question 8: Would the proposed changes impact on situations that are not in line with the stated policy objectives? 3.28 As noted above, the changes would impact on firms in the regulated (finance and law) sectors and potentially restrict access to finance. In addition, private equity structures can typically involve individuals and corporates in partnership. The comments in the consultation document on remuneration and working capital arrangements indicate that these might be adversely affected by the proposed changes Issue 3: Partnership members with differing tax attributes At paragraph 3.47 of the consultation document it notes that the arrangements to be counted are similar to those dealt with by the legislation concerning transfer of income streams and structured finance arrangements. The consultation document also notes that in many cases this legislation already operates to counter the intended avoidance. This suggests to us that a better course of action would be to revisit this legislation (Corporation Taxes Act 2010, Part 16, Chapters 1 and 2) and consult on whether the legislation should be amended to include all tax avoidance motivated arrangements where partnership structures are used to sell profits to avoid tax charges on the transferor Partnership members with different tax attributes: Proposed changes Many of the issues noted above apply equally to this proposal. Legislation that is not based on objective tests but on someone s (HMRC s?) subjective reasonable assumption should be avoided. The test proposed at paragraph 3.50 is complicated and fails to take account of normal commercial arrangements such as a new partner purchasing an interest in the partnership 3.31 Motive test The application of the proposed new rules is dependent on a tax avoidance purpose filter. In the absence of details as to how the filter might work we would be concerned that the new rules could adversely affect any arrangement where there is an economic connection between the individual members and the corporate member. For example, where a new business model is adopted in response to client P/tech/subsfinal/OMB/2013 6

7 requirements, where a route is provided to admit external equity into the business, or where a shareholding structure is implemented for a possible floatation or sale Also, will the filter take account of the fact that, although a tax advantage may be obtained, other tax disadvantages may arise as a result of the particular arrangement adopted? For example, loss of capital allowances, or capital gains or Inheritance Tax reliefs? 4 The Chartered Institute of Taxation 4.1 The Chartered Institute of Taxation (CIOT) is the leading professional body in the United Kingdom concerned solely with taxation. The CIOT is an educational charity, promoting education and study of the administration and practice of taxation. One of our key aims is to work for a better, more efficient, tax system for all affected by it taxpayers, their advisers and the authorities. The CIOT s work covers all aspects of taxation, including direct and indirect taxes and duties. Through our Low Incomes Tax Reform Group (LITRG), the CIOT has a particular focus on improving the tax system, including tax credits and benefits, for the unrepresented taxpayer. The CIOT draws on our members experience in private practice, commerce and industry, government and academia to improve tax administration and propose and explain how tax policy objectives can most effectively be achieved. We also link to, and draw on, similar leading professional tax bodies in other countries. The CIOT s comments and recommendations on tax issues are made in line with our charitable objectives: we are politically neutral in our work. The CIOT s 16,800 members have the practising title of Chartered Tax Adviser and the designatory letters CTA, to represent the leading tax qualification. The Chartered Institute of Taxation 12 August 2013 P/tech/subsfinal/OMB/2013 7