Does abuse of tax rules for partnership require a major clampdown by the taxman? That’s the £300m question and the reason that the majority of large law firm partnerships in the UK are now facing an overhaul of the tax treatment of partners and retained earnings.
Tax specialists and legal finance directors are currently sizing up proposals from HM Revenue & Customs (HMRC) to change the treatment of members and retained earnings in limited liability partnerships (LLPs).
The proposed shake-up, which was first unveiled in last year’s Budget, is aimed at combatting supposed LLP abuse with HMRC arguing that it will net around £300m from clamping down on tax avoidance in the area.
The consultation has two major proposals. First, it is set to end the presumption that LLP members are self-employed – and therefore exempt from employer’s National Insurance Contributions – in favour of a test to separate ‘salaried members’ from full equity partners. The tests will focus on the amount of risk capital a member puts into the firm and the level of variable profit-sharing the individual member is entitled to.
The second change is arguably of more relevance to large law firms: moves to end the tax break of having companies as LLP members alongside individuals, the ‘mixed partnership’ structure that many law firms use to retain profits. This would mean such structures are taxed at a higher rate of income rather than corporation tax.
While HMRC has made increasingly loud noises regarding tax avoidance at small law firms in recent years it remains open to debate regarding both the actual sums involved and the impact of these reforms on the legal industry.
The reforms will likely make law firms check which side of the line members with ambiguous status sit and arguably further increase the current trend for law firms to get capital contributions from a wider base of members. The traditional salaried partner is looking increasingly under threat.
Changing the tax treatment of ‘mixed partnerships’ is seen by some as creating a perverse incentive for law firms to avoid the sensible policy of retaining a good chunk of earnings rather than relying on scant bank finance.
George Bull, head of Baker Tilly’s professional services group, comments: ‘It is interesting that in the consultation document HMRC recognises the commercial rationale for these [retained earnings] arrangements but then goes on to disregard it.’
Bulls adds: ‘Our concerns are what the Revenue is proposing is so complicated that nobody’s going to know where they stand when it comes to filing tax returns.’
Andrew Loan, a tax partner at Macfarlanes, is more relaxed regarding the impact: ‘The abolition of the rule that treats members of an LLP as if they were partners in a partnership, even if they would be treated as an employee under the general law, is not such a significant issue for professional partnerships. Clients using LLPs have always been best advised to make sure that members would be treated as partners under the general law test anyway.’
Loan believes that the absence of a test for how much input a partner has on management decisions will be addressed at the consultation stage as this is also an important factor in deciding whether a partner is really an active member of the LLP. ‘There may be some firms with a layer of salaried partners who are in effect glorified employees that could be affected [by management decision rules],’ he adds.
All of which leaves the tax position of the second largest legal industry in the world irritatingly unclear for the moment. The consultation ends this week, with the new rules expected to be in force in April 2014.