In limited liability partnerships with individual and corporate partners, the remuneration of partners has long been a target for HMRC’s anti-avoidance efforts. These partnerships, known as mixed membership partnerships, are the subject of wide-ranging rules that operate to allow HMRC to re-allocate excess profit from the corporate partner to the individual partners for tax purposes.
The mixed membership rules were originally introduced in ITTOIA 2005 ss 849–850E, with new provisions added by FA 2014 to tackle perceived abuse. HMRC’s power to tax partnership profits that it deems to be income does not end with the mixed membership rules. Where those rules do not apply, HMRC is empowered to tax any receipts classed as ‘income’ under the ‘miscellaneous income’ rule of ITTOIA 2005 s 687.
Recent years have seen these rules scrutinised by the tribunals, with at least three cases focused on the original mixed membership and miscellaneous income rules. These cases are now subject to further appeal and due to be heard by the Upper Tribunal in the coming months: BlueCrest Capital Management Cayman Ltd & others v HMRC  UKFTT 298 (TC) (BlueCrest), Odey Asset Management LLP and others v HMRC  UKFTT 31 (TC) (Odey) and HFFX LLP and others and Badzyan v HMRC  UKFTT 36 (TC) (HFFX).
In advance of these hearings, we review the existing case law, the implications of the new rules and the practical risks facing mixed membership partnerships.
The pending appeals
The three appeals in BlueCrest, Odey and HFFX are all centred on the interpretation of ITTOIA 2005 s 850 in its original form, as well as the miscellaneous income rule in s 687. The crisp issue is whether individual members are subject to additional income tax on amounts considered to be subject to corporation tax.
Under s 850, the individual members’ profit share for income tax is determined in accordance with any profit-sharing arrangements in place. Where there is a partnership agreement or a members’ agreement, HMRC can look through the formal allocation of profits and determine an alternative allocation between the members. In these cases, under various deferred remuneration arrangements, partnership profits were allocated to each of the corporate members and to individual members. Those allocated to the corporate member were liable to corporation tax and not income tax. However, HMRC considered that the receipts of the corporate member were, in reality, enjoyed by the individuals and subject to income tax under s 850 as though they had been received in the hands of the individuals. In the alternative, HMRC raised s 687 arguments in each case to capture the funds considered to be income.
In BlueCrest, the individual partners participated in a ‘partnership incentive plan’ (PIP). In this case, the partnership allocated its profits in their entirety to the corporate partners, which, post-corporation tax, invested those profits into partnership assets as special capital. Under the PIP, the individual partners did not share in the profits of the partnership, but rather received special capital credited to the corporate partner, which it agreed to transfer to the individual partners. The First-tier Tribunal (FTT) found that s 850 did not apply: the special capital paid to partners was not a reward for any work done nor a share of profits, but rather a drawing from the partnership, and therefore the award of special capital was not within the scope of partnership tax. However, it was HMRC’s second argument which persuaded the FTT, namely that the amounts allocated were residual income (as opposed to capital) that had not been charged to income tax under any other provision. Following an earlier decision of the Upper Tribunal in Spritebeam  STC 1222 (Spritebeam), the FTT concluded that the decision to make payment to the individuals under the PIP (by way of transfer of the special capital), satisfied the requirement to be a ‘source of income’, meaning the payments could be characterised as income in the hands of the individuals.
The next instalment in the series of FTT decisions is Odey, in which the Odey fund management partnership calculated profit shares for individual members, which were actually paid to the corporate member. The corporate then contributed the profit shares, described as ‘special capital’, back to the partnership to be invested for the benefit of the individual members, which was reallocated to the individuals on specified dates over a two or three year period if certain conditions were satisfied. Following the reallocations, the individuals could withdraw the funds from the partnership. On the s 850 question, the FTT determined that the individuals had no right or legal entitlement to their individual profit share; there was only a right that the partnership allocate profits to the members collectively. Moreover, the individuals’ reallocation was conditional on future events, and so the mixed membership rule could not apply. Nevertheless, when considering s 687, the FTT found in HMRC’s favour. Going further than in BlueCrest and Spritebeam, it held that s 687 is not limited to cases where the sums are paid under a contractual obligation which is enforceable by the recipient. Payments for reallocated ‘special capital’ were seen as linked to the continued activities carried out by the individuals for the partnership and their ongoing provision of service. As this was not ‘a casual payment which depends on someone else’s goodwill’, the individuals were liable to income tax on such payments.
Four days after the Odey judgment, the FTT determined the similar case of HFFX. As in Odey, the FTT in HFFX found that the individual members had no right or entitlement to the profit share allocated to the corporate member, rejecting the s 850 argument proposed by HMRC. The FTT lowered its bar to find a ‘source’ for s 687, and ultimately sided with HMRC that the payments of reallocated capital were subject to income tax in the hands of the individuals. On this issue, it was decided that the ‘source’ of income was the members’ rights under the partnership deed, despite those rights not including any right to require the reallocation of profit share.
It is notable that in all three of these cases, the taxpayers were approached by promoters of tax avoidance schemes to enter into remuneration planning arrangements. As to be expected, the amended mixed membership rules introduced by FA 2014, however, have a wider scope and capture arrangements where individuals and partnerships inadvertently fall foul of the rules.
The amended mixed membership rules
The target of the mixed membership rules is to capture arrangements motivated by the avoidance of tax. Even those arrangements that were never designed with a tax purpose, and do not represent disguised remuneration or tax avoidance schemes, may be inadvertently captured by the wide-ranging rules. The provisions seek to allocate capital to individuals that cannot, in practice, be accessed by those individuals, and consider such capital as income. HMRC has confirmed that the rules will not apply where the individual and corporate partners are genuinely independent, acting at arm’s length and not intending to defer profits or secure a tax advantage (see HMRC’s Partnership Manual at PM214000). Evidencing the contemporaneous intentions of the parties is therefore key to demonstrating that profit allocations by partnerships are commercially driven, and that any profit allocation arrangements had a commercial genesis.
One of the new measures introduced in 2014, and already subject to contentious treatment by the FTT, is ITTOIA 2005 s 850C. This provision sets out a number of conditions which need to be fulfilled in order for the mixed membership rules to apply. Broadly, the rules will apply where either Condition X or Condition Y is met. The taxpayer carries the onus to show that the rules do not apply. This is not a light onus to
Condition X is that it is reasonable to suppose that:
- amounts representing the individual’s deferred profit are included in the corporate’s profit share; and
- the individual’s profit share and the relevant tax are lower than it would otherwise have been (s 850C(2)).
Condition Y is that:
- the corporate member’s profit share exceeds the appropriate notional profit;
- the individual member has the power to enjoy the corporate member’s profit share; and
- it is reasonable to suppose that: (i) the corporate member’s profit share (or part of it) is attributable to the individual member’s power to enjoy; and (ii) the individual member’s profit share and tax are lower than they would have been absent their power to enjoy (s 850C(3)).
The intricate drafting of Conditions X and Y is accompanied by a dizzying number of additional interpretive rules. How can partnerships and partners navigate the maze of these mixed membership rules?
The appropriate notional profit
The first limb of Condition Y requires a numerical demonstration that the corporate member’s profit share is in excess of an ‘appropriate notional profit’ that the corporate is due for its own contribution, in the absence of the individual members. The ‘appropriate notional profit’ is defined, by s 850C(10)–(15), as the sum of the appropriate notional return on capital (i.e. the return which the corporate would receive for its contribution to the firm); and the appropriate notional consideration for services (i.e. the amount which the corporate would receive in consideration for services provided to the partnership).
The legislative provisions dictate how such notional sums should be calculated. Critically, under s 850C(17), the provision of services which involves any individual partner in the LLP must be ignored for the purposes of calculating the appropriate notional consideration for services.
To fall outside the scope of the rule, the corporate member’s profit share must not exceed the appropriate notional profit. The appropriate notional consideration for services is likely to be closely intertwined with the commercial success of the corporate member and the partnership; the market price that can be charged for services is inherently dependent on the commercial value of those services. Partnerships must therefore monitor and regularly obtain valuations of services being provided by a corporate member to the partnership, particularly before significant profit allocations are determined.
Valuations of the appropriate notional profit are likely to require:
- examples of contemporaneous interest rates on an investment of capital by the corporate member;
- expert evidence for each type of service provided by the corporate member, whether that be a
- valuation of intellectual property or transfer pricing analysis of intra-group services; and
- records of decision-making processes and calculations to show that the corporate member’s profit share was calculated independently of the individual members’ contributions.
The power to enjoy
The remaining requirements of Condition Y refer to the individual members’ ‘power to enjoy’ the corporate’s profit share.
The mixed membership rules specify that the individual has the power to enjoy the non-individual’s profit share if any one of the following conditions is met:
(a)the corporate’s profit share is calculated at some time to enure for the benefit of the individual (i.e. that it is calculated with a view to the individual partners benefitting from that profit share at any time);
(b)the receipt by or accrual of the corporate’s profit share operates to increase the value to the individual of any assets held by, or for the benefit of, the individual;
(c) the individual receives or is entitled to receive at any time any benefit provided or to be provided (directly or indirectly) out of the corporate’s profit share or the part;
(d)the individual may become entitled to the beneficial enjoyment of the corporate’s profit share if one or more powers are exercised or successively exercised by any person; or
(e) the individual is able in any manner to control (directly or indirectly) the application of the corporate’s profit share.
The circumstances in which it may be found that an individual has the ‘power to enjoy’ are wide-ranging. It is for the taxpayer to demonstrate that it is not the case, and to show a disconnect between the corporate and individual profit share. In this regard, evidence of the calculation of profit mshare (and factors taken into account); the application and use of the corporate’s profit share after receipt; and the absence of any rights and entitlements of the individual members to share or actual sharing in the corporate member’s share, are all relevant.
In large group structures, day-to-day liquidity management may result in transfers between corporate entities that unintentionally allow an individual member to benefit from the corporate member’s profit share. In particular, the operation of subsections (b), (c) and (d) should be considered to ensure that no assumption of a ‘power to enjoy’ can be derived.
It is worth noting that the drafting of sub-section (d) allows HMRC to contrive an entirely hypothetical transaction in order to reallocate profits, even where no benefit or enjoyment even occurred. The use of ‘may become entitled… if one or more powers are exercised’ is entirely speculative. Therefore, a thorough assessment of the rights of each individual, corporate and partnership entity involved in the structure, whether formal or informal, by agreement or in practice would be essential to demonstrate that the rule does not apply. In corporate groups where each entity is funded or capitalised by other entities in the group, there may be myriad ways in which an individual may unwittingly fall within this subsection, without any benefit materialising in fact.
The mixed membership rules appear to be deliberately complex in an effort to close the perceived tax avoidance loophole. The optimal protective action for taxpayers is to meticulously record the profit allocation process, such as:
- documenting the value of assets held by the individual members, whether that be capital awards, deferred capital payments or shareholdings, before and after the corporate member has received its profit share;
- tracing the spending of the corporate member’s profit share to evidence that the funds are not used for the benefit of the individual members;
- recording the rationale of the corporate member when deciding how to use its profit share, to demonstrate that there is no consideration of applying it for the individual members; and
- reviewing the links between the corporate member and any entity in which the individuals hold an interest, looking at any formal or informal right to request funds (in the articles of association, intra group agreements or other documents).
Unfortunately, even if it can be shown that s 850 does not apply, the taxpayer still faces the hurdle of s 687.
Section 687: the catch-all provision?
Income is defined as the profits of a trade, vocation or profession and the miscellaneous income rule (s 687) applies to impose income tax on any income or any payments analogous to income. As illustrated by the recent FTT cases, the rule applies where income has arisen from any source that is not already charged to income under any other provision. In each of those appeals, this rule has been used as a flexible ‘sweep up’ provision for HMRC to capture payments made to individuals which ‘somehow lack the characteristics for it to fall within the other specific provisions in the income tax code’, as was concluded in Odey.
The use of the rule by HMRC creates a fine legal divide for those involved in partnership profit allocation schemes that are intended to distribute capital and not to make a payment in the course of a trade, vocation or profession. In these circumstances, critically, the taxpayer must demonstrate that the payments made to individual members pursuant to any profit-sharing or capital allocation arrangement were, in law and in fact, capital in nature and not income.
First, as a matter of law, payments made by the partnership to its members will fall within s 687 if the conditions set out by the Upper Tribunal in Kerrison v HMRC  UKUT 8 (TCC) applies. In order to be deemed as income, the payment must:
‘(1)have the nature of “annual profits”. That simply means that the receipts must be capable of being “calculated in any one year”; it does not mean that the income must recur every year (Jones v Leeming (HMIT) 15 TC 333 at 359) (Leeming);
(2)be of an income nature (Leeming);
(3)be analogous to some other head of charge under what was previously Schedule D (Leeming);
(4)be the recipient’s income (Spritebeam); and
(5)involve a sufficient link between the source and the recipient (Spritebeam).’
The issue of a ‘source’ is likely to create the biggest headache. Taxpayers were typically deemed to possess a source of income where there is a binding obligation which the taxpayer is able to enforce as regards the payment. This interpretation has been gradually watered down over time: in Spritebeam, the Upper Tribunal found that it would suffice for there to be an absolute and unconditional obligation in the absence of a legally enforceable agreement. In the recent FTT cases on partnerships, however, the tribunal has required even less than an obligation to exist for a ‘source’ to,arise. In HFFX, the corporate member’s discretionary right (to be exercised within the framework of the provisions) in the relevant partnership Deed meant that the allocation of capital from the corporate to the individuals was ‘not an entirely voluntary’ transaction and therefore a source existed for s 687. Meanwhile, in Odey, a mere ‘form of fiduciary role’ or obligation to act ‘honestly, in good faith and rationally’ under the relevant Deed provisions, was sufficient to find that payments from the corporate member to the individuals fulfilled the conditions to be deemed income. In each of those cases, once a ‘source’ had been established, the tribunal explained the ‘sufficient link’ by reference to the individual members’ activities and services for the benefit of the partnership.
Further, as a matter of fact, the taxpayers must show that the payments were always intended to be an award of capital in return for some value from the individual members that is not linked to their employment, and therefore not income in nature, such as a deferred bonus. It has been suggested that the question to be asked is whether the transfer from the corporate to the individual was ‘like the presents under the [Christmas] tree, or are they like the bankers’ bonuses’ (BlueCrest).
The interpretation of the miscellaneous income rule is in flux. In large and complex group structures, decision-makers must be circumspect; the logistically simple method of distributing funds may lead to unintended tax consequences.
To ensure the rule does not inadvertently apply, partnerships with capital award plans would be wise to:
- document the commercial and financial rationale for the plan to show that there is no employment-related or performance-related aim;
- distinguish between decision-making processes for determining remuneration or bonus payments, and
processes for determining capital awards;
- review documents justifying capital awards to ensure that employment-related or performance-related metrics are not accidentally considered; and
- actively engage the corporate member in the partnership for commercial purposes and not simply as a pass-through company for the capital payments.
What next for partnerships?
Partnership taxation where there are mixed members is not an easy area of law, but has become a key focus area for HMRC. While we await ultimate determinations from the tribunals, taxpayers involved in mixed member partnerships should invest time in identifying and documenting evidence to demonstrate their intentions, calculations, profit shares and entitlements to discharge the evidential burden.
The intertwining mixed membership rules and miscellaneous income rules have created a knotted problem for taxpayers to untangle. The objective of the rules may well be to tackle avoidance, but even commercially minded taxpayers now bear the brunt of the rules’ complexity, the all-encompassing and somewhat unclear drafting of the legislation and the trend of the FTT to lower the threshold required to fall within the rules. We now wait for the Upper Tribunal to speak, as those decisions will be binding unless the appeals progress further to the Court of Appeal and even the Supreme Court.
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