A long-running saga concerning the correct application of the Salaried Members rules has finally been concluded, with the Supreme Court ruling in favour of HMRC in their case against BlueCrest Capital Management LLP. The case has passed through the First Tier Tribunal, Upper Tribunal and Court of Appeal before reaching the Supreme Court.
The case considered Conditions A and B of the Salaried Members rules. The rules determine whether members of a limited liability partnership (LLP) are taxed on a self-employment basis as regards their profit allocations from the LLP or treated as employees of the LLP with their profit allocations subject to PAYE income tax and national insurance.
As a reminder, the Salaried Members rules set three conditions and if all three conditions are met, the LLP member is taxed as if they were an employee. The conditions are:
- Condition A – 80% or more of the member’s profit allocation is ‘disguised salary’.
- Condition B – The member does not have significant influence over the affairs of the LLP.
- Condition C – The member’s capital contribution to the LLP is less than 25% of their profit allocation.
For the purpose of Condition A, a profit allocation is disguised salary if it is:
- fixed
- variable, but without reference to the overall profits of the LLP
- not, in practice, affected by the overall profits of the LLP.
Therefore, it is necessary for each member of the LLP to fail one of the conditions if they are to be taxed on a self-employed basis.
In the BlueCrest case, both sides accepted that Condition C was met, and so the case hinged on the application of Conditions A and B.
Condition A
The majority of the remuneration awarded to the members of BlueCrest was calculated by reference to individual performance, not by reference to the overall profits of the LLP. However, a cap applied to each member’s remuneration based on the overall profits of the LLP, and it was argued that this caused Condition A to be failed.
The Court rejected this argument, choosing to focus on what it means to be in partnership, which is to share the profits and losses of the partnership between the partners, not to provide the partners with capped remuneration based on their individual performance. The Court felt that BlueCrest’s interpretation of Condition A was at odds with its purpose in distinguishing between what it means to be a partner in a traditional partnership versus what it means to be an employee.
Condition B
The Court’s ruling on Condition B has been eagerly anticipated because, of the three conditions, it was considered by many to be the most difficult to interpret. Adding to the intrigue is the fact that the Court of Appeal had largely discounted much of HMRC’s own published guidance on how Condition B should be applied in practice.
The Supreme Court upheld the Court of Appeal’s view that the actual wording or Condition B is the key to applying it. In its entirety, Condition B states:
“Condition B is that the mutual rights and duties of the members of the limited liability partnership, and of the partnership and its members, do not give M significant influence over the affairs of the partnership.”
The Supreme Court took the view that it is the legally enforceable rights and duties of the members, as set out in the LLP members’ agreement, which determine whether the condition is met or failed. As with the verdict on Condition A, the Court looked to the contrast between a partner and an employee within a traditional partnership setting, where a partner’s formal management role distinguishes them from employees.
The Court also resolved the question as to the meaning of the phrase “influence over the affairs of the partnership” Some had believed that this refers to the affairs of the entire LLP, whereas others, including BlueCrest, believed it could be interpreted as relating to specific aspects of the LLP. The Court preferred the former interpretation.
As to the meaning of “significant influence”, the Court’s view was that significant means a level of influence that has real substance in the actual management of the LLP, with participation in and influence over high-level or strategic decision-making.
The Court then applied this interpretation to the First Tier Tribunal’s analysis and found that it had applied the test incorrectly. The tribunal had considered the partners’ informal influence arising from their day-to-day activities and their personal attributes and had not properly considered their rights and duties under the LLP members’ agreement. The Supreme Court agreed with the Court of Appeal’s decision to return the case to the First Tier Tribunal for reconsideration. It is widely expected that, in light of the above, the Tribunal will now find that Condition B is met.
What does this mean for LLPs going forward?
In our experience, the vast majority of LLPs with members who receive an entirely fixed profit allocation, or a material fixed prior allocation of profit, rely on Condition C for those members to be taxed on a self-employed basis, and we do not see this changing as a result of this ruling. Condition C is formulaic, objective and relatively straightforward to manage.
Ideally, the level of partnership capital should be driven by an individual's equity participation in the firm and should be clearly distinguishable from any element of remuneration or profit share.
It remains our view that firms should regularly review their working capital requirements to identify where increases are required and communicate that to members well in advance of a capital call. While Condition C is arguably the most straightforward, an unprepared firm can easily trip up.
The ruling does not provide any particularly useful new insight into the application of Condition A, other than the fact that the Court viewed its purpose in the context of a traditional partnership and what it means to be a partner versus an employee. Any firms relying on Condition A should ensure that the variable element of the members’ profit allocations is truly variable, such that they are genuinely sharing in the fortunes or misfortunes of the business. It should serve as a reminder that profit shares driven by individual or team performance will be classed as disguised salary.
It is Condition B where much needed clarity has been given. Any member seeking to rely on this condition must ensure that:
- their rights and duties as a member are clearly set out in the LLP members’ agreement
- those rights and duties give the member real-world influence over the affairs of the entire LLP at the highest level
- the member actually exercises their rights and undertakes their duties in practice, with clear evidence available to substantiate it should HMRC challenge their tax status.
For firms with a management board, it seems highly unlikely that any member of the LLP who is not on the board could be said to have significant influence, and likewise for any members with an informal management role not evidenced in the LLP members’ agreement.
Finally, one point that should not be overlooked is that the Salaried Members rules remain focused on UK LLPs. Professional practice firms operating through a non-UK LLP structure are generally outside the scope of the legislation. As a result, there continues to be a degree of imbalance between UK LLPs and certain overseas LLP structures operating in the UK. It will be interesting to see whether the judgement prompts some firms to revisit whether their existing legal structure remains appropriate.
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