The UK Government has published two key tax proposals that may have a significant impact on the remuneration structures of fund managers operating through a UK LLP. Firstly it has proposed a new tax mechanism that will enable LLPs that are subject to the Alternative Investment Fund Management Directive (AIFMD) regime to implement deferred remuneration structures. However, it has also proposed new rules that would treat certain LLP members as employees for tax purposes. These new tax rules are likely to add further layers of complication to the remuneration structures of AIFMD fund managers.
1. AIFMD tax deferral mechanism
The remuneration deferral problem for AIFMs
Under AIFMD, there is a requirement for up to 60% of variable remuneration to be deferred over a period of at least three years and for part of both upfront and deferred remuneration to be delivered in the form of instruments (for example, shares or units in a fund). However, in the case of fund managers structured as LLPs, members are taxed on their share of profits in the year that they arise even if receipt is deferred. At a marginal income tax rate of 45%, this deferral requirement would lead to a cash flow problem for the LLP member.
The common way for an LLP to defer members’ remuneration would be to have the deferred amount paid to a corporate member of the LLP that is owned by the individual member. The individual member would then only be taxed when the corporate member distributed the deferred amount (through a dividend or some other mechanism). However, the government recognised that corporate members were being used in this way in order to reduce the ultimate tax liability for the individual LLP members. Therefore, in May 2013 it announced proposals to tax individual LLP members on any profits allocated to corporate members which they control (the ‘mixed member’ tax rules).
The proposed solution
The government has recognised that the new mixed member tax rules would create significant cash flow problems for members of LLPs subject to AIFMD. Therefore, the draft Finance Bill 2014 includes a new statutory tax mechanism that LLP members can elect for. Under this mechanism, LLP members can choose to allocate their ‘restricted profits’ (which includes deferred amounts and upfront amounts in the form of instruments) to the LLP itself for tax purposes. The LLP would be subject to tax at 45% on any amounts so allocated. The LLP member would be taxable on any upfront cash and instruments in the year they are received, but would receive a credit for tax paid by the LLP on the instruments. The receipt of any deferred amounts would be treated as taxable income in the year of receipt, but the member would receive a credit for any tax already paid by the LLP.
If instruments do not vest for any reason, then no further tax is payable by the member but there is no ability for the LLP to recover tax already paid. It is proposed that no National Insurance contributions will become payable until the variable remuneration ultimately vests - further guidance on the National Insurance position will be published in due course.
Therefore, the broad effect of the new mechanism is that deferral can be made on a net of tax basis as far as the member is concerned, though this will be at the expense of the LLP if the award doesn’t ultimately vest.
2. ‘Salaried member’ rules
While the new rules for AIFMD LLPs may present some challenges, the proposals to treat certain LLP members as employees for tax purposes are potentially more significant. These ‘salaried member’ rules are significantly different from those originally proposed and have the potential to apply to wide range of fund managers currently structured as LLPs.
Three condition test
Under the new proposals, a member of an LLP will be deemed an employee for tax purposes if all of the following three conditions are satisfied:
- The amounts payable to the member substantially wholly consist of ‘disguised salary’ – this is any amount which is:
- fixed, or
- if variable, is without reference to the profits or losses of the LLP, or
- in practice is not affected by the overall amount of profits or losses of the LLP
HMRC have proposed that this condition will be satisfied where at least 80% of the total amount payable to the member is disguised salary.
- The second condition is that the member does not have a significant influence over the affairs of the LLP
- The third condition is that the member’s capital contribution is less than the 25% of the ‘disguised salary’
Implications of satisfying all three conditions
If all of these three conditions are satisfied, members will be treated as employees for tax purposes and therefore income tax and employee National Insurance contributions will need to be accounted for under PAYE. Any deferred remuneration would only be taxable on receipt in accordance with the normal employment income tax rules. However, the most significant implication is that employer National Insurance contributions will be payable by the LLP on any amounts paid to the member (currently at a rate of 13.8%).
Difficulties in applying the test in practice
In cases where the member has little involvement in the management of the LLP and is only required to make a nominal capital contribution, it will be necessary to analyse whether any amounts payable to the member could be considered ‘disguised salary’. One area of uncertainty is where remuneration is linked to the personal performance of the member (for example, the performance of a fund). Although that personal performance has a significant impact on the profitability of the LLP, there may be no direct link between the remuneration received and the profits of the LLP. The accompanying HMRC guidance notes make clear that even if remuneration is linked to the profitability of one part of the LLP’s business, that would not be considered as giving the member a share in the overall profits of the LLP.
Any LLP which structures its members’ remuneration arrangements otherwise than through a straightforward profit share will need to carefully consider these new rules. Although we understand that it is unlikely there will be significant changes to the draft legislation, we hope that HMRC will produce further guidance in order to give LLPs greater clarity on how the rules will apply to them.