The Mixed Member Partnership Rules
The Mixed Member Partnership Rules are anti-avoidance provisions introduced to prevent members of a partnership who are individuals (i.e. natural persons) from making arrangements to accumulate profits in a non-individual member (such as a company) to reduce the overall tax liability of the partners. Where the rules apply, HMRC may reallocate profits from the corporate partner to the individual partners, bringing those profits into tax in the hands of those individuals.
The rules apply where either:
- it is reasonable to suppose that the profit allocated to the corporate partner includes an amount that represents an individual’s deferred profit, reducing the individual’s profit share and resulting in a reduction in tax (Condition X); or
- the corporate partner’s profit share exceeds a notional return based on that partner’s contribution, an individual partner has the power to enjoy that profit share; it is reasonable to suppose that, broadly, those two facts are connected; and it is also reasonable to suppose that both the individual’s profit share and the tax payable are lower than they would have been absent that power to enjoy (Condition Y).
Background
BCG UK LLP, part of the global Boston Consulting Group, was established to carry out the business previously carried out by another group entity, BCG Ltd. On transferring the business, BCG Ltd. became the managing partner of the LLP, while its senior managing directors and partners (Management) became partners.
The remuneration arrangements for Management involved granting “Capital Interests” under three limited liability partnership agreements (LLPAs). On retirement or certain trigger events, Management could sell their interests to BCG Ltd. for a sum based on the increase in value of shares in the group’s ultimate parent company. Both the LLP and Management treated payments on the disposal of these interests as capital gains, eligible for entrepreneurs’ relief. HMRC challenged this treatment.
Were the “Capital Interests” true capital assets?
Both the First-tier Tribunal (FTT) and the Upper Tribunal (UT) found that the Capital Interests were not separate, saleable interests in the LLP’s capital. Applying the Court of Appeal decision in Bluecrest (HMRC v BlueCrest Capital Management LP and others [2023] EWCA Civ 1481), the fact that the LLPAs used the term “capital” did not by itself create rights that were recognisable as capital interests.
Turning to the nature of the rights themselves, the UT found that the Capital Interests did not confer an enforceable legal right in a recognisable capital asset, but were at most “tokens” which could be sold to BCG Ltd. at the price set out in the relevant LPA. That price was in no way linked to the value of the assets held by the LLP.
This position was even clearer in later LPAs, which explicitly stated that the capital profits belonged to BCG Ltd. and removed Management’s rights on winding up.
The UT also rejected the taxpayers’ argument that the effect of section 863 of ITTOIA 2005 was to treat the property of an LLP as held by its members. The purpose of this deeming provision (and of its equivalent for capital gains tax, section 59A of TCGA 1992) was only to attribute to partners income or gains made by the LLP for the purposes of charging the partners to tax – a necessary fiction because an LLP is not itself a taxable entity.
Did the Mixed Member Partnership Rules apply?
The FTT had assumed that, had the remuneration arrangements not been structured as Capital Interests, the taxpayers would have implemented some other form of deferred profit structure. Since deferred profits were included in BCG Ltd’s profit share, the FTT concluded that these amounts would have been allocated to BCG Ltd one way or another, and so its profit share had not been increased as a result of the arrangements. Accordingly, the FTT found that Condition X was not met.
The UT found that this was an error of law. The statutory test was whether Management’s profit shares would have been higher had they not been entitled to receive a share of the profits allocated to BCG Ltd. in the future. The UT found that they were. It was also reasonable to assume that BCG Ltd’s profit share included an amount that represented Management’s deferred profit, given that deferred profits were allocated to BCG Ltd and it was expected to pay for Capital Interests sold by management. Accordingly, Condition X was met, and so the Mixed Member Partnership Rules applied.
Although unnecessary, since the rules applied because of Condition X, the UT also found that Condition Y was met. The retained profits were allocated to BCG Ltd. for the purposes of funding future purchases of Capital Interests from Management, and Management did in fact receive those payments. Accordingly the UT found that Management were entitled to benefit from BCG Ltd’s profit share, and that it was reasonable to conclude that such benefit informed the calculation of BCG Ltd’s profit share. Again, absent the arrangements Management’s profit share would have been higher.
Where the rules applied, the UT confirmed that profit should be reallocated to Management on an annual basis, not just when payments were made. Although there would be a mismatch between receipt of cash and allocation of taxable profits (a so-called dry tax charge), the UT noted that this is commonly the position in LLPs and partnerships where distributions frequently do not track amounts allocated for tax purposes.
How were the payments taxed in years prior to the Mixed Member Partnership Rules?
For the tax years prior to the introduction of the Mixed Member Partnership Rules, the UT agreed with the FTT that payments to Management were taxable as miscellaneous income under section 687 ITTOIA 2005. The tax outcome is determined by looking at the economic reality of the arrangements, not their legal form.
Were HMRC’s discovery assessments in time?
Although some of HMRC’s discovery assessments were made after the ordinary 4-year time limit, the UT upheld them, finding that the LLP had been careless by not obtaining adequate professional advice on the tax treatment of the incentive arrangements, and that such carelessness led to the loss of tax, such that a longer, 6-year, time limit applied.
Implications for LLP Incentive Arrangements
This decision will be of particular interest to LLPs operating group-wide incentive schemes or using complex profit allocation mechanisms involving corporate partners. Our key takeaways from the decision are:
- Substance over form: Simply labelling an arrangement as a “capital interest” will not secure capital gains tax treatment if, in reality, it is more akin to a shadow profit payment or phantom share scheme.
- Arrangement or no arrangement: The counterfactual tests in the Mixed Member Partnership Rules consider what the position would have been in the absence of the arrangements in question, and not a hypothetical alternative that the parties could have implemented.
- Dry tax risk: Income tax is an annual tax, and the tribunals will not shy away from allocating profit on an annual basis where it considers that just and reasonable, even if that results in participants becoming liable to tax before they actually receive any cash sums.
- Careful documentation and advice: Like all taxpayers, LLPs must ensure that their incentive arrangements are carefully structured, documented, and supported by professional tax advice.
