Where a limited liability partnership (LLP) carries on a trade, profession or business with a view to profit, s863, Income Tax Trading and Other Income Act (ITTOIA) 2005 provides that, for income tax purposes, its activities are treated as if they were carried on in partnership by its members. On this basis, the default position is that individual members of an LLP are treated as if they were partners in a general partnership, being subject therefore to income tax on their shares of the profits of the LLP on a self-employed basis.

This default position has been subject to the salaried member rules in ss863A-863G, ITTOIA 2005 since 2014. This article summarises these rules and looks in detail at an anti-avoidance provision within the rules for which HMRC has recently changed its guidance in a way that will not be considered helpful to many LLPs and their advisers.

The salaried member rules

Whether or not an individual is a member of an LLP is a simple question of fact and in the years before the introduction of the salaried member rules it was widely observed that certain individuals were being appointed as members of LLPs – and therefore automatically being taxed on a self-employed basis by virtue of s863, ITTOIA 2005 – despite the fact that in reality they looked and acted much more like employees. The salaried member rules were introduced, in short, with the aim of ensuring that such individuals would be treated as if they were employed – and not self-employed – for tax purposes.

The rules contain three conditions (A, B, and C), which together are intended to provide a way of determining when an individual should be regarded as looking and acting more like an employee than a partner. The rules apply – and the individual in question is therefore taxed as if he or she were an employee – where all three of the conditions are met.

In outline terms, the three conditions are met as follows.

• Condition A is met where it is reasonable to expect – looking forward from the point at which the position is determined until the point at which the existing arrangements are expected to end or be modified – that at least 80% of the amount payable by the LLP in respect of the individual’s services will be ‘disguised salary’. An amount is ‘disguised salary’ if it is not variable with reference to the overall profits and losses of the LLP.

• Condition B is met where the individual does not have significant influence over the affairs of the LLP. Historically, HMRC argued that this condition must be considered with reference to managerial influence over the LLP as a whole, although recent case law (HMRC v Bluecrest Capital Management (UK) LLP [2023] UKUT 232) has shown that it can be considered much more broadly (ie, it is not limited to managerial influence but can encompass financial or other types of influence, and it need not be over the LLP as a whole but can relate to a particular part of the LLP).

• Condition C is met where the individual’s contribution to the LLP (essentially their capital) is less than 25% of the amount of ‘disguised salary’ that the individual is expected to receive during the tax year in question.

The rules contain a number of anti-avoidance provisions, the most significant of which requires that, when determining whether or not the conditions are met, no regard is to be had to arrangements that have a main purpose of ensuring that the salaried member rules do not apply (s863G(1), ITTOIA 2005).

Applying the anti-avoidance provision

As is often the case, the anti-avoidance provision is widely drawn, with the legislation containing little more than is included in the paraphrase set out above. Notwithstanding this, however, it has always been understood that the rule should be read and applied not in a simplistic and mechanistic way, but in a way that is consistent with the ultimate purpose of the salaried member rules.

This understanding goes right back to the government’s 2013 confirmation that it would introduce (what became) the salaried member rules. At this point, the government explained that its proposed rules would contain an anti-avoidance provision but stated that this would not be in point “if the LLP decides genuinely to engage the member on terms that amount to a partner rather than a salaried member”.

Subsequently, as the legislation was being introduced in 2014, the government published a technical note and guidance. This set out a similar position; it said that “in applying this [anti-avoidance provision] HMRC will take into account the policy intention underlying the legislation, which is to provide a series of tests that collectively encapsulate what it means to be operating in a typical partnership. HMRC would not consider that genuine and long-term restructuring that causes an individual to fail one or more of the conditions to be contrary to this policy aim.” 

All of this is important from a practical point of view because, while the salaried member rules attempt to set out clear and objective tests as to when an individual should be regarded as looking and acting more like an employee than a partner, they could never recreate perfectly the assessment that would have been made in a real partnership scenario. Accordingly, various LLPs have members who would undoubtedly have been made partner if the business were carried on in a general partnership, but whose natural terms of LLP membership might not have taken them definitively outside the scope of the salaried member rules. 

For many LLPs in this position, it became common to structure members’ capital arrangements so that all its members clearly failed to meet condition C. In many of these cases, under the LLP agreement, all members were required to have a capital account at least equal to 25% (or more if it was felt useful to have a buffer) of any ‘disguised salary’ they were expected to receive in the year. Such an approach – as long as the individual did genuinely have capital at risk within the LLP and so really did take on this characteristic of a partner in a general partnership – was always understood to be reasonable and not one that might be subject to the anti-avoidance provision.

HMRC’s detailed guidance in its Partnership Manual on the application of the anti-avoidance provision includes comments specifically relating to financing arrangements. Consistent with HMRC’s original technical note and guidance, these (until recently) stated at PM259310 that “a genuine contribution made by the individual to the LLP, intended to be enduring and giving rise to real risk[,] will not trigger the [anti-avoidance provision]”. 

It should also be noted at this point that part of the legislation itself could be said to support the understanding described above. Section 863F, ITTOIA 2005 provides for ‘deemed contributions’ to be treated as capital for the purposes of condition C, with ‘deemed contributions’ including amounts which, at the time the rules were first introduced, existing LLP members had undertaken to put into the LLP (providing those amounts were actually put into the LLP within the following three months). The mere fact that this provision exists appears to demonstrate the principle that members who might otherwise fall within the salaried member rules should be able to make arrangements to put (genuine and at-risk) capital into an LLP with that capital then being effective in enabling them to fail to meet condition C.

HMRC’s amended guidance

As indicated above, HMRC has recently amended its guidance on the anti-avoidance provision and in doing so it appears to have turned away from the previously widely-understood and common-sense approach that has been set out above. Instead, it has adopted a much more literal and isolated reading of the provision.

In the current version of PM259310, HMRC’s previous comment to the effect that a ‘genuine contribution’ would not trigger the anti-avoidance provision has now been qualified to be dependent on the contribution’s “main purpose (or a main purpose of any arrangement of which it forms part) not being to secure that the salaried members rules do not apply to the individual”.

In addition, HMRC has introduced a new example at PM259200 as follows:

“In 2018, upon joining the ABC LLP, member X contributed capital of £15,000 (this was not part of any arrangement with a main purpose of securing the salaried members rules do not apply and is a genuine contribution).

“In 2022 it is expected that X’s remuneration for the next period will consist of £100,000 Disguised Salary, meaning that their contributed capital is below the 25% threshold, and they will meet Condition C.

“X contributes a further £10,000 as part of a separate arrangement with the LLP, where members increase their capital contribution periodically in response to their expected disguised salary, in order to avoid meeting Condition C.

“This arrangement will trigger the [anti-avoidance provision] and no regard can be given to the £10,000 when considering whether X meets Condition C. As such X will meet Condition C as their contributed capital remains at only £15,000.”

The approach described in the example, which HMRC finds problematic, is exactly the kind of approach that many firms have taken over the past 10 years. It is understood that HMRC is adopting this view in its interactions with taxpayers. Although the courts have not yet expressed an opinion on all this (except possibly in some recent obiter dicta), many will be concerned that actions taken quite justifiably over the past decade might now be called into question. Concerns have been raised with HMRC.

Final thoughts

All LLPs would now be well advised to take a fresh assessment of the position of their members under the salaried member rules. 

Where they have been relying on the previously accepted approach to the anti-avoidance provision (typically in the context of condition C) to conclude that the rules are not in point, they should at the very least be aware that HMRC may now seek to challenge this. 

They might, however, also bear in mind the point made above that HMRC’s previous approach to condition B has now been found to be unduly restrictive; this may – in some cases at least – mean that whether or not condition C is met is less of a concern than was previously thought.

Andrew Constable, Tax Consultant, Moore Kingston Smith and member of the Tax Faculty’s Business Tax Committee