Crackdown on LLPs will catch 'reasonable' arrangements

THE PROPRIETY of accountants and other professionals was called into question at this year’s Liberal Democrat party conference when Danny Alexander announced yet another crackdown on the ability of partnerships and LLPs to manage their affairs in such a way as to minimise the tax payable. The use of service companies by professional firms was held up as an example of a loophole being exploited by the wealthiest in society.

To some extent, he had a point. Professional service firms have for many years been placing their assets (particularly staff) in wholly-owned subsidiaries which then supply those assets back to the firm, generally at cost plus an amount equal to the corporation tax payable by the service company.

Transfer pricing

A tax saving arises because it is assumed for tax purposes that the service company has charged a market price for providing the services (the transfer pricing adjustment). This results in corporation tax being levied on deemed taxable profits of the service company that would otherwise be taxed at higher income tax rates in the hands of the partners (who can claim a compensating reduction in their taxable profits).

The change in the rules, which is imminent, will eliminate the tax advantages of a service company by retaining the transfer pricing adjustment for the service company but disqualifying the firm from claiming the compensating adjustment. Thus, many firms are likely to have split accounting periods for tax purposes, being able to claim the tax advantage from commencement of their financial year to the effective date of the legislation, but being taxed thereafter under the new rules. Firms are being given little time to adjust their arrangements before the changes are implemented.

The question now arises: what will firms that have service companies do with them? Doing nothing is not an option: the combination of the retention of the transfer pricing adjustment and the elimination of the compensation adjustment results in real additional tax in the service company.

Service company options

Options include bringing back into the firm the assets transferred to the service company or to have the service company levy a market charge for provision of the services. In the latter case, actual profits taxable at corporation tax rates arise in the service company, which can then be paid as dividends to partners (resulting in a very small tax saving overall at current rates) or retained in the service company, requiring a way to be found to make available a share of that accumulating value to partners who retire from the firm.

With tax avoidance now seen by many as being as immoral as tax evasion, this move is unsurprising. After all, although there may be sound commercial reasons for a service company (such as ring-fencing risk, or where staff are provided to several members of a group), many firms would privately admit that the main reason for putting a service company in place was to reduce tax.

However, professional firms, which traditionally operate through LLPs, are also under attack from two additional directions.

Further proposed legislation will nullify the tax benefits to be derived from certain structures that use corporate partners to subject profits to corporation rather than income tax rates. It will be worse still for those firms that also have partners who do not have the characteristics HMRC considers necessary for partners. HMRC intends to levy employer’s national insurance contributions on the remuneration of such partners. It seems that only the most conservative of firms, which have taken few or no steps to minimise their tax bill, will avoid the potential disruption and expense involved in having to re-consider their structures and partnership arrangements.

A cumulative weight

When viewed in isolation, the changes to the various elements of partnership taxation are understandable. But the cumulative effect will be quite severe for some firms and the changes will inevitably catch perfectly reasonable commercial arrangements.

If there is a grievance for professional partnerships and LLPs, it is not that the government is seeking to tighten the rules, but rather that it seems to be attacking the efficiency and attractiveness of partnerships and LLPs as vehicles through which to do business, when logically the choice between a company, partnership or LLP should be broadly tax neutral. The increasing disparity between corporation tax rates (which are being aggressively reduced) and personal tax rates is at the root of the problem and seems unlikely to be addressed.

Although professionals seeking to reduce their tax rates below income tax rates are unlikely to attract sympathy and many firms can operate without a service company, corporate partners or a rank of junior partners, it is a great shame that it will be taxation, rather than commercial considerations such as the flexibility that partnerships and LLPs offer, that shapes and limits the structures of modern professional firms.

Tina Williams is a partner at Fox Williams