Danger, tax change ahead

The deadline for HMRC’s new partnership tax rules is closing in. Is it too late for firms to plan a safe way through?

When was the last time you heard about a law firm, chock-full of ferociously competitive individuals, deliberately trying its hardest to fail a test?

It doesn’t happen often, that’s for sure. But the next two months are likely to see a bunch of UK 200 firms going all out to do just that.

The test in question is a tax-related gem helpfully set by HM Revenue & Customs (HMRC) on 10 December last year. That was the day it published its draft proposals – variously described by industry insiders as “surprising”, “more extreme than expected” and “drastic” – for changes to the partnership tax regime.


In short, the proposals mean that partners at firms that have converted to LLP status and who are currently salaried members and therefore self-employed for tax purposes, will become employees unless the firm can prove otherwise. The way to do that will be by failing one of HMRC’s three tests of employee status (see box).

If firms can’t fail one of these tests they will have to start paying employers’ national insurance contributions (NIC) for these individuals, adding thousands of pounds to their salary bill.

The most likely test firms will opt to fail appears to be Condition C, which would see the injection of new capital by the salaried members.

“Firms with tightly held equity and lots of salaried partners with fixed shares will be digging out the deals to see how many people are on the wrong side of the line and what it will cost the firm,” says partnership expert Richard Turnor of Maurice Turnor Gardner (MTG).

Although the changes were first trailed in the Budget last year it is only since the start of this year that management teams have begun wrestling with their response in earnest. In case you hadn’t noticed, time is running out. 

You what?

It gets worse. Numerous tax specialists say finding a solution to the problem has been made harder by HMRC’s guidance being relatively vague.

“Tax legislation is always woolly,” quips one.

The response to HMRC’s proposals late last year from several accountancy specialists was scathing. Typical was Baker Tilly, where head of the professional practices group George Bull commented: “We are disappointed that HMRC has ignored many of our recommendations, in particular those that addressed commercial concerns. By introducing the changes on 6 April  rather than allowing firms to implement the changes in the first accounting period following 6 April,  these changes will result in unnecessary complexities for firms. These could have been avoided.”

Now that the shock has subsided, the issue for firms is how they meet the challenge created by the changes.

Since 2000 an increasing number of UK firms have converted to LLP status. Indeed, among The Lawyer’s UK 200, at least 162 firms are now LLPs. One of the quirks of LLP conversion – an incidental benefit that quite possibly persuaded some firms the process was worth going through – was the tax saving they gained by a senior associate becoming a partner and therefore self-employed.

HMRC’s line now, despite having had no problem for years with the former classification of salaried members as self-employed, is that these partners are effectively disguised employees who have been given a fixed share of profits as a retention tool and staging post on the journey to full equity status.

As Turnor puts it, “lots of law firms used to have salaried partners as either a probationary period or an elephant’s graveyard”.

With anti-tax avoidance measures the flavour of the month, HMRC is clamping down. As a result, firms will be liable for stumping up the NIC on these partners unless, by 6 April, they overhaul their profit-sharing arrangements.

Or, to put it another way, firms may need to take their remuneration schemes, which in many cases have taken years to evolve, scrap them and then rebuild them in a matter of weeks.

“There are three Conditions set by the Revenue and the third [Condition C] is the most likely to engineer a fail,” says Louis Baker, the lead partnership tax partner at Crowe Clark Whitehill. “Firms have a two-month window to reconsider how they share profits. And this is not something you do in a rush.”

What appears to be unfolding has all the hallmarks of a nightmare for firms wrestling with a distinct lack of certainty and concerns over whether they will fall foul of the new rules.

The question is – are you caught? And if you are, what are you doing about it?


At a breakfast seminar at Farrer & Co on 8 January, about 30 LLPs, many of them law firms along with hedge funds and other businesses, discussed the issues raised by
HMRC’s proposals. Much of the chat centred on the option of attempting to fail Condition C.

As Farrers partner Jonathan Haley (who hosted the meeting along with Baker, who covered the accounting aspects and Dave Waters, executive director at Coutts, who provided the banks’ viewpoint), says, it was far from the only topic discussed.

“Clearly everyone was interested in and aware of the issue, although some have made more progress than others,” says Haley. “Some firms have been making plans since the autumn. The majority recognise that securing buy-in from their salaried partners is important and plan to do that via consultation. It’s fair to say the significant majority seem to be looking at failing Condition C as the solution.”

It is a route that could not only head off the pesky NIC charge, but also secure firms a tasty windfall to the tune of several million pounds (see table, page 18). It could also effectively herald a process of cashcalls at numerous firms across the UK over the next two months.

Few firms are willing to go on record as to the action they are likely to take or the extent to which they would be affected, but in some cases the consultation with salaried members has already begun.

Earlier this month DWF and Weightmans, two firms with proportionately small numbers of full equity partners, became the first to confirm they are reviewing the way they define fixed-share members as a result of the proposed changes.

The managing partner of one top 50 firm says he and his partners are in a process that will involve the finance team “looking at what’s necessary under the legislation, what’s fair and what the knock-ons are. Then we’ll put it out to the partners”.

Other firms that have broken cover include Trowers & Hamlins, Kennedys and DAC Beachcroft, the latter confirming the changes should not have any impact as it already treats all of its salaried partners as employees and pays their NIC.


Trowers’ senior partner Jennie Gubbins says she contacted all of the firm’s so-called ‘participating partners’ before Christmas and held two meetings with them this month, while at Kennedys senior partner Nick Thomas says the firm has already been in consultation with its 60 or so B, or fixed-share, equity partners.

“It’s not about ‘Oh God, more money’, it’s about ‘Okay, I’m taking a slightly bigger risk so what more information am I entitled to receive so I feel I have control of that risk?’,” says Thomas. “It shouldn’t be about money if you’re sensible and have an adult conversation about it.”

Elsewhere, at the top end of the market, Clifford Chance claims the new rules are “not expected to have any material impact”.

The magic circle firm would not comment further but the reason is likely to be that the vast majority of Clifford Chance’s non-equity partners are remunerated on a significantly variable basis, a model that will be replicated at other global elite firms and several of the silver circle or larger City firms.

“Most of these firms either have a full lockstep model or a variable remuneration policy,” says one industry source. “It’s the second tier and below where I’d expect to see the most impact.”

Avoiding trouble

For those firms that are affected and thinking of plumping for failing Condition C, here’s another headache, courtesy of one of the UK’s top tax barristers.

“There are a number of ways you can seek to circumvent the conditions and C is one,” says Jolyon Maugham, a tax barrister at Dever-eux Chambers. “But any firm that thinks it can rush into arrangements prior to 6 April that would avoid the application of NIC is being optimistic.” (See box, page 19.)

In short, Maugham believes there is a chance HMRC will view any sudden injection of capital as tax avoidance.

“If a tribunal is contemplating a claim from the Revenue over employers’ NIC and the argument is that the firm has required salaried partners to stump up capital, and they were imposed in the interregnum [between the publication of HMRC’s proposals and 6 April], it’s going to be pretty strongly suspected that the main purpose was avoidance,” argues Maugham. “And it would be rejected.”

MTG senior associate Corinne Staves offers another word of warning to any firm considering failing Condition C. She points out that the capital injection route could include “some hidden bear traps”.

“Fixed-share partners will be affected more than others and that is likely to be either a smaller group of partners or partners who are younger than the majority,” says Staves. “So it’s possible we will see the majority of partners introduce changes ‘in the interests of the whole’, which opens the door to an age discrimination claim challenging the decision after the event if any of those younger partners feels disgruntled. So good process is vital to avoid this.”

While it seems likely there will be a wide range of effects on firms, with some needing to take little or no action and some requiring a major overhaul, there is at least the possibility that several firms could receive a major influx of funds. And a windfall may not be a bad thing either for the firm or in the eyes of the regulator.

“The SRA is keen to make sure firms are monitoring their financial stability, so it will help to show firms’ financial stability is robust,” adds Staves.

“It could be helpful from a working capital finance point of view,” agrees Baker. “But a firm would need to ask if it needs it. And the banks would not want to increase their exposure, so if they lent a few million to finance partners’ capital contributions they’d reduce the firm’s overdraft at the same time.”

Peter Noyce, head of professional services and partner at accountants Menzies, points out that the legal sector is not known for retaining capital, as surplus funds are generally taken out as quickly as working capital allows.

“This could be the turning point, where partners’ capital is matched against long-term assets or perhaps even investment in technology to improve efficiency,” says Noyce. “It’s possible that the windfall will simply result in other partners’ current accounts being repaid quicker, but this would only be a short-sighted personal benefit. Firms are better off seizing the opportunity and investing capital in long-term projects and efficiencies.”


It would also kickstart the succession process and get people used to introducing equity into their firms, adds Noyce.

If swathes of salaried members suddenly have to put in capital, then in effect all they are doing is accelerating a process that would have happened anyway. It will not help pay the mortgage or the school fees, but it might just soften the blow. Possibly.

“It’s not a totally unexpected position,” says Farrers’ Haley. “Career track partners will have been expecting to inject cash. It’s just that it might come a bit earlier than they thought.

Bean counters’ cost

The tax proposals have created a major headache for finance teams across the land as year-end approaches. As Baker says, the proposals also look to be something of a retrograde step in the context of how most firms remunerate their partners these days.

“[HMRC is] harking back to the traditional view of law firm partnership, ie that all the partners share in the profit,” says Baker. “It’s the traditional lockstep view they’ve taken, rather than the merit-based system that most firms have moved towards over the past 20 years. Firms may see this as unhelpful at a time when they’re trying to drive financial performance with incentives”.

The situation seems to lack clarity but what is clear is that the approach firms take will vary enormously. Which brings us to another quirk of the new system, one that should also make interpreting the 2013/14 financial results more of a challenge.

“A partner taxed as self-employed who decides not to go forward with this and drops back into PAYE will trigger an earlier tax payment,” says Haley, confirming that the changes will make firms’ accounts for the period trickier to interpret or, as he puts it, “messier”.

“It makes me glad I’m not an accountant,” he concludes.

Partner or employee: the three conditions

HMRC’s changes are part of a wider review of certain parts of the partnership rules announced in the Budget 2013. A consultation document (Partnerships: A Review of Two Aspects of the Tax Rules) was published on 20 May 2013 and the consultation closed on 9 August that year.

Under the draft legislation, an LLP member will be treated as an employee for tax purposes if they work on terms that are “tantamount to employment”.

Legislation will be introduced in the Finance Bill 2014 to change the treatment of a salaried member of an LLP from that of a partner to that of an employee for both income and corporation tax purposes. To determine whether 

a partner is in fact an employee, all the following conditions need to be met:

To circumvent this, firms will need to ensure they fail at least one of the tests. As Louis Baker of Crowe Clark Whitehill argues, “there are three conditions set by the Revenue and the third is the most likely to engineer a fail”.

 Condition A: At least 80 per cent of their remuneration is fixed or, if variable, the variable element does not relate to the profits of the firm as a whole. The total of their remuneration that is not a share of the variable profit of the firm is their ‘disguised salary’ (see C below)

Condition B: The individual member does not directly have significant influence over the affairs of 

the LLP

Condition C: The individual’s capital is less than 25 per cent of their annual disguised salary. 

The barrister’s view

Jolyon Maugham, a tax barrister at Devereux Chambers and the sole specialist tax counsel on the Attorney General’s ‘A’ panel of junior counsel to the Crown is among the rare voices claiming that firms should ditch any attempt to fail Condition C and 

opt for taking “a bold view” of Condition B, which relates to management influence.

While Maugham agrees that very few large LLPs of 30 or more members would fail to satisfy Condition B, a court or tribunal might be sympathetic to the argument that where a salaried member possesses the same voting rights as a full equity partner, Condition B should be treated as not satisfied, even though individual salaried members could not be said to be exercising significant influence over the affairs of the partnership. In other words, condition B could be a potential get-out.

“Section 863c sub 4 ought to be critical to your approach as a firm,” says Maugham, referring to one of the proposed new sections of the Income Tax (Trading and Other Income) Act 2005. “It may be that under your partnership deed you don’t have a problem in the first place. It seems to me that, given what us tax lawyers call the TAAR (the targeted anti-avoidance rule) in section 863c, it will be considerably more difficult than might first appear to make changes to the structure of one’s LLP to dodge the charge to tax under section 863a.

“Given that starting point, it seems to me, LLPs will want to take a really good look at whether they are caught in the first place. One provision which may well have been neglected in an LLP’s analysis of whether its arrangements are caught is Condition B. Read literally, a salaried partner will always satisfy Condition B. But I don’t think option B can be read literally. I think that where a salaried partner has the same voting rights as an ‘equity’ partner, the tax tribunal is likely to hold that Condition B is not satisfied.”

On the other hand Maugham concedes that if it is going to be satisfied, a firm will need to plan quite carefully how they deal with the applications of these provisions.

“You may need to accept that you will take something of a hit on the chin,” he adds.

To that end Maugham issues a word of caution about any firm that relies on Condition C, ie an injection of salaried member capital.

“On Condition C, if LLPs are planning to ask salaried partners to put money in, and their expectation was that they would not be caught by section 863a, they are likely to be mistaken,” argues Maugham. “Section 863c – the so-called TAAR – catches arrangements (such as this) where the main purpose of the arrangements is to ensure that section 863a does not apply. Where you made changes to your rules on capital contributions in a hurry, before the advent of section 863a, you might have an uphill battle to persuade a tax tribunal that the purpose of those changes was otherwise than to seek to avoid being hit by section 863a.”

The banker’s view

Barclays’ head of professional services Tom Wood confirms that his team is already seeing firms display significant interest in increasing their borrowings.

“The majority of firms are absolutely aware that they need to do something,” says Wood. “That potentially means additional capital requirements, raising capital for salaried partners and making them equity partner status. The 25 per cent hurdle is the test we’re seeing most firms talk to us about. We’ll look at what the funds are being used for. Obviously it’s to give these partners equity in the firm but then what? Paying down on balance sheet debt? Financing strategic growth? We wouldn’t necessarily be comfortable with it being used to just pay out the more senior partners.

“Another issue is that in these cases we’d be looking at more junior fee-earners, so is their personal covenant as strong as a senior equity partner’s?”

On the issue of increased exposure by the bank to a particular firm, Wood says they would look at its on and off balance sheet lending.

“If it’s lending to salaried partners for their capital, that debt would sit off balance sheet. The resulting cash will come into the firm on balance sheet, so then the question is what is it going to be used for? This should not be an exercise to further leverage a firm.”

As for the window of time to arrange lending, Wood agrees it looks short.

“We expected something to come along but usually you’d have a bit more time. If a firm is going down the capital borrowing route they need to move quickly. You’d expect banks to have a greater influx of requests than normal so processing this might take longer than normal. The appetite will be strong.”