Know your limit

In the past, LLPs have been exploited as tax-saving SPVs. But an artificial legal structure can have adverse consequences. John McDonnell QC reports

During the debate on the second reading of the Limited Liability Partnerships (LLP) Bill, the Department of Trade and Industry minister Kim Howells made it clear that the new legislation was only intended to meet the needs of professional or trading firms whose members were taking an active part in a firm’s business. He said: “Like partnerships, LLPs will consist of members who are involved in running the firm.”

However, it was reluctantly acknowledged from the outset that the legislation would sometimes be exploited in other ways. Later in the same speech, Howells said: “Although we believe that it is right to tax LLPs as partnerships, we’re aware that the tax treatment may allow scope for LLPs to be used when the primary or only attraction of LLP status is tax treatment.”

Howells was right. But experience suggests that those who use an LLP as a special purpose vehicle (SPV) may get their fingers burnt.

The idea of limited partnerships (LPs) has been around a long time – indeed, we have had the Limited Partnerships Act 1907 for nearly 100 years. The expression ‘limited partnership’ was clearly adopted in 1907 to match the expression ‘limited company’.

Why, then, has the Limited Liability Partnerships Act 2000 had such a significant impact? Why was so little made of the 1907 act? And why is it only now that the LLP has taken off?

The answer is: incorporation. Except for a few special cases, Parliament has always shied away from legislation that would enable a business to function under the umbrella of a limitation on liability. Thus, in order to be registered under the 1907 act, a firm has always had to have at least one “general partner” whose liability is unlimited. But a corporate vehicle belonging to members who are only under a limited obligation to contribute to its assets, no matter how large the liabilities it incurs, has been accepted as a concept since the days of chartered companies, and it has proved to be an entity which the public will do business with. LLPs fit that description.

The trouble with unincorporated LPs was illustrated by the predicament of the English partners of Ivan Boesky LP. Ivan Boesky LP was a Delaware LP formed under provisions similar to those of the 1907 act. The general partner was Ivan Boesky himself, who had an international reputation as a Wall Street financial wizard, until he was convicted of insider dealing. The limited partners were investor clients of Boesky, who were in effect placing large funds with him to manage. They included a number of major English institutions, which assumed that their status as limited partners would protect them from anything more extreme than losing their own investments.

Unfortunately for them, however, the LP was involved in the Guinness share price support operation, and the English limited partners were thus exposed to claims against them in England on the basis that they themselves were principals who participated directly as partners in the questioned trading on the London Stock Exchange. It was realised belatedly (despite initial incredulity by the New York lawyers) that the Delaware provision limiting the liability of the limited partners was almost certainly unenforceable in England. Because the LP was not a corporate entity, it was the partners who had been trading in the Guinness shares; and in terms of private international law, the provision limiting the liabilities of the limited partners was merely part of the lex fori and could have no effect outside Delaware itself. What had confused the New York lawyers was that the Delaware provision was given effect in other US states; but that was not under the universal principles governing conflicts of laws, but under the ‘full faith and credit’ provision in the United States Constitution.

So LPs of the 1907 variety are no use for any international business, since the limited partners would be unprotected in overseas jurisdictions; and in any case, there always has to be at least one unlimited partner.

What the 2000 act tries to do is to enable corporate entities to be formed for the purpose of carrying on a business that would otherwise be carried on by the members in the partnership, while enabling the members to preserve something recognisably akin to the traditional partnership relationship with one another. An LLP now has a personality separate from those of its members. The corporate entity does the trading and has unlimited liability for the obligations it incurs; but the members’ liabilities to contribute to the partnership assets in order to enable it to meet its liabilities will be limited by the terms of the partnership agreement.

For tax purposes, though, the members of an LLP are treated as carrying on the business collectively as individuals, and the separate legal identity of the LLP is largely ignored. That encourages the use of the structure instead of an ordinary company as an SPV for projects or trades where individual traders can qualify for tax incentives. One or more ‘partners’ will manage the project or trading while the other partners will merely be investors attracted to the structure by the availability of tax relief, which they can offset against tax due on income earned from quite different activities.

But as is always the case with artificial legal structures, there is great scope for confusion and disagreement within these SPVs, because the legal theory (that all the members are actively involved and have a relationship recognisable as that of partners) is divorced from the practical reality (which is that, for the majority of the members, the partnership is merely a tax-efficient mode of investment).

In one case going through the courts at the moment, an LLP was formed to be the SPV for investment in a project based on an invention, the investors being attracted by the prospect of claiming 100 per cent first year capital allowances for expenditure on information and communications technology. Fortunately for the inventor, he remained outside the LLP and is successfully exploiting the invention through his own company. But the LLP has fallen into disarray internally, and the case is likely to turn into a classic illustration of the difficulty of observing even the most minimal elements of the relationship of partners when the structure is used for a purpose for which it was never intended.

John McDonnell QC is head of chambers at 13 Old Square