Tax code breakers

Firms have been frantic pondering HMRC’s new LLP rules and found a way to comply, but not how the taxman intended

HM Revenue & Customs’ (HMRC) changes this month to the taxation of LLP members kicked off one of the biggest shake-ups in the UK legal market in years.

In response to HMRC’s new tax rules, a significant number of firms have made internal changes, according to research conducted by The Lawyer. Over the following pages we report the results of the study and analyse the significance of each question posed. We also attempt to track the likely next steps, as the change sweeping the UK is unlikely to have ended on 6 April.


Three weeks ago the deadline for complying with HMRC’s rules on the taxation of LLP members passed. For many firms aiming to meet this immovable target, bookending a surprisingly narrow timeframe, the past few weeks have been little short of an administrative nightmare.

HMRC fe image

The legislation may yet change as it passes through Parliament, but to all intents and purposes LLP members will now be taxed as employees unless they can establish they are, in the words of HMRC, “true partners”.

The Revenue has predicted it will raise £3bn from its tax changes which, it is thought, were primarily aimed at hedge funds. To many LLP members, both in law firms and in partnerships of other forms, this has been a revenue-raising exercise – nothing more, nothing less.

What is certain is that the rules mean the tax treatment of certain LLP members in the UK legal market will change unless conditions are met. In short, firms will now have to pay national insurance contributions (NIC) for any partners who, as of 6 April this year, are treated as employees for tax purposes after their status shifted from self-employed to PAYE.

As most people in the market will know by now, the way to prove a partner is a “true partner” – otherwise known as self-employed – is by failing at least one of three HMRC-imposed conditions, all of which have been designed to assess the extent to which the individual owns and runs the business.

In short, do these partners have a significant amount of capital at risk; do they have a major say in the running of the firm; and are they remunerated primarily with reference to the performance of the firm?

In trying to ensure that their partners pass the test of true partnership (or, conversely, fail at least one of the Revenue’s tests of employee status), firms have been working since Christmas to put in place a range of steps. These include: new remuneration structures; over-hauled profit-sharing arrangements; enhanced voting rights; and rewritten partnership agreements.

For many finance teams and firms more generally this has been an unlooked-for headache as they wrestle with what are widely regarded as rushed-through and woolly rules.

In an attempt to assess how widespread the effect of HMRC’s changes really is, last month The Lawyer surveyed UK law firms and asked them what impact, if any, there had been. 

The results are startling.

Q1  Has your firm implemented, or is it considering implementing, any changes as a result of HMRC’s new rules on LLPs?

Yes: 95%   No: 5%

The response speaks for itself. While the proportion of firms answering ‘yes’ would likely be significantly lower if a larger number had responded to the survey, and the fact that several firms are already structured in such a way that they do not need to make changes in light of HMRC’s new rules, this statistic underlines how widespread the impact of the changes has been.

“The fact that 95 per cent of your respondents are making or planning changes emphasises how the rules have a far-reaching effect on the ordinary commercial arrangements of typical law firms,” says Baker Tilly’s professional practices group chair George Bull.

The small number of firms that say they are not implementing any changes as a result of the new rules are likely to be those where all partners already have largely variable profit-sharing arrangements or few, if any, fixed-share partners.

Jennie Gubbins, senior partner at Trowers & Hamlins , which was one of the first firms to confirm it would be making changes as a result of HMRC’s new rules, says this result is, “not in any sense a surprise”.

“You have no choice unless your firm is structured in a certain way,” adds Gubbins. “These are a pretty radical set of changes. Before Christmas it was clear it was something we had to take seriously. There wasn’t much time. We got off the starting block quickly.”

Q2  Has your firm consulted partners about its response to HMRC’s rule changes?

Yes 87%  No 13%

Again, an overwhelming confirmation that HMRC’s rules have led to significant internal discussions at many firms.

Although the need to consult became apparent when the HMRC consultation began last summer it was only with the publication of details in December 2013 that any meaningful proposals could be put to partners (see Timeline of Change).

There is an interesting disparity here with Q1. Almost
95 per cent of firms seem to be considering implementing changes, but only 87 per cent say they have consulted with their partners.

“It is right to consult partners,” says Trowers’ Gubbins. “This is a big change that was likely to have an impact on individual partners.”

However, 87 per cent is still confirmation that management at most firms has been spending at least some of its time in the past few months consulting partners about the new rules.

Q3 If your firm is making changes, which condition are partners most likely to fail as a result?

This question amply confirms what had been widely believed for several months, that the primary route firms were likely to take to avoid paying additional NICs would be via injecting new capital from individual partners.

“We were anticipating the majority of firms seeking to fail Condition C and this has proved to be almost universally the case for larger firms (more than 10 partners),” says Farrer & Co partner Jonathan Haley. “We’ve also seen a number of firms entering into arrangements that are acknowledged to be relatively short term to meet the April deadline, but with an indication that a wider review of profit-sharing will follow in the medium term.”

In other words, there is only so much that could be done before the new tax year started, but these changes are acting as a catalyst for wider ranging structural reviews.

“Most firms have gone down the capital contribution route because this has provided the greatest certainty, being an arithmetical test,” says Smith & Williamson private client tax services partner Pamela Sayers. “The other routes have more subjectivity, relying on interpretation of phrases such as ‘reasonable to expect’ and ‘significant influence’.”

Since Christmas a consensus has grown that failing Condition C would offer most certainty and would also be the most manageable or practical route. The high level of new loan applications made by fixed-share partners to banks, thought to be in the thousands, confirms this.

Coinciding with this wave of applications was a period of intense lobbying from the legal market that resulted in HMRC effectively handing firms a three-month extension to July to put new capital in place, so long as a clear commitment to do so had been agreed by April.

The result has been a significant roster of firms choosing to go down the capital contributions route. They include: Eversheds , which issued a cash-call to its 164 fixed-share partners earlier this month; Hogan Lovells , which announced plans to ask its 65 fixed-share partners to inject between £60,000 and £100,000; and Addleshaw Goddard , which voted in favour of changing the partnership agreement on 20 March and asked 60 fixed-share partners to make a cash injection of just over 25 per cent of their salary (see ‘Firms’ actions to comply’, below).

Trowers ’ Gubbins outlines the thought process she and her partners went through, leading up to the decision to ask partners to inject capital.

“We have a number of categories of partner,” she says. “All full-equity partners fail Condition C. It was the non-equity partners in the UK, known here as participating partners, this was going to affect.”

Gubbins says this was because a certain amount of participating partners’ take is fixed while some of it (described as a bonus at Trowers) depends on the profits of the firm.

“The relative proportions between these weren’t sufficient to get over the line,” adds Gubbins. “In the three-month timeframe you couldn’t rip up everyone’s deal, years of practise and start afresh. It’s not practical to do this on the back of a tax-driven whim. You can’t just react to a new tax thing by changing the way you pay people.”

Gubbins’ criticisms of the HMRC-imposed tight timeframe is echoed by Baker Tilly’s Bull.

“As we have regularly observed, faced with having to change highly evolved partner compensation systems (Condition A), governance (Condition B) or capital contributions (Condition C), capital has clearly proved to be the most flexible figure,” says Bull. “Nevertheless, the sheer number of applications to banks made it necessary for HMRC to allow the three-month period of grace for capital contributions.”

Not every firm has gone down this route however. Indeed, the plethora of new models appearing in the UK legal market has meant there is also a divergence in the responses firms have made to HMRC’s rules. There is also still a high degree of confusion over
what will or will not satisfy the taxman’s requirements with regard to “pure partners”.

The following verbatim responses to this question from The Lawyer’s research reflects this:

“None of the above, as we are abandoning LLP and incorporating as a limited company.”

“We are not making changes as we operate as a limited company now, but not as a result of the changes.”

“We are proposing a hybrid of Conditions A and C, a variable share linked to profits, the share being determined by a small capital contribution.”

“The question is slightly misdirected in the context of our structure. As things stand, we have no clarity as to whether any of the three tests would be met without changes to our structure. Even with changes, a firm of our size (29 partners) would be unlikely to satisfy the influence test. Only one test requires to be satisfied. Having taken advice, our view is that the only test that can be readily applied is that of capital contribution. And even with that, there is still some doubt as to which elements of the primary share, secondary share and discretionary share of profits
our partners may be eligible for would be taken into account in determining ‘disguised’ salary.”


Q4  Is your firm making any changes to its profit-sharing system as a result of the LLP tax changes?

No 56%   Yes 44%

This question resulted in far more of a split opinion, suggesting a significant number of UK firms are overhauling their profit-sharing arrangements as a result of HMRC’s new rules.

This may reflect nothing more than provisions to pay interest on the new capital being introduced by partners. Alternatively, it may mean the tax changes have triggered wider reviews of the way firms organise themselves.

This is a surprising finding in that few firms would voluntarily change their profit-sharing arrangements in a rush.

The response to this question suggests that while most firms have chosen to go for Condition C, they are also looking at changing their profit-sharing arrangements in case the rules become more onerous and HMRC comes back for a second bite.

“Once a sizeable firm has gone down the C route the only other easily accessible way is Condition A,” says Smith & Williamsons’ Sayers. “For large firms Condition B, the significant influence test, is still largely unworkable.”

Q5  Is your firm making changes to its partnership agreement as a result of the new rules?

Yes 70%   No 30%

According to Baker Tilly’s Bull, almost any way a firm modifies its arrangements in response to the tax changes amendments to documents, including the LLP members’ agreement, will be necessary.

“Firms will have to get used to the idea that the taxman may routinely demand to see the LLP members’ agreement in a way which has not previously been the norm,” adds Bull.

Q6  Are there likely to be any changes to voting rights for any partners because of the tax changes?

No 67%   Yes 33%

Fewer firms have been looking at changing their profit-sharing arrangements, according to the responses to this question.

Each firm will, of course, have a different response to HMRC’s new rules but the replies to this question seem to confirm that the tests partners will look to fail depends to an extent on the firm in which they work.

For example, firms with 10 to 15 partners should generally have little trouble satisfying the significant influence test.

“For those firms there’s certainly an appetite to seek clearance from HMRC, albeit they can’t do that until the Finance Act receives Royal Assent in mid July,” says Sayers.

It is interesting to see that more firms say they are changing their voting rights than are looking to Condition B. This may suggest a tax prompt for changes partners may feel are long-overdue, argues Baker Tilly’s Bull.

Nervousness remains

The Lawyer’s research and the interviews conducted in relation to it suggest there is still nervousness in the market about HMRC’s new rules and future plans.

“While understanding the ‘evil’ the rule changes are directed at, their application to professional service practices have far wider ramifications affecting structure, business model and, most importantly, culture,” says Ledingham Chalmers chairman Jennifer Young. 

“It is difficult to identify any similar circumstances where such rule changes could possibly have such a wide impact on the day-to-day management and culture of a business. The tight timescales have resulted in a focus on ensuring compliance with the rules. We have hopefully achieved this. However, as a firm with an effective, transparent and collegiate structure, that has meant compromising on our strong culture of consultation with a primary focus on what is good for the business.”

The lack of certainty in the rules has not been helped by drafting that is widely regarded as having been woolly. Condition B, which relates to a partner’s influence in their firm, is seen as highly subjective. The revised HMRC guidance published on 27 March was seen as helpful but there is still uncertainty around A and B.

There is nervousness that HMRC may feel it is not raising the funds it wanted and will make its rules more stringent in future. For example, if the £3bn target is missed by some way, firms may find partners have to fail two of the three conditions to be considered true partners.

The grace period of three months to July this year for capital to be physically injected has been a relief. But because it is a forward-looking test in which partners will have to work out what the so-called “disguised remuneration” will be for the forthcoming tax year, firms may not know if they will fail the test or not.

Consequently, there could now be a protracted period of uncertainty while the new rules either bed in or are reassessed.

The Lawyer’s research, coupled with market soundings, suggests there is widespread disquiet with both the impact of the rules and the apparent accelerated way in which they were introduced.

“[The Lawyer’s] responses indicate the overall market sentiment that in the frustratingly short timeframe given for firms to address the issue, most have had to resort to failing Condition C by increasing capital as it is the least culturally challenging,” says Peter Gamson, head of the professional practices team at Grant Thornton . “The changes driven by this legislation will result in firms having much more engaged partners, which can only be a good thing over time. The great shame is that firms were given so little time to consider, discuss and then embrace the change.”

Farrer & Co partner Jonathan Haley says the potential NIC charge is too significant for any large firm to ignore. Consequently, if HMRC’s intention was to create a new generation of ‘real’ partners with capital at stake in their business, it will have achieved its goal.

“If it was – as originally suspected – simply a revenue-raising exercise it is going to be disappointed, certainly with the amount received from law firms,” argues Haley.

The situation is summed up by one of the respondents to the survey: “HMRC appears to be making some hurried changes to the tax regime for LLPs to score political points. We suspect it will be back to take another bite at this, so we don’t expect these changes to be the last.”


What do you think of the LLP tax changes?

“The changes to profit-sharing and the partnership agreement are largely administrative to reflect new requirements and reinforce existing arrangements. True equity partnerships like ours should not be significantly affected by the changes. Those firms that are not true equity partnerships and have large numbers of what are effectively employed lawyers with a partner badge have much more to do.”

It’s difficult to see how, in any reasonably sized firm that tries to deploy a merit-based remuneration system referenced to a partner’s performance, Conditions A and B can easily be failed, yet it’s not clear why this should mean partners are salaried.”

HMRC appears to be making some hurried changes to the tax regime for LLPs to score political points. We suspect they’ll be back to take another bite at this, so we don’t expect these changes to be the last.”

If there is one way to boost UK bank lending, this is surely it.”

Equity partners seem not to recognise new capital as having any value or carrying any risk. Fixed-shares feel used as a result.”

The changes appear to have been made with scant regard to the realities of practice in international partnerships. While it’s helpful to see HMRC is prepared to discuss the impact these changes might have on profit- and loss-sharing arrangements, its timetable for change is unnecessarily brief and has, in the case of my own international partnership, triggered an urgent need for consultation and change across multiple jurisdictions with differing tax and accounting ramifications.”

Timeline of change

July 2014  Finance Act receives Royal Assent.

5 July  Deadline for LLP members who have committed to providing capital in a bid to fail Condition C to introduce that capital.

6 Apr  Date of implementation of HMRC’s new rules. LLP members are taxed as employees unless they can establish they are, in the words of HMRC, “true partners”.

27 Mar  HMRC publishes more revised guidance. Again it amends each of the three conditions, but major changes stand.

21 Feb  HMRC publishes revised guidance. It amends each of the three conditions, but the major changes stand.

11 Feb 2014  House of Lords Economic Affairs Committee’s Finance Bill sub-committee publishes its report on the draft legislation. It calls on HMRC to defer LLP tax legislation until April 2015.

10 Dec  HMRC publishes detailed proposals to change the partnership tax regime, specifically targeting the so-called “disguised salary” of LLP members as well as partnerships with individual and company members.
Firms have three months to make changes, if necessary. HMRC also launches an informal consultation on the changes that will last until 4 February 2014.

Mar 2013  Chancellor George Osborne announces what he calls one of the “largest ever packages of tax avoidance and evasion measures”. The new measures include an overhaul of LLP structures. Shortly afterwards HMRC’s consultation on the tax treatment of LLP members begins.