Taxation of partners: special capital arrangements

Update: The Court of Appeal has confirmed that the awards of special capital in HFFX were taxable as miscellaneous income, see "Special Capital arrangements and miscellaneous income". 

The First Tier Tribunal (FTT) decisions in HFFX v HMRC and Odey Asset Management v HMRC deal with the question whether amounts paid to the corporate member of a partnership as part of a "special capital scheme" should be treated as if they had been allocated to individual members of the partnership for the purposes of s.850 ITTOIA 2005 and therefore are taxable in the hands of the members as partnership profits or if such amounts should otherwise be taxable in the hands of those individual members.

The decisions on special capital are largely consistent with the relevant parts of the earlier BlueCrest decision, save that the Tribunal in the Odey case concluded that the awards would not have been taxable under the sale of occupational income provisions. In addition, discovery assessments issued to the individual members in connection with the miscellaneous income and sale of occupational income issues were upheld as being procedurally correct in both cases.

Odey case

Odey adopted a remuneration policy under which a proportion of Odey's profits which could otherwise have been allocated to and received by certain of the individual members in that year were subject to a "deferral" mechanism whereby those members could receive relevant amounts only over two to three years if certain conditions were satisfied. In each relevant tax year, Odey calculated and paid the relevant profit shares to a corporate member of Odey, Partners Special Capital Limited (PSCL), which was specifically set up to facilitate the operation of the plan and had no other purpose.

The Tribunal has held that the Odey members should not be subject to income tax on partnership profits in the year of allocation in respect of the 'shares' awarded to them in that year, nor in respect of sums received in later years on reallocation of special capital. However, the Tribunal held that the awards to the individual members were taxable as miscellaneous income in the year of receipt under s.687 ITTOIA 2005.

FTT decision

The Tribunal's judgment focused primarily on the first argument advanced by HMRC, concerning s.850 ITTOIA. HMRC advanced 4 arguments to support their position that the allocations to the corporate member should be taxed as partnership profits in the hands of the members in the year of allocation:

• HMRC stated that, on a purposive construction of s.850, viewing it in the scheme of the overall rules covering taxation of partnerships, the partnership members had the right to the 'individual shares' as a share of the profits of Odey in the years of allocation, as those shares were in fact allocated to the relevant members in that period as a 'deferred profit share' -- with the benefit of that share being received in stages over time.
• Further, HMRC went on to suggest that the individual shares being 'regarded' as allocated, on the basis that the corporate member effectively held the shares for the benefit of the members throughout, was sufficient to make the allocations to the members taxable in the year of allocation -- it being inevitable that they would ultimately receive the reallocation.
• Additionally, they argued that even if the relevant profits were, in fact, allocated to the corporate member, the individual shares were still considered rewards for the work of the members, and therefore remuneration taxable in the hands of the members regardless of whether the amounts were paid to the members, as they 'consented' to the redirection of the sums to the corporate member.
• Finally, that the deferred shares allocated to the corporate member were an 'unallocated reserve' from which awards would be made to members, rather than a right for the corporate member to share in the profits, on the basis that the corporate member was unable to deal with the sums transferred to it as it wished. On that basis, the sums allocated to that reserve should be divided amongst the members who enjoyed the profits of Odey in the same proportion as they had received the profit shares for the year in question.

The Tribunal stated that the purpose of s.850 was to tax partners and members only on profits to which they had a 'right' in the relevant period, a 'right' here being a legal entitlement to those profits against the other partners, from which they could therefore obtain value, whether physically received or otherwise at the time that the entitlement arises.

The Tribunal therefore turned to assess what (if any entitlement) the members had in the year of allocation of the individual shares -- concluding that, at the 'very most' the members had a contractual right to (i) require the relevant allocating committees to act in accordance with remuneration policy by exercising their discretionary powers to allocate profits, and make awards of individual shares; and (ii) require the corporate member to exercise in good faith discretion with regards to contributions and reallocations of special capital. Therefore, the members had no legal entitlement to either the individual share, or a reallocation of special capital, in the initial period of allocation. As such, there was no profit to which they had a 'right', in the year of allocation, on the basis of which the members could be taxed under s.850.

The Tribunal then turned to HMRC's three alternative arguments on this point and rejected them, with its conclusions on these arguments making up less than a page of the 171 page judgment.

HMRC's second argument was that the special capital received by the members was subject to tax as miscellaneous income under s.687 ITTOIA. Section 687 ITTOIA provides that income tax is charged on income 'from any source' that is not charged to income tax elsewhere in ITTOIA or other legislation. The Tribunal stated that the sums received by the members on the withdrawal of special capital which had been reallocated to them by the corporate member was income and was analogous to employment income. HMRC considered, and the Tribunal agreed, that the 'source' of the sums received by the members of the partnership was their continued activity as a member of the partnership and the ongoing provision of fund management services for the benefit of the partnership. There was found to be 'sufficient connection' between the source of payment and the members, despite there being no enforceable contractual obligation to provide the rewards (as per the previous Upper Tribunal decision in Spritebeam). Whilst the corporate member was under a fiduciary duty and a contractual obligation to reallocate the sums, this was unenforceable by the individual members in question -- however, this was insufficient to break the connection between the source of income and the recipient.  The fact that the sums were paid to the members through the special capital mechanism, rather than directly, did not remove the 'clear link' between the allocation of the shares and the activities carried out for the partnership.

The Tribunal characterised s.687 ITTOIA as a 'sweep-up provision' to 'capture income which ought to be taxable but which somehow lacks the characteristics for it to fall within the other specific provisions in the income tax code.'

Thirdly, HMRC argued that the special capital received by the members was subject to tax under s.773 to 778 ITA as relating to the sale of occupational income. On this issue, the Tribunal concluded that the Odey members were not subject to tax on the basis of ss.773 -- 778 ITA. The Tribunal first set down that there are three conditions that must be fulfilled in order for these provisions to apply:

• A - an individual must carry on an occupation wholly or partly in the UK-  such occupation being "any activities of a kind undertaken in a profession or vocation";
• B - arrangements are made to exploit the earning capacity of that individual by putting another person in a position to enjoy all or part of those income or receipts, or anything derived directly or indirectly from those income or receipts; and
• C - in those arrangements, a capital amount is obtained by the individual for that individual or another person.

There is a further requirement, relating to Condition B, which requires the 'main object' of the arrangements in question to be the avoidance or reduction of liability to income tax.

The Tribunal first addressed Condition B, noting that, were this not satisfied, there was no need to consider Conditions A or C provisions further. It concluded that, even where the Odey members could be considered to be carrying on activities undertaken in a profession or vocation (i.e. where Condition A was satisfied), there were no transactions or arrangements effected under which the members' earning capacity could be exploited by putting someone else in a position to enjoy them. This conclusion was reached as the individual members of the partnership did not have a legal entitlement to the shares which were 'awarded' to them in the year of allocation -- only the corporate member was so entitled. Instead the Tribunal concluded that the individual members' entitlement only crystallised when the decision was later made to reallocate them special capital. Therefore, at the time of allocation to the corporate member, that corporate member was not in a position to enjoy part or all of the income or receipts of the individual members -- instead, the corporate member was considered to have received its own income (in the form of a profit share), such income derived from its membership of the partnership. Condition B was therefore not satisfied.

Conditions A and C were considered briefly, with limited commentary provided, given the conclusions were no longer material. It was concluded that Condition A was satisfied, with the activities of all individual members akin to those of a profession -- with a 'modern and common sense' approach to be applied. The Tribunal noted that the 'the modern ordinary reasonable man would consider that the Members' activities are those of a profession given, in particular, the intellectual skill and special ability their activities evidently require'. On Condition C, it was noted that whilst there were evidently commercial reasons underlying the arrangements effected by the plan, one of the main objects behind the plan was the avoidance or reduction of tax. This motive was apparent from a memo prepared by Ernst and Young which had been put before the court, which confirmed that the Odey plan had been designed to achieve an overall reduction in the effective rate of tax on the profits.

Procedural issues

The amendment to the Odey partnership tax return for the 2011/12 year was found to be invalid. The Tribunal agreed with the case of Albermarle in order to confirm that the amendments made to that return under s.30B TMA were invalid, as s.30B TMA is not the appropriate provision for adjusting the allocation of income between members, and should be confined to adjustments to the total profits of the partnership. However, the Tribunal concluded that HMRC had demonstrated, to the 'usual standard of proof' that an officer had made a valid 'discovery' of an insufficiency of tax, for the purposes of ss.29 and 30B TMA, for the 2011/2012 tax period. Although the appellants had raised concerns that the 'discovery' of the insufficiency of tax that is required in order to issue a discovery assessment had lost its 'essential newness' (per the Upper Tribunal's decision in Tooth), this was not found to be the case based on the evidence available, and the 'discovery' was found to have taken place around the time that the discovery assessments were issued in 2016.

HFFX case

The HFFX case also concerned a special capital scheme and raised very similar issues to those in the Odey case.

On the primary argument concerning s.850 ITTOIA 2005, the Tribunal (as in Odey) allowed the LLP's appeal against the amendments to the partnership tax returns. The Tribunal did not consider that the profit sharing arrangements of HFFX LLP gave the individual members any entitlement to the profits allocated to the corporate member.

On the secondary argument that the Tribunal also concluded that awards to the individual members were taxable as miscellaneous income in the year of receipt under s.687 ITTOIA 2005. However, the analysis seems to differ slightly from the Odey decision. The Tribunal here concluded that even though the individual members had no right to require a reallocation of special capital, the reallocations that did take place did so in accordance with the provisions of the LLP deed. There was therefore a relevant relationship between the reallocations and the individuals' rights under the LLP deed such that there was a 'source' for the purpose of s.687 ITTOIA 2005.

On the tertiary argument that the awards to the individual members would also have been taxable under the sale of occupational income rules, the Tribunal reached the opposite conclusion to the Tribunal in Odey.  The HFFX members do not appear to have disputed that there were arrangements made to exploit the earning capacity of the individual members and the Tribunal held that it was clear that those making the decisions had a main object of reducing a liability to tax. The Tribunal also found that the activities of the individual members were of a kind undertaken in a profession.

Procedural matter

The amendment to the LLP return for 2011/12 fell away because of the decision on s.850 ITTOIA 2005. However, unlike the Odey decision, the Tribunal held that s.30B TMA 1970 does allow HMRC to amend a partnership statement to reallocate amounts of profit between members.

Comment

Despite being very clearly applicable to the facts and arrangements before the Tribunals, the decisions contain a number of aspects of potentially wider application.  Although the reasoning differed, the willingness of the Tribunals to conclude that the amounts in question represented miscellaneous income perhaps reflects an extension to the scope of amounts that fall within this residual charge, with a broad interpretation being applied to the identification of the source from which the income arises.  Whilst subsequent changes of law such as the mixed membership partnership rules and the disguised investment management rules are likely to limit the effect of this aspect of the decisions to partnerships and LLPs, in particular those operating in the asset management sector, it will be interesting to see whether this broad interpretation may be followed in other contexts.  On the procedural aspects, the differing decisions further underline a number of challenges in the application of tax administration rules to partnerships and LLPs, in particular on the thorny topic of HMRC's ability to raise discovery assessments outside the normal enquiry window.