Special Capital arrangements and miscellaneous income

The Supreme Court has dismissed the taxpayer's appeal in HMRC v HFFX LLP [2026] UKSC 17 against HMRC's decision to tax reallocations of Special Capital as miscellaneous income. The Court has rejected the argument that a taxpayer must have a legal right to receive the income for it to fall within this category. Furthermore, the Court rejected the contention that contractual arrangements providing, in principle, for complete discretion in relation to the allocation of Special Capital were in practice unfettered. Taken together, the contractual arrangements in the Partnership Deed, together with the reallocation process, provided the necessary “source” for the receipt of miscellaneous income in the hands of the individual members.

However, the Court did reject HMRC’s appeal that the allocations of profits to a corporate member should be treated as taxable profit shares of the individual partners. The arrangements in this case did not give the individual partners the necessary right to the profit shares in the relevant period and the arrangements were not subject to a Ramsay analysis on the particular facts of this case.

Background

The case concerns incentivisation arrangements put in place when GSA, an investment management business, transferred its high frequency foreign currency trading team to a limited liability partnership called HFFX LLP. HFFX's business was to second members of the team to GSA Capital Partners LLP, GSA's primary trading entity.

As a result of the restructuring, members of the team who were made members of HFFX became treated for tax purposes as self-employed partners rather than as employees. Under the arrangements with GSA their overall "pay-out" from the profits they earned for GSA was also increased, but a substantial proportion of it was deferred. The deferral was achieved via a "Capital Allocation Plan" (CAP), under which 50% of the pay-out that the team would otherwise have received was allocated to a corporate member of HFFX, GSA Member Ltd (GSAM). GSAM invested those amounts in funds managed by GSA.

On the first, second and third anniversaries of the allocation GSAM sold a third of the investments that it had acquired and contributed the net proceeds back to HFFX as "Special Capital". GSAM then decided to reallocate the Special Capital to individual members, who were able to withdraw it.

The hoped-for tax analysis was that GSAM would be taxed at corporation tax rates on the amounts allocated to it (rather than the higher income tax rates to which individual members would be subject if the profits were allocated to them) and that the subsequent reallocation of Special Capital would not give rise to tax for the individual members.

HMRC argued that the individuals were nevertheless taxable on the profits based on three arguments:
(a) The allocation of profits to GSAM should be considered an allocation to the individual partners under ITTOIA 2005 s.850
(b) The individuals were taxable on the reallocation of Special Capital to them as miscellaneous income under ITTOIA 2005 s.687
(c) The individuals were taxable on the reallocation of Special Capital to them as sales of occupational income under ITA 2007 Part 13 Chapter 4.

The FTT held against HMRC on (a), but upheld HMRC's assessment on the basis of (b) and (c). This decision was upheld by the Upper Tribunal and the individuals appealed to the Court of Appeal. HMRC accepted that the Court of Appeal decision in BlueCrest determined the s.850 issue against them, however HMRC reserved their right to seek permission to appeal to the Supreme Court on that issue. The Court of Appeal rejected the argument that a taxpayer must have a legal right to receive the income for it to fall within the charge to tax as miscellaneous income. Furthermore, the Court did not consider that contractual arrangements providing, in principle, for complete discretion in relation to the allocation of Special Capital were not in practice unfettered. Taken together, the contractual arrangements in the Partnership Deed, together with the reallocation process, gave rise to income in the hands of the individual members.

HMRC sought and were given permission to appeal the s.850 issue to the Supreme Court and the taxpayers appealed the decisions on miscellaneous income and sales of occupational income.

Decision of the Supreme Court: section 850

HMRC sought to tax the individual members in relation to the indicative allocations of Special Capital as received by them under ITTOIA 2005 s.850. Section 850 deals with profit-sharing arrangements, and provides that “for any period of account a partner’s share of a profit or loss of a trade carried on by a firm is determined for income tax purposes in accordance with the firm’s profit-sharing arrangements during that period.” HMRC argued that the profit shares that were allocated to GSAM were to be regarded as the individual members’ profit shares in accordance with HFFX’s “profit-sharing arrangements” and invited the Supreme Court to overrule the reasoning of the Court of Appeal in the earlier BlueCrest decision.

The Supreme Court held that it is implicit in s.850(1) (which states that for any period of account, a partner’s share of a profit or loss of a trade carried on by a firm is determined for income tax purposes “in accordance with the firm’s profit-sharing arrangements during that period,”) that it must be possible to tell from the profit-sharing arrangements in place in the firm in the relevant period whether any part of the profit or loss of the firm’s trading in that period is definitively attributable to the individual, and if so in what amount. This means that the arrangements have to include a contractual right for the partner to receive (or suffer) the part of the firm’s profit (or loss) which is to be treated as his/ her income under section 850 in that period. The reference in section 850 to rights of the partners to share in the profits “during that period” is to rights which exist during the relevant period of account.

Applying s.850, properly construed, to the present case meant that the profits of HFFX in the relevant period of account are translated into income of the individual members in that period of account only to the extent that they had a contractual right in that period to share in those profits (that is, a contractual right subsisting in that period to have a share of HFFX’s profits paid to them, even if the right was satisfied by a payment in fact made after the end of that period). The amounts in the indicative allocation letters were therefore not profit shares within the scope of s.850, because the individual member had no contractual right subsisting in the relevant period to receive that sum of money.

The Court entirely agreed with the analysis of Sir Launcelot Henderson in BlueCrest on this issue. HMRC essentially contended that this interpretation failed to give proper weight to the object and purpose of s.850, in accordance with the approach to statutory interpretation set out in Rossendale [2021] UKSC 16. According to HMRC, the object and purpose of s.850 is that members of the partnership should be taxed in accordance with the division of partnership profits as a matter of commercial reality, and the commercial reality here was that through the operation of the CAP and by application of the LLP Deed, the individual members received sums of money which reflected their contributions to the business of HFFX in the relevant period.

Whilst accepting that s.850 was not immune to a Ramsay analysis, the Court noted that this required that the statutory purpose of the relevant provision can be safely identified, and the wider meaning, when realistically applied to the facts, is needed to prevent the frustration of Parliament’s intention in enacting it. And that is where HMRC’s analysis in this case failed. The CAP arrangement in the present case, like the PIP arrangement in BlueCrest, had a valid commercial purpose. Unlike in the Ramsay case, there was no part of its operation which did not share in that purpose, so as to justify ignoring it. The purpose of the statutory regime is to be determined primarily by reference to the language used by Parliament, read in context. That purpose is to impose taxation on the “look-through” basis and in accordance with the contractual rights of the partners (including GSAM) applicable in the relevant period. HMRC’s “appeal to the general object and purpose of section 850 is pitched at a level which is too general and abstract, and is untethered from the language used by Parliament to impose the tax charge”.

Consequently, the Supreme Court has dismissed HMRC’s appeal in relation to s.850, and held that the profit shares that were allocated to GSAM were not to be regarded as individual members’ profit shares in accordance with HFFX’s profit-sharing arrangements.

Miscellaneous income

The taxpayers argued that the receipt of Special Capital did not fall within the scope of taxation as miscellaneous income under s.687. In particular, they argued that:

1. In order for there to be a source of income for s.687, the taxpayer must have a legal right to receive the income, whereas the individual members at no stage had a right to receive the Special Capital.
2. Another way of expressing this is that the taxpayer must "possess" the source. That requirement is said to be apparent from case law and legislation, and to cast light on what is meant by "source".
3. If wrong on those arguments and the existence of a "fettered" discretion exercised in the recipient's favour is sufficient, then the proper interpretation of the Partnership Deed was that the discretion to reallocate Special Capital is unfettered, in contrast to the position in BlueCrest where it was common ground that the Braganza principle applied.

In particular, the taxpayers pointed to the express terms of the agreements in this case which gave GSAM an absolute discretion over allocation of the Special Capital.

In contrast, HMRC argued that in these circumstances the deferred payments under the CAP are income not otherwise charged to tax and they have a source of a kind recognised under the current and previous tax codes, since it is clear where the payments come from, why they are made and that they are not purely voluntary or in the nature of a gift. They are paid by reason of the individual members’ rights under the CAP and the LLP Deed in combination with the exercise of discretion under the provisions of the LLP Deed. It was noted that Braganza principles applied in this case to give the individual members certain rights in relation to the exercise of discretion by GSAM, and hence a sufficient interest as to prevent the payments made from being a “mere voluntary gift”.

The Supreme Court has agreed with the Court of Appeal that the deferred payments fell within the charge to tax as miscellaneous income under s.687. In order for s.687 to apply there must be a relevant ‘source’ of the income in question. The word ‘source’ is to be given its natural meaning. Section 687 refers only to there being a source of the income, not a source that is possessed by the recipient of the income. A ‘source of income’ for the purpose of s.687 may exist so long as there is some relevant and sufficient factor connecting the income to the recipient. An activity may qualify as a source. There is no reason why the decision-making process in implementing the CAP and the LLP Deed, subject to the Braganza obligations (that a contractual discretion may be subject to an implied term that the discretion is exercised rationally), could not qualify as a relevant “source” for the purposes of s.687. Indeed, the Court held that, on a natural reading of that term, in its context, it is clear that the decisions to reallocate Special Capital were the source of the deferred income received by the individual members.

Consequently, the Court agreed with the Court of Appeal that the individual members’ rights under the LLP Deed, combined with decisions taken in their favour to reallocate Special Capital, amounted to a source from which the receipt of the Special Capital pursuant to those decisions was derived. The Special Capital received by the individual members under the CAP is therefore income charged to income tax under s.687.

Priority of Part 2

On appeal, the taxpayer sought to raise a new argument based on the provisions in ITTOIA s.575 which give priority to the charge under Part 2 (receipts of a trade etc) over Part 5 (including the charge under s.687). The taxpayer contended that HMRC was seeking to tax the income from a trade, and it is the trade of HFFX which is the source of the income; therefore it is that part which applies, excluding the operation of s.687.

The Supreme Court rejected this argument. “There is no relevant overlap between taxation of the profits of the underlying trading activity of HFFX and the taxation of the deferred remuneration element received by the individual members pursuant to the LLP Deed and the CAP arrangement so as to allow for the operation of section 575.” Indeed, the Court pointed out that the taxpayer’s submissions in relation to the issue arising in respect of s.850 rightly emphasised the fact that the deferred remuneration was distinct from the trading profits of the partnership.

Sales of occupational income

Having held against the taxpayers that the allocation of Special Capital amounted to miscellaneous income, it was unnecessary (and inappropriate) to determine the sales of occupational income issue. The Court indicated that it should not be taken as either endorsing (or disapproving) the reasoning of the Upper Tribunal in the present case or in BlueCrest. The point should be argued out afresh in a case in which it is determinative of the issue whether income tax should be paid.

Comment

The HFFX case deals with incentivisation schemes implemented before the introduction of the mixed-member partnership rules (which took effect in April 2014). Because the arrangements preceded these specific anti-avoidance rules, HMRC could not rely on the mixed-member legislation and instead argued that the "special capital" allocated to corporate members should still be taxed as the individuals' profit share. Whilst HMRC have been unsuccessful in arguing that a purposive interpretation of s.850 applied to the deferred and discretionary profit allocations under the CAP scheme in this case, they have been successful in arguing that those allocations were taxable as miscellaneous income.

Indeed, recent decisions on the scope of the miscellaneous income head of charge in cases such as BlueCrest and in Boston Consulting Group have consistently applied a wide interpretation to this head of charge and these are reinforced by the Supreme Court decision in HFFX. In particular, the fact that contractual arrangements may be drafted so that the discretion to allocate awards is, in principle, unfettered have not prevented the courts from reaching the conclusion that the provisions should be interpreted more restrictively and that such discretion is not, in practice, unlimited.