The Supreme Court's decision, in HMRC v BlueCrest Capital Management (UK) LLP, has supported HMRC's narrow interpretation of "significant influence". For these purposes, a member's influence only counts if it derives from legal rights and duties and, to be significant, is likely to need to be strategic influence over the affairs of the LLP generally. On the positive side from a taxpayer perspective, although the ruling is very much in line with last year's Court of Appeal decision, it slightly softens its approach in some helpful regards.
BlueCrest: Supreme Court confirms narrow interpretation of “significant influence” exclusion from salaried members rules
Overview
Key takeaways
- The salaried members rules do not apply unless "Condition B" is met. The Court's decision confirms the reduced scope for taxpayers to argue that they have sufficient influence so that Condition B is not met.
- The process for assessing whether Condition B is met can be seen as having three stages: (i) to what extent does the relevant member's influence derive from legal rights and duties of the members? (ii) is the member's influence over the affairs of the LLP as a whole (likely to be strategic affairs)? and (iii) is their influence that derives from those rights and duties "significant"?
- Taxpayers will be disappointed that the Court took a narrow view of when influence is "significant" – focusing on decision-making at strategic level and holding that influence must be exerted over the affairs of the LLP generally. However, this seems to be in line with HMRC's longstanding view which had been firmly rejected by the lower tribunals before finding support in the Court of Appeal last year.
- To be significant, influence must have practical and commercial substance in the conduct of the LLP's affairs in the real world.
- It is not necessary for a member's rights and duties to be expressly set out in the LLP agreement provided they can be traced back to that agreement, e.g. influence can be derived from a delegated authority or arise by virtue of an appointment to a specific role in the LLP.
- Where, as is often the case, particular members (e.g. founders or a corporate member) hold veto or reserved voting powers, these do not necessarily act as a bar to significant influence for other members.
- Firms that rely on failing Condition B to prevent the salaried members rules applying should, in addition to revisiting their LLP agreements, reflect on whether their current payroll processes are aligned with the principles coming out of the Court's judgment.
Background
The salaried members rules
Under the salaried members rules, members of an LLP are treated as employees for tax purposes if three conditions (A to C) are all met. A key consequence of an individual being a salaried member is that employer NICs / social security become payable (by the LLP) on the profits allocated to them. The rate is currently 15% – the cost of the salaried member rules applying can, therefore, be substantial.
The three conditions, all of which must be met for the salaried members rules to apply, are broadly:
Condition A - it is reasonable to expect that at least 80% of the individual's total remuneration is "disguised salary" (basically, it is fixed or does not vary by reference to the LLP's overall profits or losses);
Condition B - the mutual rights and duties of the members of the LLP do not give the individual significant influence over the affairs of the partnership; and
Condition C - the individual's capital contribution to the LLP is less than 25% of their expected "disguised salary" for the tax year.
The Supreme Court considered both the first two conditions but focused on Condition B.
The facts of BlueCrest
BlueCrest was a UK LLP that provided investment management and certain back-office services.
Under the LLP agreement day-to-day management and control of the business and the affairs of the partnership was vested in the Board which delegated wide powers to an executive committee (ExCo). ExCo originally only had four members but a further 15 individuals were added when it became apparent that HMRC attached significance to membership of ExCo in the context of the dispute.
Some of BlueCrest's individual members were fund managers or traders (Portfolio Managers) and others carried out different functions (Non-Portfolio Managers). Most Portfolio Managers were given capital to invest on behalf of clients, with more senior members being given larger amounts. For Portfolio Managers, the discretionary allocation was a percentage of the profit they made on their individual portfolio less costs, whereas for the Non-Portfolio Managers the methodology for determining the allocation was more nebulous and less formulaic.
Both the First-tier Tribunal and Upper Tribunal had found that:
- the discretionary allocations were disguised salary for all the relevant members, such that Condition A was met; but
- HMRC was wrong in saying that "significant influence" required managerial influence over all the affairs of the LLP. Accordingly certain of the senior Portfolio Managers (those allocated at least $100m to invest and desk heads) had significant influence, such that the salaried members rules did not apply in relation to them.
However, in relation to Condition B, things took a very different turn in the Court of Appeal. It focused on the source of a member's influence, holding that the only influence that counts is that derived from legal rights and duties. In addition, it appeared to support HMRC's view that the scope of significant influence is limited to strategic influence over the affairs of the LLP generally.
BlueCrest appealed to the Supreme Court, whose judgment was handed down yesterday morning.
Decision
Significant influence – source of influence
Prior to the Court of Appeal decision, it had been HMRC's longstanding view that, when identifying whether a member has "significant influence", it is important to look at not only the written LLP agreement but also how the LLP operates in practice. Both parties, HMRC and BlueCrest, had been happy for this approach to be taken, and the lower tribunals had duly followed it.
However, the Court of Appeal focused on the wording of Condition B and held that influence is only relevant if it derives from, and has its source in, the legally enforceable mutual rights and duties of the members of the LLP as conferred by the statutory and contractual framework which governs its operation. Although the Court found that this sort of influence, which it referred to as "qualifying influence", is the only basis on which a member can meet Condition B, it considered that other influence ("non-qualifying influence"), including that of third parties, may be highly material in deciding whether a person's qualifying influence is "significant".
The Supreme Court has backed this approach, but has added some welcome colour. Qualifying influence is not limited to the four corners of the LLP agreement itself: influence that can be traced back to the LLP agreement (even if it cannot be found expressly on the face of the LLP agreement itself) also counts – e.g. influence derived from a delegated authority or arising by virtue of an appointment to a specific role in the LLP. In contrast, influence that cannot be traced back to an identifiable legal source is excluded – e.g. influence derived from a member's performance, financial contribution, personal qualities or relationships. The Supreme Court did acknowledge that non-qualifying influence remains relevant to the question of whether qualifying influence is "significant" (see below).
Significant influence – scope of influence
The Supreme Court has largely followed the Court of Appeal's view as to what scope influence must have to be "significant". The Supreme Court held that:
- influence is not the same as control. To have influence a member does not need to have the ability or power to control the LLP’s affairs or determine a particular course of action. It is sufficient that they have the right to participate in important decisions capable of affecting the affairs of the partnership or the way the affairs of the partnership are conducted, whether through meaningful voting or other rights.
- the influence must be exerted over the affairs of the partnership generally. The term "affairs of the partnership" has the widest meaning. It encompasses, but is not limited to, the LLP's business. Helpfully, the Court addressed the common situation where particular members (e.g. founders or a corporate member) hold veto or reserved voting powers. It confirmed that these do not necessarily act as a bar to significant influence for other members;
- the influence is likely to need to be at a strategic level. Although the Court expressly said that it was not excluding the possibility that non-strategic influence could be significant, it did not explore when that would be the case and indicated that it would be rare. It observed that "participation in decision-making at board or strategic and/or management level is likely to qualify, whereas day to day decision making on a purely operational level may well not qualify."; and
- the influence must have sufficient intensity. The requirement for influence to be significant adds some intensity to the strength of the influence. The Court agreed with the Court of Appeal's view that it connoted “a degree of influence … which has practical and commercial substance in the conduct of those affairs in the real world.”
This led the Supreme Court to reject BlueCrest’s argument that influence, derived from, or by virtue of, a delegated role on operational or day to day decisions in a particular part of the business, can count as significant. It is not enough just to perform a role which is financially important to the LLP.
Having agreed with the Court of Appeal, the Supreme Court did not interfere with its order to send the case back to the First-tier Tribunal for reconsideration using the correct legal principles.
Disguised Salary
The Supreme Court upheld the approach of the lower tribunals and Court of Appeal in rejecting BlueCrest's argument that the fact that discretionary allocations might have to be repaid if there were insufficient LLP profits (i.e. there was ultimately a "cap" on profit distributions) meant that they were sufficiently linked to the LLP's profitability to avoid being disguised salary.
Comment
Whilst many in the private capital industry will be disappointed by the Supreme Court's decision, the judgment provides some much needed clarity on the application of the significant influence condition.
The Supreme Court decision confirms the importance of rights and duties under the LLP agreement when assessing whether a member fails Condition B. If they have not already done so, we are likely to see firms revisiting their LLP agreements to ensure influence is properly embedded in them.
The Court's view that it is sufficient for influence to be ultimately traceable to the LLP agreement (without necessarily being express on the face of the document), is a welcome development and tempers a potentially stricter interpretation of the original Court of Appeal decision. For this reason, we may now see greater emphasis on embedding delegated authorities (e.g. the terms of reference for board/Mancom sub-committees) and the roles and responsibilities of specific offices (e.g. CFO), into the LLP agreement. From a private capital perspective, this approach may potentially allow additional scope for argument that significant influence occurs via governance arrangements prevalent within private capital managers (for example, in relation to sub-committees that derive their authority from the firm's main management committee).
The focus on strategic, top-level, influence will be welcomed by HMRC, and in many ways represents a return to HMRC's longstanding view of Condition B reflected in its published guidance. However, it largely closes the door to arguments (which found favour in the lower courts) that members with operational or financial influence (for example, by virtue of being a 'star' investment professional) have significant influence. As a practical matter, in many cases, this means that the firm's top constitutional body is likely to become a key area of focus and firms may wish to review who is appointed to that body, as well as its rights and responsibilities over the affairs of the LLP. This exercise may necessitate a wider review of the governance framework of LLPs, and in this regard careful consideration should be given to the wider legal and regulatory implications of any changes.
Many private capital managers are founder-led or part of a wider corporate group, with founders or a corporate member retaining veto rights or reserved powers over certain matters. The Court's confirmation that the existence of such reserved powers does not act as a bar to significant influence for other members is a welcome clarification.
For firms that have been relying on significant influence as their primary argument, in addition to revisiting their LLP agreements, these firms may need to reflect on whether their current payroll processes are aligned with the principles coming out of the Court's decision.
As regards Condition A of the salaried member rules, it is a shame that the Court did not take the opportunity to elaborate further on the meaning of variable pay. There is still therefore some uncertainty over the degree of link that is required to profitability.
