Transactional Tax Lessons from M&A Market Trends

A number of areas of tax compliance take on elevated importance when a target business is structured as an LLP, particularly given HMRC's increasingly aggressive posture in several of these areas. We have highlighted a handful of these below. A range of LLP-specific warranties will be needed, alongside this additional due-diligence.

• The salaried members rules. These rules are intended to apply to LLP members where their relationship with the LLP is more akin to an employment relationship than to that of a partner in a traditional partnership. The rules seek to achieve this distinction through three conditions (A to C). If each condition is met in relation to a particular member, then they are treated as employed by the LLP for tax purposes: an important consequence of which is that compensation paid to the member from the LLP is subject to PAYE income tax and class 1 National Insurance contributions.
  
  There have been significant developments in the interpretation of the salaried members rules through the BlueCrest litigation, culminating in the Supreme Court's decision in July this year, which have heightened the risk of there being historical non-compliance. In particular, the Supreme Court has confirmed a narrow interpretation of the concept of "significant influence" under Condition B, which must derive from the mutual rights and duties conferred by the LLP's constitutional documents and which is likely to entail strategic influence over the affairs of the LLP as a whole – see Travers Smith's briefing. Whether historical compliance with the salaried members rules can be covered by W&I insurance will be case-specific. Insurers will typically require detailed coverage in due diligence.
  
  
• The miscellaneous income rules. These rules apply a residual charge to income tax on income not otherwise charged. Following a string of recent cases, HMRC is turning to these rules with increasing frequency and, in particular, is using them to target aggressive remuneration structures involving LLPs. The structures at risk often involve profits being allocated to a corporate member and then reallocated to individual members. Whilst primarily a risk for the relevant individual members, as opposed to the business itself, the rules should nonetheless be covered in due diligence so that prospective investors have visibility of fact patterns which could increase the risk of future HMRC enquiries (which could impact the business more broadly).

A range of structuring considerations arise on PE investments in LLPs which generally do not arise on investments into corporates. Some are short-term decision points for structuring the transaction itself; others are longer-term strategic questions about the post-completion operating model. We have summarised some particular examples below.

Short-term structuring considerations

• Business asset disposal relief (BADR). This is often front of mind for selling LLP members from the outset because, if applicable, it gives them access to a reduced capital gains tax rate (although the importance of BADR may lessen in future, following the increase of the BADR rate to 18% this year). Advisers should work with sellers early to identify a structure which preserves BADR eligibility, noting its interaction with other structuring options such as incorporation of the LLP.
  
  
• ECI withholding tax. US federal withholding tax applies to certain transfers of partnership interests unless an eligible certificate has been provided which confirms the partnership does not generate income which is effectively connected with a US trade or business (ECI). The default US classification of a UK LLP is as a body corporate, but this should be confirmed on a deal-by-deal basis (including that no "check-the-box" elections have been made for it to be treated as a partnership for US tax purposes).
  
  
• Stamp duty. Whilst instruments transferring interests in a partnership (including an LLP) which holds stock or marketable securities are technically within the scope of stamp duty, in practice there is often no imperative to get the instrument stamped in this context because this is not required in order to register the change in legal ownership (unlike with the transfer of shares in a UK company). Advisers should consider whether the fact that the unstamped instrument will be inadmissible as evidence in civil proceedings in the UK is acceptable. The impact of this can often be mitigated by using a separate deed of transfer aside from the main SPA, thereby isolating the stampable instrument away from the SPA (which is where the key contractual protections are). These considerations should substantially fall away in 2027, when the new "Securities Transfer Tax" regime is expected to come into effect. This is because transfers of partnership interests are expected to be outside the scope of the STT regime (other than in the case of certain tax avoidance arrangements).

Long-term structuring considerations

• Incorporation. Whether to "incorporate" the target LLP as part of the transaction or post-completion, so that the business is carried on through a corporate rather than an LLP, is a significant strategic decision which will be based on a range of commercial, compliance, and long-term investment considerations. A tax relief called "incorporation relief" enables this to be done on a tax neutral basis for individual LLP members, if it is structured as the transfer of the LLP's business as a going concern to a company in exchange for the issuance of shares. However, the PE transaction itself may represent the best opportunity to take this step (rather than pushing the decision down the track) because the corporate member through which the PE fund will invest will not be eligible for incorporation relief. The timing and sequencing of this step should also take into account any regulatory approvals which may be required, because incorporation can trigger additional approvals or undermine approvals already obtained.
  
  
• Salaried members rules (going forward). LLPs will often need to reassess and remodel their strategy for navigating the salaried members rules following PE investment. For example, the introduction of the PE fund's corporate member, and the governance rights vested in the fund through that corporate member, can make it more difficult for individual members to demonstrate "significant influence" under condition B. The transaction itself will often be the point in time at which the relevant conditions under the salaried members rules must be re-tested, which should be evidenced in contemporaneous transaction documents.
  
  
• Mixed member partnership rules. These anti-avoidance rules apply to partnerships with a mix of individual and corporate members, targeting the diversion of profits to corporate members in such a way which enables the individual members to benefit from those profits but with lower overall tax rates. If they apply, the relevant profits are deemed to be reallocated to the individual members for tax purposes. PE funds will typically invest in LLPs through a new corporate member and individual members may also participate in a management incentive plan through the acquisition of interests in the PE fund's investment holding structure. These fact patterns make the application of the mixed member partnership rules to PE structures highly nuanced and deserving of close consideration by advisers.

It is also worth noting in general that the deal dynamics on a PE investment in an LLP can differ markedly from an investment in a more conventional corporate structure. A large number of LLP members can slow decision-making processes; structuring gating items are more common, particularly given the interaction between tax and regulatory considerations; and individual members may be personally attached to existing partnership terms and relationships in a way that creates friction in negotiations.

• Extrication from seller's tax groups. On a carveout, the mechanical tax provisions required to extricate target entities from the seller's wider tax groups take on elevated importance. For example, if the target sub-group includes entities which are members of the seller's VAT group, or (for sufficiently large groups) its group for the purposes of Pillar Two (the OECD global minimum tax framework), the transaction documents will need to address not only the procedural steps of removing those entities from the relevant groups (where not automatic), but also the allocation of tax liabilities referable to those groups in relation to the pre- and post-completion periods. This requires careful drafting and close attention to the commercial allocation of risk — questions which may be less contentious on a whole-group buyout where there is no residual seller group with ongoing exposure.
  
  
• Integration and information sharing. Where the target sub-group has been dependent on the seller's wider group for tax compliance functions – a common feature on carveouts – a more extensive set of information-sharing provisions may be required in the SPA. The provisions dealing with responsibility for preparing and filing tax returns in respect of pre-completion and straddle periods may also need to lean more heavily on the seller group, reflecting the practical reality that the buyer will not have the information or institutional knowledge to discharge those obligations alone. Buyers and Sellers alike may need to push for more robust co-operation obligations and access rights, with appropriate deadlines and approval mechanisms.
  
  
• Cross-perimeter group relief. On a carveout, it may be possible — depending on the structure of the transaction — for both the seller group and the target sub-group to utilise excess losses to make group relief surrenders across the transaction perimeter to shelter pre-completion tax liabilities. This raises a number of negotiation points. For example, should one party be entitled to require the other to make such cross-perimeter surrenders in certain circumstances? If so, at what price – par value, discounted, or free? The answers will be closely tied to both the structure of the transaction (in terms of when the target sub-group is separated from the seller's group for group relief purposes  and what is legally possible in terms of group relief surrenders) and the pricing of the deal (in terms of what is commercially viable and consistent with the overall allocation of value).

While this remains a relatively nascent market, certain commercial expectations are beginning to harden.

• Deferred consideration. It is very common on GP-stakes deals for a significant proportion of consideration to be deferred, reflecting the fact that the value of the GP is tied in large part to key individuals who may be stepping back from the business or whose continued involvement the buyer wishes to incentivise.
  
  
• Earn-outs. Relatedly, earn-out structures tied to the performance of the GP are common, reflecting the inherent difficulties in pricing asset management businesses and the desire to align incentives.
  
  
• Future funding commitments. Depending on the nature of the strategic partnership, the stake investor may also be expected to fund future GP commitments in underlying funds or to invest directly in those funds.

From a tax perspective, these commercial expectations and structures give rise to important considerations around the characterisation of the consideration received by selling LLP members and of ongoing returns. For example, advisers will need to consider whether the way in which any deferred consideration or earnouts are structured result in capital or income treatment for selling LLP members and whether these structures limit the ability of selling LLP members to access BADR on their full proceeds.

While GP-stakes deals and more conventional PE investments in professional services businesses structured as LLPs share common ground in terms of some of the tax regimes engaged (e.g., the salaried members rules and the mixed member rules) there are significant differences in terms of commercial context.

• Investment returns strategy. The investment returns strategy of a typical PE fund is to hold long and generate gains on exit. On a GP-stakes deal, by contrast, there is often an expectation of mid-investment income through the various income streams which the manager generates, such as management fees and co-investment returns. 
  
  
• Deal dynamics and market practice. Notwithstanding the hardening of some market expectations on GP-stakes deals, the approach to key transaction documents and the deal process in general is much more well established in a conventional private equity context, even when the target is structured as an LLP. As a result, the term sheet stage of negotiations takes on additional importance on GP-stakes deals – this is the opportunity, for example, to set expectations in terms of the types of tax protections which will be required or offered.