The salaried member rules in the investment management industry following BlueCrest: the $100m answer
The decision in the BlueCrest case, released last week (29 June 2022) is the first case to consider the application of the rules in the investment management context (or indeed any context relevant for those purposes).
The salaried member rules treat a member of a UK LLP as an employee for tax purposes if three conditions are met. To avoid being treated as an employee, a member must therefore fail at least one condition. Condition C relates to the level of capital contribution made to, and maintained by a member in the LLP and was not considered in the BlueCrest case.
BlueCrest considered Condition A (variable remuneration) and Condition B (significant influence) although it is its decision in relation to Condition B, which is most illuminating. The case also considered, albeit obiter, the SMR targeted anti-avoidance rule (TAAR) and the decision on that point will give taxpayers some pause for thought.
The stated purpose of the SMR, summarised at the start of the decision, frames the decision. At paragraph 5, the judgement states:
“They are intended to apply to those members of LLPs who are more like employees than partners in a traditional partnership. They are designed to ensure that LLP members who are, in effect, providing services on terms similar to employment are treated as employees for tax purposes”.
Condition A is met if at the relevant time it is reasonable to expect that at least 80% of the amount to be paid by an LLP over the reference period to an individual member is disguised salary. Disguised salary includes amounts that are variable but vary without reference to the overall amount of the profits or losses of the LLP, or are not, in practice, affected by the overall amount of those profits and losses.
Condition B is met if the mutual rights and duties of the members of the LLP do not give a member significant influence over the affairs of the LLP.
The members of the LLP considered in the BlueCrest case fell into three broad categories: portfolio managers (e.g. discretionary traders) and non-portfolio managers being infrastructure members (e.g. legal) and other front office members (e.g. researchers).
The case considered whether their bonuses, which were clearly variable, were disguised salary.
Without wishing to prejudge any appeal, it is not surprising that the court found that the bonus amounts were disguised salary, in that they were calculated based on individual performance without any meaningful reference to the overall profits of the LLP. Despite the bad taxpayer facts on Condition A in the BlueCrest case, the judgement contained some useful guidelines for those seeking to fail Condition A on better facts.
The case is most interesting on Condition B, where the decision firmly finds against HMRC's more recent application of this condition in practice to investment managers.
While the original HMRC guidance in relation to Condition B published in 2014 (including specifically in relation to investment managers) was sensible and helpful, this guidance has been deleted over time and replaced with guidance of little practical benefit. This watering down of the guidance has been accompanied by an enquiry approach from HMRC in relation to those managers seeking to rely on members failing Condition B, which can best be described as “hard line”. HMRC has taken to stating that it expects only a handful of individuals within an investment management LLP to fail condition B. We have been party to enquiries in relation to condition B that have gone on for years with HMRC demonstrating extreme reluctance to accept that individuals outside a core executive committee fail condition B. This is because of a position that was repeated by HMRC’s counsel in this case, and which was roundly rejected by the court that, when considering significant influence, it is only possible to consider managerial influence not financial influence, and that influence needs be over all of the affairs of the LLP generally not in relation to individual aspects or departments. Accordingly, in the BlueCrest case, HMRC asserted that only four members had significant influence.
The LLP in BlueCrest is a hedge fund sub-investment manager to a Jersey managed main investment manager whilst also providing back-office services to other group entities.
The LLP for the relevant period did not include the lead executive (and following their return of external investor money in 2016) main investor, Mike Platt.
As at 3 April 2014 there were 82 individual members of the LLP. 48 were portfolio managers, 16 were infrastructure members and 18 were other front office members.
Portfolio manager members were allocated a minimum of $100m capital and had discretion as to how to invest that capital subject to certain checks and balances. Their use of leverage meant that the exposure they ran for the funds and so the firm greatly exceeded that amount.
For portfolio managers, their bonus each year was calculated as a proportion of the profits earned on their book, less directly attributable costs. For non-portfolio managers their bonus was principally based on their performance and the market. While in all cases, the bonuses would be reduced if there was insufficient overall profits, that potential reduction was not a determining factor in the bonus amounts in practice.
In terms of governance, the board of the offshore manager had overall responsibility for the strategic direction, governance and oversight of the group which it delegated to a Group ExCo. This governance took place outside the LLP. Within the LLP, there was an LLP executive committee (UK ExCo) which had full operational responsibility for the LLP. UK ExCo created a number of committees to which it delegated specific responsibilities.
The court held (in a non-controversial but useful by way of reminder way) that the burden of proof of establishing that either Condition A or Condition B is not met rests with the taxpayer, with the standard of proof being the balance of probabilities. As will be seen, one of the issues for BlueCrest was not putting forward sufficient evidence that non-portfolio managers exercised significant influence as a matter of fact – most of the evidence centred on the portfolio managers.
In order for variable remuneration to not be treated as disguised salary, the amount must not be variable "without reference to the overall amount of the profit or losses of the limited liability partnership" and must be "in practice, affected by the overall amount of those profits or losses”.
The meaning of the “in practice” limb of this test has always felt relatively straightforward1 and the decision in the case confirms that interpretation. Our difficulty has always been what is meant by the first “without reference to” limb and here the case includes some useful pointers.
First, the decision summarised the requirement for variable remuneration to be treated as disguised salary as being remuneration that is “capable of variation without reference to the overall profits or losses” of the LLP. The decision went on to make the following points of interest:
- the expression “is variable, but is varied” does not require an actual variation to a preliminary allocation once the overall profits and losses of the LLP had been determined – all that is required is that the amount of variable remuneration is capable of variation with reference to the LLP's overall profits and losses;
- there is no need for the individual members’ remuneration to “track” the LLP’s overall profits and losses, i.e. there is no need for the bonus allocation of the individual members to increase if the overall profits and losses of the LLP increase;
- there must be a link between an individual’s variable allocation and the overall profits and losses of the LLP which is not simply that if there were fewer profits available for distribution, the amount would be lower. There must be a more concrete link, even though the threshold is a low one to achieve the "without reference to" condition;
- a member must be concerned whether or not the LLP has a good year in overall profits terms. The fact that a bonus amount takes into account the financial performance and future financial stability of a firm is not sufficient, nor is an adjustment mechanism if the variable amounts exceed accounting profit; and
- factors that might impact the overall profits of an LLP are irrelevant unless they influence how the actual profits are shared.
In applying these criteria, the court decided that the bonuses in this case were more akin to employee performance related bonuses than to the profit shares of a partner in a traditional firm sharing in the overall profits of the partnership. There was no evidence that, as a matter of fact, when the board came to consider the final discretionary allocations, it took into account the accounting profits of the LLP – the bonuses were in effect, “rubber stamped” on the basis that the overall profits were sufficient to cover the preliminary allocations.
The court decided that the portfolio managers’ bonuses were not sufficiently linked to the overall profits of the LLP. At paragraph 140, the judge concluded:
“There is no evidence that I have seen that the mechanism of computing the portfolio manager’s bonus is intended to establish the share of the overall profits of the partnership to which the individual is entitled any more than computing an employee’s bonus. Clearly there must be accounting profits to distribute, and equally clearly, if there are insufficient accounting profits to satisfy the bonuses, they will be abated in some way. But the mechanism does not, in terms, entitle a portfolio manager to share in a proportion of the overall partnership profits.”
The court made two key findings and set out a clear basis for applying Condition B.
The two key finding were that (i) there is no justification in limiting significant influence to managerial influence; and (ii) “affairs of the partnership” is not restricted to the affairs of the partnership generally but can be over an aspect of the affairs. In terms of guiding principle, the test to be applied was whether the individual would be a partner or an employee in a traditional partnership.
The judge stated at paragraph 173
“To my mind, it does this by taking the characteristics of a traditional partnership, and the ways in which a traditional partner contributes to that partnership, and sets them out in three conditions. Condition C looks at the capital structure of the LLP, and reflects what one would expect to be a contribution of capital by a partner in a traditional general partnership. Condition A considers the profit and loss arrangements and looks to align the way in which profits and losses are shared in a traditional partnership with those being shared by members of an LLP. And only where there is a variation to an individual member’s remuneration similar to that of a partner in a traditional general partnership does that member fall outside Condition A. Condition B looks at the ongoing contribution, from an operational perspective, which a partner would make to that traditional partnership’s business.”
The judge was formerly a partner and head of tax at Burges Salmon and this experience seemed to have weighed significantly on the decision. The shaping of the meaning of Condition B would clearly have resulted in Nigel Popperwell being found to have exercised significant influence in relation to Burges Salmon LLP when he was a member there. This was effectively stated at paragraph 177:
“Given, therefore, that HMRC accept that the purpose of salaried members legislation is to distinguish between activities of an individual who is effectively an employee, but operating under the guise of a member of an LLP, on the one hand, and the activities of a partner in a traditional partnership, on the other, I can see no justification to restricting significant influence to solely managerial influence. Financial and other influence demonstrated by a partner in a traditional firm colours my interpretation of this Condition. I agree with Mrs Hardy that it extends well beyond solely managerial influence, and into the other aspects of a partner’s activities in a traditional partnership.”
The court held that in applying Condition B, the starting point is what the LLP actually does (in the BlueCrest case, investment management and back-office services). The court held at paragraphs 181 to 183:
“To my mind, therefore, provided it can be shown that an individual member significantly influences either the investment activities, or the provision of back-office services, (or indeed both) undertaken by the appellant, then the member falls outside Condition B. The “affairs of the partnership” is a wide enough expression to encompass both of these activities…To my mind those operational decisions, and operational influence, at the level of the appellant fall squarely within the ambit of Condition B.”
The court continued at paragraphs 185 and 186:
“Turning first to the activities of the portfolio managers….They took key investment decisions on a daily basis, and their main if not sole purpose was to make money for the appellant so that the appellant, in turn, could make money in its capacity as a sub-investment manager. This was the core activity of the appellant….Furthermore, the evidence shows that, on an operational basis, they were involved in the sort of activities which a partner in a traditional partnership would have undertaken; namely: hiring and firing; identifying and then exploiting new business opportunities; bringing on junior members of staff; and managing counterparty relationships.”
The court held that it was not important that this influence was not exercised through particular committees – that it occurred as a matter of fact was what mattered.
The court concluded on this point in relation to portfolio managers at paragraph 194:
“In my judgment, each individual portfolio manager with a capital allocation of $100m does have significant influence over the affairs of the partnership. I say this from both a quantitative and qualitative perspective. … They will have made a significant impact on the financial performance of the appellant. From a qualitative point of view, as I have already said, those portfolio managers who were made up to be members of the LLP, and thus in the same position as a partner in a traditional partnership, would have already demonstrated the personal managerial and operational qualities to justify that elevation, and that they were capable of performing the tripartite role of a partner, namely generating work, doing the work, and, if necessary, supervising work. These roles are absolutely fundamental to the core activity of the sub-investment manager, namely to maximise its sub-investment fees, and the evidence shows that these individual portfolio managers demonstrated “managerial clout” in the discussions with other portfolio managers concerning managerial and operational issues which, if necessary, were then ratified by the Board or UK ExCo. Each such individual’s view was of significance, as was their influence.”
In relation to non-portfolio managers, the court determined that they did not have significant influence. This was not necessarily because they did not, but because it was not proven to the requisite standard that they did. In relation to such members participating in operational committees, the judge stated at paragraph 199:
“The members of the committee are clearly highly competent and experienced individuals. Although the appellant does need to be seen in the context of the Group (and in light of the overarching influence of Mike Platt, and that strategy is a matter for Group ExCo, in the main, rather than UK ExCo) there is still scope for significant influence to be exercised at the level of operational management and implementation of that strategy, by those managing the appellant. To my mind, effective operational implementation of a strategy is just as important as the strategy itself. And it certainly falls within the ambit of the affairs of the partnership.”
So while members performing operational roles can fail Condition B, the judge again viewed whether they did through a traditional partnership lens. The judge commented (at paragraph 200):
“The activities undertaken by members of that committee are not, in my experience, ones which would have necessarily been undertaken by partners in a traditional partnership. They could equally (and given the specialist nature of the operational activities discussed, for example risk, HR, finance, tax, perhaps more appropriately) be undertaken by employees who specialise in those areas. Indeed, this is my experience of professional services partnerships of any significant size. The executive committee is usually chaired by a partner but is attended by the heads of the internal operational units who are highly competent and experienced employees.”
Whilst not strictly necessary, the court considered the SMR TAAR. Section 863G ITTOIA 2005 provides that, in determining whether the SMR apply to an individual, “no regard is to be had to any arrangements the main purpose, or one of the main purposes, of which is to secure that [the rules] do not apply [to the individual]”.
In the BlueCrest case, in April 2014, in direct response to the introduction of the SMR, the operation of the bonus award arrangements were changed by board resolutions which sought to link the bonuses to total profits and to provide a mechanism for reducing bonuses when overall profits exceeded aggregate bonus allocation.
The court found that the main purpose or one of the main purposes of those resolutions was to secure that members that might otherwise be treated as employees, should not be so treated and that these resolutions should be disregarded.
The concern in relation to this part of the decision is not so much in relation to the facts of this case, but it begs the question as to what steps LLPs take to avoid the application of SMR need to be ignored in applying the rules. For example, if the LLP changes its capital contribution arrangements or profit allocation method to ensure a condition is failed, should these changes be ignored? It cannot be the case that the TAAR prevents an LLP making material changes to their terms and structures to avoid the rules. This is accepted by HMRC in their guidance at PM259200 where they state
“In applying this test (Targeted Anti-avoidance Rule (TAAR)), HMRC will take into account the policy intention underlying the legislation, which is to provide a series of tests that collectively encapsulate what it means to be operating in a typical partnership. A genuine and long-term restructuring that causes an individual to fail one or more of the conditions is not contrary to this policy aim.”
The BlueCrest changes effected by the board resolutions were clearly more in the nature of “window dressing” and the decisions can perhaps can be explained on that basis. As such, we do not think the finding in relation to 863G is as wide ranging as it might first appear.
The decision has not really changed our view in relation to Condition A. To fail Condition A, the variable allocation needs to be a top down allocation which starts with the overall profits of the LLP and, while other factors can influence the final allocation amount to an individual, a concrete link with the overall profits must be maintained.
In relation to Condition B, the decision (if upheld) materially broadens the availability of significant influence beyond HMRC’s current approach in practice. The case is arguably overly influenced by the judge’s career as a law firm partner but the constant link back to whether the individual is akin to a partner or employee in a traditional partnership is striking. On Condition B, the test is almost to ask whether the firm draws the line between member and employee at an appropriately senior level. If they do, and the significant influence of the member to the financial or operational aspects of the business can be evidenced, based on this decision, they will have significant influence and not be salaried members.
HMRC will be considering how to respond. We expect they will want to appeal the decision, likely focusing on a view that the decision is too dependent on the judge’s personal experience. HMRC will believe that the three SMR conditions were intended to set a higher threshold than the (pretty low) one for whether a partner in a partnership is respected as such. They are likely to argue that, in relation to Condition B, there is significance in the word “significant” that the judge missed by focusing on whether an individual functions like a partner in a traditional partnership. HMRC will be concerned about how the principles articulated by the case might apply more generally, especially to larger professional services LLPs that might have several hundred members. On appeal, we might expect the logical conclusion of this decision to be somewhat narrowed but we would still expect that to leave the application of Condition B more in line with HMRC’s original guidance and materially broader than their current approach in practice.
1 The purpose of this limb is to bring within the definition of disguised salary provisions that theoretically take variable remuneration outside the “without reference to” limb but then, in practice, remunerate a member without reference to the overall accounting profits.