Limited Liability Partnerships Uses In Venture Capital Structures. January 2004

Transcription

1 January 2004

2 1 Introduction 1.1 The purpose of this memorandum is to introduce the UK limited liability partnership ( LLP ) as provided for in the Limited Liability Partnerships Act 2000 and to consider its role as a management vehicle in a standard limited partnership fund structure, as an alternative to using a management company. 1.2 The essential characteristics of LLPs (explored in greater detail below) are as follows: they are taxed as partnerships; broadly, they have the same disclosure and accounting requirements which apply to companies; they have the internal flexibility of a partnership; members each have limited liability; they are available to anyone carrying on a trade, profession or business in partnership; an LLP is a separate legal entity and a body corporate ; all members may take part in management, without losing limited liability status; and members are not employees. 1.3 When LLPs were introduced, the Government said that they had been developed to combine the organisational flexibility of partnerships with the benefits of limited liability, providing a modern alternative business structure which was expected to be particularly attractive to professional partnerships. Since then, around 6,500 LLPs have been registered and a number of private equity and venture capital houses have made use of them as management vehicles. 1

3 2 Relevance to private equity structures In a typical limited partnership fund structure, a company will be the general partner of the limited partnership fund, which will contract to receive management supplies from a management company. For the reasons set out below, private equity and venture capital houses (and especially smaller, independent houses) should consider whether it may be more tax efficient to use an LLP instead of a company to carry out the management function, by transferring the management role of existing or new funds from the management company to a new LLP. Executives would be members of the LLP, instead of being employed by the management company. As the liability of members of an LLP is limited, any additional liability risks for executives will generally be manageable. 3 Tax aspects The main tax consequences of using an LLP are as follows: (a) Tax Tr ansparency The fees earned by the management LLP will accrue directly to its members, in the same way as they would in an ordinary partnership. That compares to a management company, which pays tax on its profits. However, an LLP cannot be in a group with other companies for the purposes of loss relief and capital gains tax so that, for example, excess management expenses of a corporate general partner cannot be surrendered to it. (b) National Insurance 2 The national insurance position of members of an LLP is the same as that of partners in an ordinary partnership. The members themselves will pay class 2 and 4 national insurance contributions which will amount to approximately 2,200 a year, together with the 1% surcharge on profits introduced in As the members of an LLP are, strictly speaking, self-employed, there will be no obligation on the LLP to pay employer s national insurance contributions on such amounts, only on the amounts of the payments to employees of the LLP. A company would have to pay national insurance contributions at the rate of 12.8% on the value of the employees salary/benefits.

4 (c) Restricted Securities Regime: Part 7 ITEPA Schedule 22 of the Finance Act 2003 (now incorporated in Part 7 of ITEPA) introduced sweeping changes to the tax treatment of securities and interests in securities acquired by reason of employment. Where any such securities or interests in securities are acquired on or after 16 April 2003, and where any condition or restriction applies which would or could reduce the market value of those securities, they will fall within the new regime. When the restrictions fall away, or when the securities are sold, an income tax charge will arise based on market value, with a proportionate deduction depending on what the employee paid (if anything) to acquire the securities. There could also be PAYE and national insurance liabilities. This regime raises problems both for the management company structure and for a structure using an LLP. Normally, the executives would be employees of the management company. If they are also awarded shares in the company, such shares would almost certainly be employment related securities and may fall within the restricted securities regime. However it will not be in every case that shares will be awarded to the executives, and it may now be sensible, taking other commercial considerations into account, not to award shares.the new regime also creates two potential problems for members of an LLP. First, the term securities is extremely widely defined and includes units in a collective investment scheme, which term is also given a broad definition. It is potentially wide enough to cover any partnership but the Revenue have indicated that it would not cover one that is trading. Although the LLP may be carrying on a trading activity (for example, as manager of a fund), if it has a significant investment (and this could include its shareholding in the general partner company) this could bring it within the collective investment scheme definition and therefore interests in it would be securities for the purposes of the legislation. 3 Secondly, employment is also widely defined, including both former and prospective employments. Therefore if a group of existing employees operating through a management company re-forms and creates an LLP, they will probably acquire an employment related security (their interest in the LLP) by virtue of a former employment. Similarly, if a new joiner becomes a member of an LLP and at the same time it is expected that he will join the board of an investee company, he

5 may acquire his LLP interest in connection with that prospective employment (a non-executive directorship counts as employment for these purposes). It is possible to make an election to disapply the restricted securities regime. If there is the slightest possibility that the LLP itself could be a collective investment scheme as described above, and if the former or prospective employment condition could apply, the founder members of the LLP should make such an election, before the LLP acquires an interest in the general partner company. Making such an election could give rise to an income tax liability on joining the LLP but that liability will not be significant if the LLP has no real value at that time. (d) Carried Interest Where executives are employed by (or are directors of) a management company, there will always be an employment and it will be more difficult to ensure that carried interest is not within the restricted securities regime, especially for those who join after the fund has been raised. The entitlement of an LLP member to receive carried interest would not normally be an employment related security. However, if the members' interest in the LLP itself is an employment related security as described above, and carried interest holders (members of the LLP) obtain carried interest through their LLP membership, the carried interest is also deemed to be obtained from employment. Also, if any individual members of the LLP hold an office or employment with any company or other person connected with the LLP (for example, a general partner company or an investee company controlled by the fund) the opportunity for those LLP members to receive carried interest can be deemed to arise from that office or employment, and the result would be to bring the carried interest within the restricted securities regime. We do not believe that the new rules were intended to have this effect and discussions are taking place with the Inland Revenue to seek clarification. 4 It should be emphasised that an interest in an LLP will not in every case be regarded as an employment related security, and with careful structuring, this possibility can be avoided. Specific consideration should always be given to whether an election to disapply the regime should be made, in which case the possibility of adverse tax consequences is minimised, and the benefits of the LLP structure can apply without subjecting members to tax on deemed employment income.

6 (e) Personal service company rules The Inland Revenue impose income tax and national insurance charges in situations where an individual provides services through an intermediary company in circumstances where, in the absence of an intermediary, the individual would be an employee of the ultimate recipient of the services. The legislation itself seeks to apply the tax charges where an individual personally performs, or is under an obligation personally to perform, services for the purposes of a business carried on by another person. As the LLP (which will be separately regulated) is not providing the services of any particular individual performing the services, the Inland Revenue may accept that there will be no income tax or national insurance liabilities, because there is no intermediate entity to which the legislation could apply. However, careful structuring is required to ensure that the arrangement is not vulnerable to attack on these grounds. (f) Flexibility for Changes of Partnership Interest Using an LLP could give greater flexibility when changing the interests held by the members of the management entity. Where the entity is structured as a company, any award of shares or share options to a new executive joining as an employee could give rise to an income tax liability. If the management entity is an LLP, new joiners could immediately be given equity with no tax consequences, provided that the arrangement is structured in such a way that there is no possibility of the restricted securities regime applying. (g) Sale of shares in management company A sale of shares in a management company could potentially give rise to a tax charge on capital gains, although business asset taper relief would apply to any disposal, with the maximum rate of taper (an effective tax rate of 10% for a higher rate taxpayer) applying after only two years ownership. Sales of shares in a management company can be made tax-free by a trust established by non-residents or non-domiciliaries. (h) Sale of management business where LLP used as management vehicle Business asset taper would of course also apply to a disposal of a partnership share in a trading LLP. However, on a disposal of the entire management business, 5

7 there may not be any significant assets as the main asset would be the contract to manage the limited partnership. Gains made on the sale of an LLP interest by trusts set up by non-domiciliaries or non-residents as mentioned above will remain liable to capital gains tax because the trustees will be treated as carrying on a trade in the UK, but incorporation of the LLP prior to disposal of the business may improve the position (i) Stamp Duty The transfer of an interest in an LLP is liable to stamp duty at the relevant rate, that is, at 1%, 3% or 4%, depending on how much is paid for the transfer. Such interests are treated for stamp duty purposes as if they were interests in a general partnership, rather than as shares which would attract stamp duty of 0.5%. (j) Interest Relief Where new partners take out a loan to join the LLP (which has a trade), interest relief will be available. (k) Liquidation When an LLP ceases to trade, the tax transparency also ceases so that the LLP will be subject to corporation tax on its chargeable gains when amounts are realised on final dissolution. Management LLPs set up to manage a particular fund which are not intended to be used for other future funds may therefore fall foul of this rule; however, it is difficult to see exactly what assets the LLP would have at that stage, as it is a service entity, rather than providing goods and therefore having stock in trade assets. Even then, the Inland Revenue have said that they will not take the point unless the LLP is being wound up for tax avoidance reasons, or the period of winding up is protracted. (l) Pensions 6 Members of an LLP will have to make their own personal pension arrangements out of their proportionate share in the LLP s profits. The maximum contribution which can be made is 17.5% of net relevant earnings up to 99,000. Older members (36 plus) will be in a slightly better position, as they can contribute between 20% and 40%, depending on age.

8 (m) VAT Since an LLP is a body corporate, the LLP itself is the legal entity for VAT purposes. It can therefore be registered for VAT and, most importantly, in the typical limited partnership scenario, it can be VAT registered as a group with the general partner, provided that the control test is met, that is, either the LLP will have to have the general partner as its subsidiary, or the general partner would have to be a controlling partner in the LLP (it seems that the former scenario is much neater). 4 Summary There are both advantages and disadvantages to adopting an LLP structure, and anyone considering whether to go down this route would need to analyse all the relevant factors by reference to their own individual circumstances. The decision will be a finely-balanced one and will depend on a range of factors, including the extent to which the executives involved in management are to share in incentive arrangements. In many cases it will be advantageous to use an LLP as the management vehicle, because there will only be a risk that the restricted securities regime will apply if the structure falls into one of the specific traps, and it will generally be harder to avoid these traps using a management company structure. We will be happy to advise on the structure which will be most suitable and efficient for your particular case. SJ Berwin January 2004 For more information about any of the matters referred to in this bulletin, please call your usual point of contact at SJ Berwin, or Michael Tr ask or Mark Hainsworth in our Tax Department. Warning: This memorandum is intended as a general guide only and is not intended to offer professional advice. Specific advice should be taken before acting on any information contained in this memorandum. 7

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