Property hybrid structure – Introduction
In Greek mythology, the Chimera was a monstrous fire-breathing hybrid creature with the head and body of a lion, the head of a goat emerging from its back, and the tail of a snake.
It was the offspring of Typhon, a monstrous giant, and Echidna, a half-woman, half-snake creature.
So, an impressive pedigree.
Spotlight 63
Towards the end of the year, HMRC published Spotlight 63 which relates to the hybrid partnership structure offered by a particular property tax focused outfit.
Is the ‘hybrid partnership’ more chimera than hybrid?
The Chimera terrorized the land of Lycia until it was slain by the hero Bellerophon, who rode the winged horse Pegasus to defeat it.
So, have HMRC assumed the role of Bellerphone… with Spotlight 63 their equivalent of Pegasus?
Indeed, it is perhaps not a surprise that HMRC has taken action to against the planning. Not just the way in which it was marketed, but also that the relevant promoter has made some unique, and rather bold, claims in its marketing material.
These, at best, seem somewhat ‘muddled’.
However, of course, they were not the only ones offering similar structures (though seemingly the only ones making the ‘boldest’ of tax saving claims).
Broadly speaking, these structures involve the transfer of an interest in properties / property business from individual names to an LLP. The members of the LLP being the individuals and a company – either formed for that special purpose or an existing company used by the individual already.
More generally, I have seen two distinct structures emerge over the years where either:
- The properties remain in the name of the individual (which I believe is the case in the spotlighted cases); or
- The properties are transferred to the LLP (which might be via full legal conveyance or simply transferring the beneficial ownership)
I will point out where the treatment might differ as a result of which of these two approaches it taken.
The Spotlight begins as follows:
HMRC is aware of a scheme being marketed as a tax planning option available to individual property landlords to structure their property business. Sometimes referred to as a hybrid business model, the arrangement claims to…
It is clear that this refers to a particular scheme and one cannot presume that the analysis applies to any mixed partnership structure (although there are common features and issues).
The Spotlight raises some issues relating to the scheme. We’ll look at them one by one.
As a point of interest, I also believe I have a copy of the opinion that was used by the provider of the structure in question. I will refer to this where relevant.
Please note, this article is for discussion purposes only and is perhaps closer to a stream of consciousness than tax advice. So don’t rely on it. Capiche?
Mixed Partnership rules
Introduction
Spotlight 63 implies that HMRC believes that the mixed partnership rules apply to the relevant provider’s structure:
“mixed member partnership legislation contained in Income Tax (Trading and Other Income) Act 2005, S850C and S850D, which details how excess profits of a corporate member of an LLP are reallocated to individual members”
Outline of the rules
The rules apply where we have an individual Partner (I) and a Corporate Partner (C) and C receives a profit share in the partnership.
It is also necessary for either of the following to apply:
- Condition X: C’s share includes amounts representing I’s deferred profit; or
- Condition Y: C’s share includes an amount exceeding something called NPI – which could be described as a fair return
Condition X is as follows:
“850C(2) Condition X is that it is reasonable to suppose that–
(a)amounts representing Aʼs deferred profit (see subsection (8)) are included in Bʼs profit share, and
(b)in consequence, both Aʼs profit share and the relevant tax amount (see subsection (9)) are lower than they would otherwise have been.”
I would aver that it is unlikely, in the context of this type of structure, that there are any deferred profits to consider.
Condition Y is as follows:
“850C(3) Condition Y is that–
(a)Bʼs profit share exceeds the appropriate notional profit (see subsections (10) to (17)),
(b)A has the power to enjoy Bʼs profit share (“Aʼs power to enjoy”) (see subsections (18) to (21)), and
(c)it is reasonable to suppose that–
(i)the whole or any part of Bʼs profit share is attributable to Aʼs power to enjoy, and
(ii)both Aʼs profit share and the relevant tax amount (see subsection (9)) are lower than they would have been in the absence of Aʼs power to enjoy.”
Where the rules apply, then I’s profits are adjusted to reflect the deferred profit or A’s power to enjoy under Condition Y:
“850C(4) Aʼs profit share is increased by so much of the amount of Bʼs profit share as, it is reasonable to suppose, is attributable to–
(a)Aʼs deferred profit, or
(b)Aʼs power to enjoy,
as determined on a just and reasonable basis.
But any increase by virtue of paragraph (b) is not to exceed the amount of the excess mentioned in subsection (3)(a) after deducting from that amount any increase by virtue of paragraph (a).
…
850C(9) “The relevant tax amount” is the total amount of tax which, apart from this section, would be chargeable in respect of A and Bʼs income as partners in the firm.
850C(10) “The appropriate notional profit” is the sum of the appropriate notional return on capital and the appropriate notional consideration for services.”
In any event, I think there are two different payments in the majority of structures:
- The company is obligated to make a payment on behalf of the LLP as financing costs: The LLP then reimburses this expenditure; and / or
- The company receives a payment for its services
I will look at each in turn. However, it should be noted that the actual split will depend on the particular case.
Consideration for services
The position is as follows for services:
“850C(15) “The appropriate notional consideration for services” is–
(a)the amount which B would receive in consideration for any services provided to the firm by B during the relevant period of account were the consideration to be calculated on the basis mentioned in subsection (16), less
(b)any amount actually received in consideration for any such services which is not included in Bʼs profit share.
850C(16) The consideration mentioned in subsection (15)(a) is to be calculated on the basis that B is not a partner in the firm and is acting at armʼs length from the firm.”
So far, so reasonable. However, there is a sting in the tail:
“850C(17) Any services, the provision of which involves any partner in the firm in addition to B, are to be ignored for the purposes of subsection (15).”
But what does this mean? Importantly, what does “involves any partner in the firm in addition to B” mean?
HMRC’s manuals state the following:
“When calculating the appropriate consideration for services, any services that involve an individual who is a member are excluded from the calculation.”
Of course, this simply repeats what the legislation states. It then elaborates further:
“A purpose of the excess profit allocation rules is to ensure that the profits generated by an individual’s work for the partnership are taxed on that individual rather than on a corporate partner at CT rates.
- This includes where the individual carries out work for the partnership either as an employee or contractor to the corporate member.
…
This prevents arguments about whether the individual carries out some services as a partner other as employee of the corporate member. The legislation operates on the premise that the company is not to be entitled to any profit share for these services and as if any profit actually allocated to the company were treated for tax as reallocated to the individual member.”
We are then provided with some examples:
“Example 2
This example looks at where the partners themselves are also working for the corporate member.
HED LLP has as members D, E, F, G and H together with a corporate member, HED Ltd. HED Ltd provides management services to the LLP which is carried out by H, E and D as directors of HED Ltd.
Whilst the work was carried out by the directors of the company, these directors are also members in their own right. As the work was done by members the appropriate notional consideration for services is NIL. That the work was done in their capacity as directors of the corporate member makes no difference.
Sometimes work may be done partly by other members and partly by non-members.
Example 3
This example looks at where people other than the partners themselves are working for the corporate member.
DHE LLP has as members D, E, F, and H together with a corporate member, DE Ltd. DE Ltd provides management services to the LLP which is carried out by three unconnected individuals and D and E as directors of DE Ltd.
The appropriate notional consideration for the work done by D and E, who are members of DHE LLP, services is NIL. That the work was done in their capacity as directors of the corporate member makes no difference.
If the work done by the three non-members can be distinguished from the work done by the members then the appropriate notional consideration for services is arm’s length value of these services. If the work cannot be distinguished then the appropriate notional consideration is NIL.
…
Example 5
This example looks at how the test is whether the individual provides the services, not the nature of the services.
EHD LLP has as members D, E, F, G and H together with a corporate member EHD Ltd. Under the LLP agreement the management of the LLP is delegated to EHD Ltd, the individual members are specifically excluded from taking part. As members, the individuals D, E and H manage portfolios of investments. As directors of EHD Ltd, they manage the LLP.
The LLP is managed by the directors of the company, these directors are also members in their own right. As the work was done by members the appropriate notional consideration for services is NIL.
The fact that under the LLP agreement the individuals are not allowed to take part in the management of the LLP does not affect the position under the excess profits allocation rules. The services provided by the corporate member involved individual members, so no credit is given for the services provided.”
As such, it is clearly HMRC’s view that this is a tight restriction.
However, is HMRC’s analysis necessarily correct? It is clear that their analysis is firmly anchored in the specific mischief for which these provisions were introduced to combat. As you may be aware, the rules were introduced to combat the common route by which the members of the professional services firms (structured as LLPs / general partnerships) would use personal service companies to warehouse surplus profits in companies. These companies would then, say, be disposed of by means of a capital transaction with potentially the benefit of entrepreneurs’ relief (as was).
As such, the individual was already providing their personal services to the firm. They would continue providing their personal services to the firm, albeit, some of the income profits were simply diverted through a company. However, there would be no suggestion that the individual would be providing anything other than personal services via the company. Indeed, it is likely that the firm would not sanction those services to be provided by, say, any other employee or contractor arranged by the firm as a substitute.
As such, a view might be that the services referred to in 850C(17) are personal services.
Indeed, if one accepted HMRC’s analysis, there would also be the possibility of rather perverse outcomes.
For example, hybrid structures have been used for well over a decade in the context of property. Certainly, it has been common in the past for a company to contribute property and land into a LLP or partnership.
If 850C(17) were to apply in any scenario where there was a duplication of, say, directors and members of the LLP then this scenario would be caught too. This would be disastrous as, suddenly, services provided by the company to the LLP would be ignored when it came to calculating the tax liability.
This would be a perverse outcome for a commercial transaction.
Another issue would be, say, where there is an existing property management company. Say it has a number of clients. One of those clients is an LLP of which one of the directors of the company is a member. What if it is decided that the company becomes a member of the LLP?
Well, again, the results would be irrational in that the profit share attributable to the company would suddenly be nil. This is despite the fact that the services might have been provided by the company for many years.
Further, if the company continued to offer the services under a simple contract for services then there would be no adjustment (assuming they were at fair value). This is perverse and would be a clear example of taxing pure form over economic substance.
In any event, my ruminations might be academic for those who have used the scheme that Spotlight 63 is targeted at. This is because, it seems, it is suggested from the marketing documents that the majority of rental income is being diverted to the Company. On that basis, the user would fall foul of the rules anyway as, presumably, the company was receiving more in consideration for the services than it deserved.
Reimbursement of expenditure
The outline above considers the services element.
However, there is also the differing nature of the payments to the company to deal with the financing costs.
I think the position here is nuanced and that the partnership is, in reality, providing a reimbursement of its expenditure on behalf of the LLP and not a profit at all.
This distinction is relevant because the test is that “A has the power to enjoy B’s profit share”:
A fundamental question is therefore whether the amount paid to the Company in respect of the finance payment is a profit share at all?
In the opinion I have seen from Counsel on this structure, the relevant section of the advice is that “[the Company’s] profit share is not attributable to [the Individual’s] power to enjoy, as there is no profit expected to accrue to B, the Company.”
But how can it be the case that “there is no profit expected to accrue to the Company?”.
Well, the answer to that question is set out earlier in the same advice. I will not reprint the passage here, but basically the advice is that the amount received by the company in respect of its obligation to pay the finance costs is a reimbursement rather than an allocation of the profit.
If that were true, there would be no adjustment increasing the taxable profits of the individual.
Transfer of income stream rules
Introduction
The other set of anti-avoidance provisions referred to in the Spotlight are the transfer of income stream rules which come in two varieties:
- The general rule; and
- The rules on transfers through partnerships
As the Spotlight only refers to the second of these, However, I will cover both for the sake of completeness.
Transfer of Income Streams – main gateway
Section 809AZA ITA provides:
“[809AZA Application of Chapter]
[(1) This Chapter applies where—
(a) a person within the charge to income tax (“the transferor”) makes a transfer to another person (“the transferee”) of a right to relevant receipts (see subsection (2)), and
(b) (subject to subsection (3)) the transfer of the right is not a consequence of the transfer to the transferee of an asset from which the right to relevant receipts arises.
(2) “Relevant receipts” means any income—
(a) which (but for the transfer) would be charged to income tax as income of the transferor, or
(b) which (but for the transfer) would be brought into account in calculating profits of the transferor for the purposes of income tax.
(3) Despite paragraph (b) of subsection (1), this Chapter applies if the transfer of the right is a consequence of the transfer to the transferee of all rights under an agreement for annual payments; and for the purposes of that paragraph the transfer of an asset under a sale and repurchase agreement is not to be regarded as a transfer of the asset.”
Where there is no transfer of the properties to the LLP, then subsection (1)(b) ought not to be met. This in light of section 809AZF:
“809AZF Partnership shares
For the purposes of this Chapter a transfer of a right to relevant receipts consisting of the reduction in a transferor’s share in the profits or losses of a partnership is to be regarded as a consequence of a transfer of an asset from which the right arose (that is, the partnership property) …”
Where the property is transferred to the LLP then the transfer of the right is clearly as a result of the transfer of an asset.
As such, these provisions do not apply to either version of the planning.
Transfer of Income Streams – Through Partnerships Gateway
Section 809AAZA ITTOIA provides:
“Chapter 5AA Disposals of income streams through partnerships
809AAZA Application of Chapter
(1) This Chapter applies (subject to subsection (2)) if directly or indirectly in consequence of, or otherwise in connection with, arrangements involving a person within the charge to income tax (“the transferor”) and another person (“the transferee”)—
(a) there is, or is in substance, a disposal of a right to relevant receipts by the transferor to the transferee,
(b) the disposal is effected (wholly or partly) by or through a partnership (“the relevant partnership”),
(c) at any time—
(i) the transferor is a member of the relevant partnership or of a partnership associated with the relevant partnership, and
(ii) the transferee is a member of the relevant partnership or of a partnership associated with the relevant partnership, and
(d) the main purpose, or one of the main purposes, of one or more steps taken in effecting the disposal is the obtaining of a tax advantage for any person.
(2) This Chapter does not apply if—
(a) the transferor is the spouse or civil partner of the transferee
and they are living together, or
(b) the transferor is a brother, sister, ancestor or lineal descendant of the transferee.
(3) In subsection (1)(a) the reference to a disposal of a right to relevant
receipts includes anything constituting a disposal of such a right for
the purposes of TCGA 1992.
(4) For the purposes of subsection (1)(b) the disposal might, in particular, be effected by an acquisition or disposal of, or an increase or decrease in, an interest in the relevant partnership (including a share of the profits or assets of the relevant partnership or an interest in such a share).”
I cannot see that there is a disposal to the Company of the right to receive rents.
The concept of ‘disposal’ is widened by reference to TCGA and this ought to therefore also include disposals within TCGA 1992, s22. Here, there is deemed to be a disposal where any capital sum is derived from assets. Subsection (3) of section 22 provides:
“(3) In this section “capital sum” means any money or money’s worth which is not excluded from the consideration taken into account in the computation of the gain.”
I cannot see that Individual receives money from the Company under either of the routes set out. Where the services to the Individual are non-delegable, it also ought to be the case that this benefit does not constitute money’s worth.
CGT Base Cost Point
As referred to above, the Spotlight appears to state that the relevant provider’s scheme has the following benefit:
“the transaction relating to the contribution of properties to the LLP has no upfront tax cost and the properties’ base costs (the amount that can be set against the sale price of an asset when calculating Capital Gains Tax) are uplifted to their market value at the date of transfer for Capital Gains Tax purposes.”
My own view is that this is where things start to get really muddled.
If we first deal with where there is no transfer of the property to the LLP then we can assume there are no CGT consequences at all. No disposal and no uplift as the property does not move.
What about where there is a transfer of the property?
The making of a capital contribution to a partnership or LLP would usually result in there being a part disposal only to the extent that an interest in the current capital was transferred to a third party. The other side of this coin is that, where there is no CGT on the transfer to the LLP or partnership, there is no uplift in the base cost.
HMRC sets out the following view in their view in Spotlight:
Taxation of Chargeable Gains Act 1992 S59A, which treats any dealing in chargeable assets by an LLP as by the individual members — LLPs are transparent for tax purposes so members own a fractional share of assets, and this means the base cost of properties are unchanged following their introduction to the LLP…
As such, I agree with HMRC’s analysis.
Although it is not my role to make sense of the provider’s planning (I really need a hobby!) I wonder whether they are bolting on an additional piece of planning. For instance, as I understand it, there was no movement of the property. So, why would one think that there was an uplift in the base cost of the properties?
BPR Point
HMRC states that the following claims are made about the planning:
“Business Property Relief (BPR) may be claimed in respect of a hybrid structure carrying on a property rental business resulting in no Inheritance Tax being due, if the landlords die”
Again, the relevant provider seems to be overreaching here. I agree with HMRC’s submission that:
“a property rental business is likely to be within the exclusions from BPR of ‘making or holding investments’ under the Inheritance Tax Act 1984, s105(3) — the use of the hybrid business model does not change the availability of such relief”
Of course, if the company is providing property management services then this, in isolation, could qualify for BPR. This is because property management is a trade.
However, it would not own the properties. As such, the lion’s share of the value of the combined business (the capital value of the properties) would be excluded as per the section referred to by HMRC above.
At best then, the benefit of this would appear to be a drop in the ocean.
Next steps
General
Of course, the publication of Spotlight 63 will have created a high degree of concern for those who have entered into property business restructuring including a mixed partnership. However, the Spotlight is clearly targeted at relevant provider’s planning so potential actions might be, first of all, broken down as follows:
- Those who undertook the planning with the relevant promoter; and
- Others
The relevant provider
In the first category, it is clear that there are special features which might be summarised as follows:
- HMRC is sufficiently concerned to issue a Spotlight in respect of the scheme with quite a detailed analysis (perhaps unusually so, for a Spotlight). Of course, this does not mean that HMRC are correct in their assertion and the Spotlight has no statutory footing;
- As it is understood the relevant provider registered many of the LLPs at their own office, this means that HMRC can readily identify many of the LLPs that have entered into the planning. Indeed, HMRC has issued nudge / one to many letters to those on its list (more on this below); and
- On the face of it, a number of the advertised benefits seem highly unlikely to be achieved
As such, anyone who has entered into planning will need to think carefully about what they do next, particularly if their LLP is registered at the provider’s registered office.
If they have had a nudge letter, they should think carefully about disclosure before 31 January 2024.
I am unclear as to whether users of the relevant scheme received any formal tax advice, but that will be very relevant to:
- How far HMRC can go back to open prior years if the planning is found to be defective; and
- whether any penalties could ever be imposed on the participants.
Others
In respect of other users of mixed partnership property businesses, the position is slightly different:
- HMRC will have no clear criteria for identifying businesses that have structured themselves in this manner as they are unlikely to be registered at a common office. As such, it seems less likely that they would have received a one to many / nudge letter;
- There are no indications that HMRC’s Spotlight is aimed at re-structuring beyond relevant providers;
- It is likely that the tax analysis provided by other advisers is not quite so ambitious in the benefits being provided.
Of course, users might still have some concerns and should perhaps consider a couple of points.
The first point to check is to ensure that you have tax advice from a qualified adviser. If so, this should constitute ‘reasonable care’ with the consequences that, in a worst-case scenario:
- There will be a discovery window of a maximum of four years; and
- There should be no prospect of penalties being imposed
That said, I think it is arguable that neither the mixed partnership rules or the transfer of income streams for the reasons set out above.
The elements of the Spotlight with which I agree (around CGT base cost and BPR) are unlikely (I hope!) to be relevant to most structures of this nature beyond those offered by the relevant promoter on the basis that these, in my opinion, are untenable claims. Of course, we do not know how accurately these claims are being presented by HMRC.
However, a participant does have a decision to make around:
- Keeping the structure in place but taking note of the risk of challenge; or
- Revising the structure and, say, removing the corporate member from the partnership
If one keeps in place the structure then, of course, despite my comments above, there is a real risk that HMRC comes along and challenges the validity of the structure.
On the assumption that advice has been provided, then the furthest HMRC could go back would be four years and there should be no question of penalties. However, of course, a HMRC investigation is not something to be relished.
A simple change to the structure might be to remove the corporate partner as a member of the LLP and for it provide services to the LLP as supplier rather than a member. This would put beyond any doubt at all that the mixed partnership rules applied.
Alternatively, in a scenario where the properties were transferred to the LLP, then it may be possible for the LLP business to be transferred to a company where this was desirable.
In either scenario, one would need to consider the tax implications.
Regardless, I would recommend that any relevant clients obtain advice around the robustness of the structure they have entered into (to further keep discovery and penalties at bay) and then decide whether to continue or restructure the corporate member.
HMRC one to many / nudge letter campaigns
Nudge letter to relevant scheme users
HMRC’s Wealthy Team recently sent letters to a small number of agents and their clients who were involved in relevant provider’s property tax planning utilising an LLP and corporate member early in November. The letters invite recipients to withdraw from any such scheme, make a disclosure by 31 January 2024 and settle their tax affairs. Of course, this was on the basis of HMRC’s analysis.
My view is that, regardless of whether someone used the relevant provider or not, the position on what to do next should start at whether they have received a nudge letter or not.
If they have received one, then it is clear that HMRC has them on their ‘hit list’ and thoughts will turn to whether and how to respond to that letter. They will need to bear in mind the 31 January disclosure.
If they have not, then the position is perhaps less pressured. I have set out above in more detail as to what a client might wish to consider.
In either case, the client might decide they have taken advice and therefore they wait until HMRC takes formal action – rather than the fishing expedition represented by the nudge letter.
Nudge letter to incorporation
The furor in this space was initially created by comment on another providers marketing of property incorporations. I wrote an article on this a number of weeks ago.
Ironically, that promoter and the promoter of the relevant hybrid structure have gone at it like hammer and tongs over the years as they have largely competed with each other at landlord shows and networks.
As a result, it is worth noting that HMRC also embarked on a campaign of ‘one to many’ or ‘nudge letters’ to those landlords who it believed had over-claimed incorporation relief.
Of course, with the mixed partnership structure, incorporation relief would not have been claimed at all. As such, this is not relevant to the matters discussed here.
If you have any queries about this overly long article on property hybrid structures, or property tax at all, then please get in touch.