Residential Property Incorporation Models – Beware of Mixed Membership

Hybrid Partnerships – The Mixed Membership Problem

HMRC’s Spotlight 63 states that HMRC believes that a property incorporation model whereby residential property held by an LLP, or moved into an LLP, which also has a corporate partner, does not work as described by the promoters of the arrangement.

Less Tax 4 Landlords promoted one such scheme, and there may be others. HMRC highlights several possible issues, but the one we focus on here is the ‘mixed membership legislation’, which you will find at s850C ITTOIA 2005 if you want to look it up. HMRC’s guidance on this subject can be found in its online Partnership Manual at PM213000 onwards.

This article is intended to give a high-level description of how the legislation works and is not intended to be advice to rely on.

What does s850c, of the ‘Mixed Membership Legislation’ do?

In 2014, s850C was introduced to combat a perceived abuse whereby profits in a partnership were being diverted to a company partner and being taxed at corporation tax, rather than income tax, rates. In brief, for tax purposes s850C moves profit back to an individual partner (i.e. a ‘real’ person) from a corporate partner, if certain conditions are met. The individual is then taxed on that profit.

The legislation has two initial tests or ‘conditions’: X and Y. Condition X looks at deferred profit, and we will ignore that for now, although it may be in point. However, in the property structures, it is condition Y that is probably engaged for many landlords who have used this type of planning.

Condition Y states that:

• if there is a partnership with an individual partner ‘A’ and a non-individual partner (e.g. a company) ‘B’, and
• the profits allocated to ‘B’ exceed the ‘appropriate notional profit’, and
• A has the ‘power to enjoy’ B’s profit, and
• B’s excess profit can be attributed to A’s ‘power to enjoy’, and
• A’s profit share and tax are lower than they would have been absent that, A’s profit share is increased.

What does this mean in English? We’ll use a simple example to explain.

Bob and Sue are married and are both partners in an LLP, which runs their business. There is also a corporate partner of the partnership, Bob&Sue Ltd (‘BSL’). They are 50/50 shareholders in BSL.

In this example, Bob and Sue can both be considered to be ‘A’. BSL is ‘B’. Bob and Sue have ‘power to enjoy’ BSL’s profits by virtue of their shareholding.

Their LLP makes £150,000 profit. Bob and Sue allocate £25,000 each to themselves and £100,000 to BSL.

The legislation would consider whether £100,000 is the ‘appropriate notional profit’. That is computed in two ways (possibly in combination):

• one is a return on capital invested,
• the other is the ‘appropriate notional consideration for services’, or what ‘work’ has BSL done to be entitled to some profit and how much it should be paid for that work?

If BSL has neither invested nor performed any work, the legislation moves all of BSL’s profit back to Bob and Sue and it would then be taxed on them personally.

In terms of whether the profit is in BSL because of Bob and Sue’s power to enjoy, HMRC’s view is that if, as a majority shareholder (or combination of majority shareholders together), you have power to enjoy the profit, that is why it is there. It would be difficult, but not impossible, to envisage a situation like the example above where the profit was not in the corporate partner because of the individuals’ power to enjoy.

In the example above, if BSL employed a member of staff to look after the online sales of the LLP, and the cost of that was £50,000, BSL would be entitled to some profit. How much? In that scenario probably some kind of ‘cost plus’ arms-length figure would have to be proposed and agreed with HMRC. BSL would retain that element of the profit, say £60,000 for the sake of this example (its appropriate notional profit), and the balance of £40,000 would be allocated back to Bob and Sue.

No ‘Avoidance Purpose’

One of the things argued, we understand, by Less Tax 4 Landlords, is that only mixed memberships with a ‘tax avoidance purpose’ or ‘tax motivation’ are caught by the mixed membership legislation. We don’t agree. There is a ‘purpose’ test within the legislation (s850C(18)(b)), but that is not the only test, and it is not directly an ‘avoidance purpose’ test. The key is the ‘power to enjoy’.

Where an individual partner (or combination of individual partners) controls the limited company partner, in most cases it is likely that the ‘power to enjoy’ test will be met. The question is then, what profit share is the company partner entitled to, in the context of what it has contributed to the LLP’s business? If the company has done nothing, it will not be entitled to any profit.

Some Good News, with a Possible Sting in the Tail

In our example, let’s assume that BSL has the £100,000. It has previously been allocated the profit, and that profit sits in BSL’s bank account. But Bob and Sue have been taxed on it as if it were theirs. Can they access that £100,000?

Once a settlement has been agreed, s850E of the legislation allows that BSL can pay Bob and Sue the £100,000 without further tax being due. That seems a fair result in the circumstances, and it is gratifying that avoiding a double tax charge has been considered in the legislation.

However, the legislation states that this tax-free payment can happen if “there is an agreement in place in relation to the excess part of B’s profit share”. In other words, arguably, only after it has been agreed and settled (possibly by contract) with HMRC.

HMRC themselves pointed this out to us when we were settling a large mixed membership case a couple of years ago – its view was that any movement of money from company to individual should not happen until after the settlement was signed, since any payment before that date might be considered a normal distribution and be taxable as such, because s850E could not be engaged prior to settlement. HMRC stated that it was not sure how strict HMRC’s view would eventually be on this ‘timing issue’, but our view, and HMRC’s at the time, is that it is better to avoid the argument, if possible.

Going back to our example, in the worst case, if Bob and Sue had paid themselves the £100,000 before settlement was agreed with HMRC, but anticipating that a settlement would need to happen, they would potentially be taxable on the £100,000 as a distribution from the company when the ‘cash’ moves to them, and in relation to the reallocation of profit from the partnership. Not a happy place to be. Therefore, if possible, don’t move money around, even if you may eventually be entitled to it, until a settlement is done and dusted if one is necessary.

How We Can Help

We’re helping a number of clients in relation to various property incorporation arrangements, including those promoted by Property118, as well as the Less Tax 4 Landlords arrangements. We note that, as far as we understand, the Property118 arrangements do not include a hybrid or mixed membership structure. The Property118 arrangements potentially have some other issues.

Firstly, we can help assess if there is a problem, and if so, determine the extent of the problem. Next, if exiting the arrangements is necessary, we can help with that, ensure that additional liabilities are minimised and that exiting does not create further unwanted tax. Finally, if the arrangements have created a past liability, we can work on your behalf to get the best possible settlement with HMRC.

We note that mixed membership partnerships, as well as property portfolio incorporation, are not ‘wrong’ or ‘illegal’ per se. The trouble may arise if incorporation of a portfolio has been done in a rushed or incorrect manner. Also, the mixed membership legislation is longer and more complex in its entirety than can be encompassed by a brief article (HMRC’s guidance runs to thirty-five separate sections); our description of the legislation and the example given have been simplified to explain some key points.

Get In Touch

You can get in touch with our friendly and experienced team on: 0203 675 8122 or email jeremy.johnson@intaxltd.com, or call him on 07739 093 976.