HMRC succeed in latest case regarding historical LLP pay arrangements
Following its recent decision in another case, the Court of Appeal decides that members’ deferred remuneration was miscellaneous income
Following its recent decision in another case, the Court of Appeal decides that members
Background
HMRC v HFFX LLP [2024] EWCA Civ 813 (HFFX) concerned deferred pay arrangements put in place shortly after employees in the high-frequency foreign currency trading team at GSA, an investment management firm, became members of a separate but related limited liability partnership (LLP). Profits that the LLP would otherwise have allocated to the individuals were instead allocated to GSAM, a corporate member, who reinvested them as ‘Special Capital’ in GSA-managed funds. After three years, GSAM reallocated Special Capital to individuals who satisfied certain ‘bad leaver’ and other conditions and were recommended awards by the LLP’s managing member.
HMRC determined that GSAM’s profit share belonged to the individuals for income tax purposes or, alternatively, that Special Capital reallocations were chargeable to income tax as miscellaneous income (s687 ITTOIA 2005) or under the sales of occupation income rules (Ch 4 Pt 13 ITA 2007). The taxpayers appealed.
The tribunals below decided that Special Capital reallocations were miscellaneous income. The Court of Appeal then reached the same conclusion in respect of similar arrangements in Bluecrest Capital Management LP and others v HMRC [2023] EWCA Civ 1481 (Bluecrest). When HFFX reached the Court of Appeal, the taxpayers’ arguments therefore focused on why their case was distinguishable from Bluecrest.
Key to the case was whether Special Capital reallocations arose from a source not otherwise charged to income tax as required by s687 ITTOIA 2005.
What did the Court of Appeal decide?
First, the taxpayers argued that the ratio decidendi (the binding reasoning) in Bluecrest was that the exercise of a discretion – here, the discretion to reallocate Special Capital – is a source for the purposes of s687 ITTOIA 2005 only if it creates a legal entitlement to the receipt in question, which the taxpayers said was not the case here.
The Court rejected this argument. Falk LJ carefully reviewed the relevant cases on Schedule D Case VI (the predecessor to s687 ITTOIA 2005) and concluded that neither they nor Bluecrest established that a legal right to payment was required.
Next, the taxpayer argued that GSAM’s discretion to reallocate Special Capital was unfettered and therefore purely voluntary, which again meant that it could not constitute a source.
The Court also rejected this argument, finding that GSAM had an implied duty to exercise its discretion rationally and in good faith. The duty, which is designed to prevent abuse of significant imbalances of power, has been found to exist in the context of employee death-in-service benefits (Braganza v BP Shipping Ltd [2015] UKSC 17), employee bonuses (Horkulak v Cantor Fitzgerald International [2004] EWCA Civ 1287) and allocating LLP profit shares (Reinhard v Ondra LLP [2015] EWHC 26 (Ch)).
The Court accepted the taxpayer’s argument that for a source to exist, something more than this implied duty (but less than a legal right to payment) was required. The critical factor was that the individuals had “rights under the Partnership Deed which provided the legal context for the decisions” to reallocate Special Capital (see [62]). In other words, reallocations were clearly not mere acts of largesse; they were made against a detailed legal and commercial backdrop.
Accordingly, the exercise of the discretion to reallocate Special Capital – subject to the implied duty described above and in the context of the individuals’ rights – was sufficient to constitute a source for the purposes of s687 ITTOIA 2005.
The Court therefore dismissed the taxpayers’ appeals. As in Bluecrest, the Court declined to address the sales of occupation income issue. HMRC reserved the right to argue that GSAM’s profit share belonged to the individuals should the case go to the Supreme Court.
Why does it matter?
HFFX helpfully clarifies the reasoning in Bluecrest. It confirms that an unfettered discretion to make a payment will not constitute a source for the purposes of s687 ITTOIA 2005 but a fettered discretion can, depending on the context in which the discretion arises. A legally enforceable right to payment is not required.
HMRC’s decision not to argue that GSAM’s profit share belonged to the individuals suggests an acceptance that genuine (i.e. non-sham) remuneration deferral arrangements like those in HFFX are effective for the purposes of s850 ITTOIA 2005. However, this is unsurprising given HMRC’s success to date on their alternative arguments and the introduction in 2014 of the mixed member rules (the arrangements in HFFX predated the rules).
It remains to be seen whether the taxpayers in HFFX seek permission to appeal to the Supreme Court. The test for permission is whether the appeal raises an arguable point of law of general public importance. Given the introduction of the mixed member rules the case is largely of historical interest for LLPs, but because s687 ITTOIA 2005 is a provision of general application there could be enough to justify the Supreme Court’s intervention, so watch this space.
