A common question, but let’s reframe it slightly to consider taxation, regulatory compliance and the ever increasing need for a holistic approach.
The UK has long been a place of attraction for Investment Firms, and according to HM Treasury, the UK’s asset management industry is the largest in Europe and second largest in the world.
The UK government is committed to the sector and is continuously looking at ways in which the UK could be a better option for a Fund (and not just the Investment Firm) to be based. For example, very recently, draft legislation was published on changes to the UK REIT regime and Qualifying Asset Holding Company Regime. Only time will tell as to whether regulatory and tax frameworks will be adapted to further bring down the barriers to entry for UK investment firms to choose the UK as a domicile for Funds. In our experience, clients’ mindsets have not changed and non-UK domiciled funds are the preferred option. Nevertheless, the appeal of the UK as a location for Investment Firms in the alternative investment space remains strong, both for domestic businesses and those inbound from overseas.
Wheelhouse Advisors has over 20 years of experience in advising investment firms and as a trusted advisor, we know the importance of ensuring tax and regulatory requirements complement one another. A key example, especially given the upcoming regulatory changes discussed below, is over the choice of vehicle i.e. the long-debated question of which is the better structure for a UK investment firm; the Limited Liability Partnership (“LLP”) or the Limited Liability Company (“LTD”)?
So which is best?
Much advice points towards the LLP because it is more tax efficient, but for investment firms the decision is so much more nuanced, and the changing regulatory framework adds even more complexity. How do the two structures compare on regulatory capital requirements? Which is the more adaptable to the new Investment Firm Prudential Regime (“IFPR”), coming next year?
This article pulls all these variables together to give investment firms something to consider as they work their way through the complicated regulatory requirements and brace for impending changes.
Most investment firms in the UK are LLPs. Typically a tax driven decision, as individual members of an LLP (subject to Salaried Member anti avoidance rules) are treated as self-employed for tax purposes. Accordingly, remuneration received by a member is not subject to Employer’s National Insurance (“NI”), currently 13.8%. Given the level of performance fees an Investment Firm could receive, and therefore the “bonus” an individual could be paid, a 13.8% hit on top of this bonus is a substantial dent on a firm’s business. Hence, LLPs tend to be the preferred choice for most investment firms. It also means that individual members do not fall within the complex employment related tax rules.
The tax-based debate is tempered by the rate at which profits are taxed. Currently the UK corporation tax rate is 19% but this is going up to 25% from 1 April 2023. As a result of employer’s NI, the effective tax rate under a LTD structure tends to be around 50%, compared to around 47% for an LLP, based on a corporation tax rate of 19%.
However, whilst an LLP saves the Employer’s NI on remunerating its principals, a LTD and its shareholders have more tax flexibility when distributing profits. i.e. tax deferral by way of distributing profits when required to do so.
Some of the pros and cons of the entity choice are summarised below
Whilst tax may be a driver for choosing an LLP over a LTD, investment firms have complex regulatory requirements to consider, principally ensuring they are able to meet capital requirements at all times.
Most investment firms are required to maintain a level of capital in the business based on their P&L expenditure (“the fixed overhead requirement” or “FOR”). The calculation for the FOR allows specific types of expenses to be excluded – thereby lowering the requirement.
Comparing two investment firms, one an LLP and one a LTD, but otherwise identical, the expectation would be for the FOR of the LLP to be lower due to the aforementioned Employer’s NI savings. LLPs can further leverage this calculation to their advantage by ensuring Members’ drawings are not guaranteed – noting of course to weigh this against the possibility of diminished remuneration during periods of poor performance.
The advantage that a LTD has over an LLP is its ability to retain profits – net of 19% tax – which can be used as capital resources once they are audited. Very useful, particularly for a growing business with increasing costs, assuming profits increase commensurately with the cost base – with careful business planning a LTD should have no problems with meeting a growing capital requirement over time. This is markedly more efficient than for an LLP, the Members of which have two options; (1) inject more capital; or (2) agree to not distribute profits which have been allocated to them – the problem with these is the 47% tax rate, Members’ will have to pay this even if profits are retained within the business.
So, whilst an LLP is likely to have a lower FOR, investment firms should consider whether the flexibility to utilise profits efficiently, especially in a growth phase, is a weighty enough advantage to move the scales.
Regulatory changes on the horizon
Above, we introduce the regulatory pressures on capital resources for investment firms. There is a further layer that all UK investment firms should be aware of. Only with careful business planning will an investment firm be prepared for these changes and have decided on the right type of vehicle with which to succeed.
As a consequence of the new IFPR
which is effective from 1 January 2022, many investment firms are expecting large increases to their capital requirements, either because they are newly required to calculate the aforementioned FOR, or new capital requirements known as K-factors become a biting point.
Affected firms will need a plan to increase capital resources and, as outlined above, LTDs will have an easier time tackling this than LLPs. So, this becomes a debate not just for the start-up, but for the established players too. Some LLP investment firms are considering a change of entity type as they plan to bolster their retained earnings over the next five years. Similarly, start-ups are increasingly choosing LTDs, as they serve as an easier means of retaining profit and accumulating capital whilst also allowing principals to achieve their desired net pay.
Some of the pros and cons of LLP v LTD:
|Pros of LLP
- Tax efficient provided members are not salaried members
- Avoid complex employment related rules provided members are not salaried members
|Cons of LLP
- Profits for tax purposes must be allocated to members even if retained in the business
- The way in which individual members are taxed in the initial years will be based on basis period of taxation, which for certain accounting periods, can result in overlap profits (i.e. profits taxed in more than one tax year)
- Dealing with an enquiry by HMRC into the LLP can affect more than one member of the LLP’s tax return.
- Salaried member rules are complicated and its application could be scrutinised by HMRC
|Pros of LTD
- Simple and easy to understand
- Profits after corporation tax can be retained in the business – thereby facilitating IFPR (compared to members of an LLP having to contribute cash externally or after tax at rates up to 47%) – see below
- R&D relief available for LTDs (but you can structure an LLP with a LTD subsidiary as the entity carrying out R&D)
|Cons of LTD
- In some circumstances LTD may not be as tax efficient as an LLP
Plan for today and tomorrow
It’s not a decision to be taken lightly, but it’s a debate that will continue to evolve in line with tax, legal, regulatory and political pressures. Investment firms should give careful consideration to the LLP vs LTD debate, taking into account the increasing scrutiny from HMRC of the salaried member rules and other anti-avoidance provisions.
This is true for investment firms just setting out and for established firms ensuring it still works for them at its stage of their lifecycle. What is clear is that, for UK investment firms, it is not just a matter of tax efficiency; regulatory and indeed other factors can be a game-changer and the answer is different for every business – careful business planning, financial forecasting and a weighing of the factors will help principals make the right choice.
We will work with you to ensure that tax planning and regulatory compliance are considered together and not in siloes. Please contact me, Sutharman Karangajah, Head of Corporate Tax
at Wheelhouse Advisors, to find out more.