HFFX: Court of Appeal upholds defeat of incentivisation scheme

HMRC v HFFX LLP and others [2024] EWCA Civ 813 involved a remuneration planning scheme of a fund manager organised as a limited liability partnership. Under the scheme, a profit share was allocated to a corporate member of the LLP instead of to the individuals who were members of the LLP. The corporate member invested its allocations and over time contributed the amounts back to the LLP as 'special capital', which was in turn reallocated to the individual members.

The Court of Appeal held that the amounts allocated to the individuals were taxable as miscellaneous income under s687 ITTOIA 2005 and therefore subject to income tax. A key question considered by the court in reaching this conclusion was whether the relevant payments had a 'source', as a source is required in order for s687 to apply. In this regard, the Court of Appeal confirmed that a legally enforceable right to a payment is unnecessary for there to be a source, with it being sufficient that there was an exercise of discretion within the legal framework established by the LLP deed.

Whilst anti-avoidance legislation applicable to LLPs has expanded significantly since the time this particular scheme was in operation (with the mixed membership rules introduced by Finance Act 2014 especially relevant), the decision remains a significant milestone in the interpretation of the nebulous miscellaneous income head of charge within the income tax regime. It is therefore likely to prove an important reference point across a range of scenarios going forwards.

Facts

This case involved a remuneration planning scheme used by fund managers, very similar to that considered by the Court of Appeal in HMRC v Bluecrest Capital Management LP and others [2023] EWCA Civ 1481 ('Bluecrest').

In broad outline, under the scheme, profit share which would otherwise have been allocated to individual fund manager members of an LLP was instead allocated to a corporate member. The corporate member invested the post-tax amounts allocated to it, then sold the investments in tranches over three years, and contributed the proceeds back to the LLP as 'special capital'. The special capital was then reallocated to the individual members who were able to withdraw it, subject to the discretion of the corporate member (exercised in accordance with the partnership deed).

The 'hoped-for tax analysis' of the scheme was:

• profit share allocated to the corporate member was to be subject to corporation tax at 28%, rather than a higher rate of income tax which would have been due if it had been paid to the individual members; and
• payment of special capital to the individual partners was to be free of income tax because, although it had the character of income, the receipt was not derived from a taxable source.

Issues

HMRC disputed this tax treatment. The tax issues raised by the appeal were as follows:

1. should the allocation of profits to the corporate member be considered an allocation to the individual members, and therefore be subject to income tax for the individuals under s850 ITTOIA 2005.
2. If the answer to (a) is 'no', should the individual members be taxable on the reallocation of the special capital to them either as:
   1. Miscellaneous income under s687 ITTOIA 2005; or
   2. Sales of occupation income under ch 4, Part 13 ITA 2007.

Findings

Previously, both the First-tier Tribunal and the Upper Tribunal had found for the taxpayer on issue (a). On issue (b), however, both Tribunals had found for HMRC.

Although HMRC obtained permission to appeal on issue (a), in the end this did not form part of the Court of Appeal's review. This is because HMRC accepted that the Court of Appeal's decision in Bluecrest on this issue was determinative in favour of the taxpayer. HMRC did, though, reserve the right to appeal to the Supreme Court on this issue.

On issue (b), the Court of Appeal found that the allocations of special capital to the individuals were taxable as miscellaneous income under s687. It was therefore unnecessary for the Court to opine on whether the separate ‘sales of occupation income’ rules could have also applied.

In considering issue (b), the Court of Appeal focussed on the wording of s687, which taxes 'income from any source that is not charged to income tax under or as a result of any other provision of this Act or any other Act'. (Underlining added.)

It was not disputed that the amounts received by the individuals as special capital were income, but the issue considered by the Court was whether the relevant income had a 'source' for s687 purposes.

The taxpayers asserted that they had no legally enforceable right to the special capital and therefore the payment had no source.

Finding in favour of HMRC, the Court disagreed, confirming that a legally enforceable right to a payment is unnecessary for there to be a source. The Court found this case "materially indistinguishable" from Bluecrest, noting that the decision in that case was not contingent on the existence of an enforceable legal right to funds.

Whilst a pure gift will not meet the source requirement, the exercise of discretion within the legal framework of an agreement is sufficient. The individuals in this case had the right to a proper exercise of the company's discretion to reallocate special capital to them. The exercise of that discretion, resulting in the allocation decision, in combination with their rights under the partnership deed which provided the legal context for that decision, was capable of amounting to a source from which the receipt of the special capital was derived.

The Court of Appeal therefore dismissed the taxpayers' appeal and held that the receipt of special capital was taxable as miscellaneous income under s687. 

Reflections

The miscellaneous income charge has been in legislation for some time (previously Schedule D Case VI) but has been little used by HMRC until recently.

The Court of Appeal's decision in this case is unsurprising as it is very much in line with its decision in Bluecrest; but it does help to shed further light on the requirements of s687 and indicates that it may be difficult for a payment made pursuant to a contractual discretionary remuneration arrangement to escape the charge. There is also a question as to whether the rationale which the Court of Appeal's decision has confirmed could lead to wider application of the miscellaneous income charge, for example to discretion exercised within a legal framework but outside a remuneration context.

It is noteworthy that, whilst the decision may not be surprising, and would most likely now have been counteracted by the mixed membership legislation, it resulted in a significant overall tax burden for the LLP and its members, as no relief was available for any of the corporation tax paid by the corporate member, even though ultimately amounts allocated to the corporate member were transferred to individual members. This can be contrasted with the position under the mixed membership rules, where there is a mechanism designed to prevent amounts being taxed twice.