Capital interests under LLP agreement taxed as income

The Upper Tribunal has rejected the taxpayer's appeal against the decision of the FTT regarding the tax treatment of "capital interests" issued to members of a UK LLP: The Boston Consulting Group UK LLP and others v HMRC [2026] UKUT 25. Indeed, the UT decision goes further in finding that the proceeds from those capital interests also fell within the scope of the mixed member partnership rules for tax purposes.

Despite the interests being labelled as capital interests, the FTT had been correct to consider their true nature led to the conclusion that they did not in fact give rise to interests of a capital nature in the LLP or its assets. The FTT was also correct to conclude that the disposal of such interests on the facts gave rise to proceeds of an income nature which fell to be taxed as miscellaneous income. However, the FTT had incorrectly rejected HMRC's alternative arguments that amounts received would otherwise have fallen to be taxed pursuant to s.850C ITTOIA 2005 under the mixed membership partnership rules (MMR). The FTT had approached the counter-factual test within those rules incorrectly in concluding that there was no evidence that the amounts which might be viewed as deferred by those arrangements would, in the absence of those arrangements, have been allocated to the individual partners as partnership remuneration (such that Condition X was failed) or that the amounts which were allocated to the corporate member would otherwise have been allocated to the individual members (such that Condition Y was failed).

Background

Boston Consulting is an international management consulting business. Prior to 2011, the business of the UK group was carried on through BGG Ltd and the senior individuals in the business (the managing directors and partners (MDPs)) were employees of that company. In 2011, the business was transferred to a UK LLP and the MDPs became members of the LLP under the terms of a LLP Agreement (LLPA).

The group operates a single, global compensation and equity framework for all MDPs, including UK MDPs. This is used to determine the amounts of compensation received by MDPs. In addition to various annual compensation components in the framework, there was also an "equity" component (the LTCV). Under the LTCV, MDPs acquired a long-term interest in the group. This was implemented in the UK (prior to 2011) by issuing shares in BGG Inc (the US parent company). From 2011, these were replaced with so-called "capital interests" in the LLP.

Capital interests were notified to MDPs by the remuneration committee (but were not dependent on the profit of the UK LLP or its balance sheet). They were also entirely separate to the Capital Contribution account of each UK MDP and of the other members of the LLP. Issues of capital interests took into account seniority and length of service and on retiring an MDP would be required to sell their entire holding of capital interests in the LLP. The UK LLP retained an 18% margin from the LLP's profits to fund future disposals of capital interests.

UK MDPs were not required to pay to acquire their capital interests. The value of those capital interests was entirely dependent on the changing value of BGG Inc shares between the grant of capital interests and their disposal. The FTT found that the total value of capital interests could, in fact, potentially exceed the value of the UK LLP. MDPs would usually dispose of their capital interests on retirement or otherwise on leaving the UK LLP.

Were capital interests capital in nature?

The taxpayers argued that under the LLPA, whenever the MDPs were provided with "units" and there was a later rise in value of the BCG Inc shares, the MDPs held an interest in the capital of the UK LLP. This interest was a form of chose in action which crystallised on the sale of the asset. As such it was a "share" in the UK LLP, or at least an "interest" in the UK LLP or its goodwill. Since the capital interests gave MDPs interests in the goodwill of the UK LLP, the disposal of those capital interests was a disposal of part of a business owned by each MDP, such that they were entitled to entrepreneurs' relief in calculating the capital gains tax arising on those disposals.  In contrast, HMRC argued that they were simply cash rights which crystallised in certain circumstances and were subject to income tax under one of a number of heads.

The UT has comprehensively rejected the taxpayers' argument, concluding that the FTT was entirely correct to find that the payments were not for the disposal of a capital interest. Quite apart from the point that goodwill is not something that can be sold apart from the sale of a business, as the FTT had noted, amounts paid to MDPs on disposal of capital interests were not linked to the value of the UK LLP directly in any event and, together with the fact that they had no value on grant, tended towards a conclusion that the capital interests were not in fact interests in the partnership itself. The value to the MDPs of being granted the capital interests was simply the agreement to buy back the interest at a price calculated under the LLPA.

Since no one other than BCG had any interest in any capital profits and only BCG would receive any surplus that might be available on the sale of the business (for example as a result of a payment for goodwill), there was no conceivable "interest" that was being sold when payments were made in respect of the rights.

In truth, the payments were not being made because the MDPs had a capital interest that BCG wanted to buy out. It was rather that to accord with the global equity framework, under which it was desired to provide the MDPs with payouts on or approaching retirement by reference to increases in the value of the BCG Inc Shares. The UT noted that the FTT had been entitled to place little weight on the terminology used in the drafting of the LLPA given that it was a fair conclusion that the terminology chosen had been chosen more for the impression it would give than to reflect the nature of the rights.

Bearing in mind the overall nature of capital interests, the FTT had been right to conclude the capital interests were not in fact interests in the capital of the UK LLP or a share in its assets.

Having held that the capital interests were not in fact interests in the capital of the UK LLP, it was necessary to consider how the tax provisions applied to the payments on disposal of those interests. HMRC raised a number of bases under which the disposal proceeds should be taxed as income. These included:

• the arrangements fell within the anti-avoidance rules in s.850C ITTOIA (the mixed membership partnership rules)
• the disposal by UK MDPs of their capital interests gave rise to income subject to income tax as miscellaneous income (under s.687 ITTOIA)
• the payments were taxable as the sale of occupational income (s.773 ITA ).

Did the mixed membership partnership rules apply?

The FTT held that the mixed membership partnership rules did not apply to treat the amounts received by MDPs on disposal of capital interests as income profits. For these provisions to apply, section 850C requires either Condition X or Condition Y to be met, which essentially involve the deferral of profit by its allocation to a non-individual member of the partnership concerned, or an excess allocation of profits to such a member in circumstances where the necessary "power to enjoy" those profits remains with an individual member and certain other conditions were met.

The FTT had concluded that neither Condition X nor Condition Y were met. Whilst the amounts might be viewed as representing the deferred profits of the MDPs allocated to BCG under the arrangements (in the form of the 18% margin), the FTT considered that this did not result in the profit allocations to MDPs being lower than otherwise would have been the case. In particular, the FTT considered that there was no evidence that the 18% held back on a worldwide basis would otherwise have been allocated to MDPs in the absence of the capital interest arrangements. Even in the absence of those arrangements, there would have been worldwide arrangements to set aside 18% towards the LTCV structure and it was not appropriate to consider a scenario where there was no LTCV. This meant Condition X was failed. Condition Y was failed for the same reason - the global firm wanted all MDPs to participate in the LTCV, and that participation would not have been achieved by allocating more profits to UK MDPs because of the disparity this would have created with the profit shares of others.

On Condition X, the UT agreed with the FTT that the 18% allocated to BCG to fund the scheme did represent deferred profit of the MDPs. However, the FTT had been wrong to conclude that it was not reasonable to conclude that, as a result, the MDPs' profit share was lower than it otherwise would have been. In effect, the FTT had concluded that in the absence of this particular arrangement, a different arrangement would have been put in place which would have tracked the value of BCG. However, it was an error of law for the FTT to answer this question on the basis that a different system to provide for deferred profit would have been introduced. In effect, this approach makes it impossible to satisfy the condition. The correct counterfactual is to ask whether individuals would have been allocated more profits in the absence of the deferral and, given that the whole of an LLP's profits must be allocated to the partners for tax purposes (ITTOIA ss 848 and 850), it was clear that profit share of MDPs would have increased. The FTT had been wrong to speculate as to how the global business would have implemented the LCTV in the UK had it used a different approach. On Condition Y, the statutory question is simply whether it is reasonable to suppose that the MDPs' profit shares would have been higher if they were not in the future going to receive a share of the profits which had been allocated to the corporate member, and that the answer to that question had to be "yes". It is not permissible to assume an alternative arrangement would have been implemented as a result of which the MDPs obtain payments under the LTCV without having "power to enjoy" part of the profits allocated to the corporate member.

Since the MMR applied, it was necessary to adjust the profit shares on a just and reasonable basis. The UT agreed with HMRC that the appropriate approach in this case would be to ascribe to each MDP the increase in value (if any) of their potential capital interests each year (rather than only increase profits at the point when an MDP received a payment). The purpose of s. 850C was to reallocate profits arising in a tax year from the corporate partner to individual partners and that process was better served on an annual basis when the value of the capital interests were revalued.

Miscellaneous income

Section 687 ITTOIA taxes income from any source not otherwise charged to tax. However, it was clear that to fall within this section, an amount received must have the nature of annual profits, be of an income nature, be analogous to other cases within the former Schedule D head of charge and the source of the income must have a sufficient link with the individual recipients. The UT decision also emphasises that it is also appropriate to stand back and examine the commercial reality of the arrangements as a whole.

The UT has held that the FTT were correct to consider that the amounts received on "sale" of capital interests in this case were income in nature. Standing back and examining the commercial reality, the capital interests did not give the MDPs any interest in the capital of the UK LLP and were not capital in nature. Moreover, the FTT had been correct to conclude that the payments were intended to reward partners for their contribution to the success of the business because of the services they provided and to incentivise them for the future were analogous to amounts falling within other heads of charge under Schedule D. The payments were analogous to the receipt of income.

Finally, the UT agreed that the source of the income was the rights under the LLP agreement which set out the terms of the capital interests and the basis of their allocation to MDPs. As such, there was clearly a sufficient link between that source and the MDPs. As such, section 687 applied to payments made on the sale of capital interests to the extent that they were not taxed under the MMR rules.

It is not necessarily clear why HMRC sought to apply the miscellaneous income charging provisions to the proceeds received on the sale of the capital interests, rather than the award of the capital interests themselves (given it is clear that the miscellaneous income rules charge money or money's worth). The UT decision records that HMRC's barrister sought to draw a distinction between the capital interests and share option arrangements, which have an independent existence and do not arise under the terms of the relevant partnership agreements - such options would appear to lack the requisite source. This distinction may be relevant in other cases in which HMRC are seeking to apply the miscellaneous income rules.

Sale of occupational income

ITA 2007 section 773 imposes a charge to income tax on individuals where arrangements are put in place to exploit the earning capacity of an individual and one of the main objects is the avoidance of tax. HMRC argued, in the alternative, that this provision applied in this case. Whilst it was not strictly necessary for the UT to consider this argument (having held that both the MMR and section 687 applied), it did go on to consider the application of this provision. Before the UT, the taxpayers conceded that the object of the arrangements was to achieve capital gains treatment for disposals by arranging the incentive as "capital interests" (rather than shares in BCG Inc for example), and as such one of the main purposes of the arrangements was the avoidance of tax. The UT agreed with the FTT that the arrangements were made to exploit the earning capacity of MDPs and that the amounts received were not attributable to the value of the UK LLP. As a result, the disposals by UK MDPs of capital interests would have been treated as giving rise to amounts chargeable to income tax under these provisions if the MMR and s 687 had not applied.

Procedural issues

In addition to the substantive issues, the appellants also challenged many of the assessments made by HMRC on procedural grounds, largely based on the question whether discovery assessments had been validly made for earlier periods in this case. To a large degree, this issue depended on whether the appellants had been careless so as to extend the basic time limits for issuing assessments. HMRC argued that there had been carelessness both in terms of the steps taken to implement the capital interest arrangements and the advice received. HMRC argued that the level of care fell below that required for a large business with access to tax expertise. In particular, the advice received from PwC (and later EY) was high level without detailed consideration of whether, in the light of their terms, capital interests were in fact capital assets. HMRC also argued that the advice from PwC indicated that that there was some doubt as to the application of the mixed membership partnership rules when these were being introduced and that counsel's advice should have been obtained in the circumstances.

On the issue of carelessness, the UT agreed with the FTT that evidence of obtaining advice by the business was insufficient to counter the evidence that it was careless. The advice obtained was predicated on a structure that had some differences to that actually implemented and there were incorrect assumptions in that advice. The advice was also lacking in depth and quality especially given concerns that had been raised by senior management over the arrangements. 

Comments

Whilst this decision is highly fact dependent, the decision that the proceeds of disposals of capital interests in this case were subject to income tax emphasises that it is the economic and commercial reality of the arrangements which will determine their tax treatment and not the labels applied to the rights arising under them. In fact, the UT decision goes further than the FTT in concluding that the proceeds not only represented miscellaneous income, but were also caught by the MMR, where the UT considered that a much stricter approach to the counterfactual scenario was necessary. More generally, the willingness of the tribunals in this case to conclude that the amounts in question represented miscellaneous income perhaps reflects an extension to the scope of amounts that fall within this residual charge and may require a reconsideration of other arrangements through the lens provided by the FTT's comments on the scope of this charge.

The UT's interpretation of the meaning of "reasonable to suppose" in Conditions X and Y is extremely favourable to HMRC more generally, and, at least in our view, fails to construe the rules purposively. The UT approves the statement in the FTT judgment that "the core element of the purpose of the rule is to prevent individual partners making arrangements which seek to accumulate profits in a corporate partner". The UT does not, however, then seem to require there to be any indication of this type of manipulation - instead, it just says, in essence, "who would the profits have gone to had they not gone to the corporate member?". It seems to us that this robs "reasonable to suppose" of any real meaning.

On the procedural aspects, the decision further underlines a number of challenges in the application of tax administration rules to partnerships and LLPs, in particular on the thorny topic of HMRC's ability to raise discovery assessments outside the normal enquiry window. Reliance on external professional advisers is not a complete shield in this scenario, particularly where the advice was clearly lacking in detail given the nature of the complex arrangements involved.