Recent proposed legislation regarding partnership tax could sound the death knell for investment management partnerships. It may even produce an own goal for the UK tax authorities.

The main thrust of the proposals as originally envisaged in May 2013 seemed perfectly reasonable. Where partnership structures have been used to present staff as partners rather than employees, with the intention of avoiding national insurance payments, it is understandable that the government should seek to use legislation to stop this.

But the draft legislation issued in December 2013 could prove highly damaging to smaller wealth managers, investment managers and hedge fund managers that have used partnerships as their structure of choice since they were established in 2001.

Limited liability partnerships have a number of inherent attractions, particularly for businesses such as investment management firms. Most importantly, they protect the limited liability position of members while allowing broad ownership by the people in the business. They offer a flexible way for partners to participate in the returns and risks of a business. This creates greater incentives for performance while ensuring that risk-taking is measured. In essence, partnerships offer the best structure for aligning the interests of investment managers and their clients and they ensure that the risks taken by investment managers are not excessive.

One of the most worrying ramifications of the proposed legislation concerns limited liability partnerships that reward investment managers based on the performance of their funds rather than on the general profits of the partnership. These partnership profits would be subject to national insurance contributions.

The natural consequence of this would be that investment management partnerships would be discouraged from attracting new teams and rewarding them based on their specific performance. This in turn would probably lead to smaller, less efficient investment management companies that are more susceptible to market downturns and are less likely to invest in strong infrastructure to support their businesses.

The proposed legislation may also force partners to increase the capital invested in their limited liability partnerships significantly, while ignoring any direct investments partners make in the funds they manage. This seems to be working against the Alternative Investment Fund Managers Directive that came into force earlier this year. This European regulatory framework requires managers to co-invest in their funds with their clients.

There is certainly no better way of aligning the interests of fund managers with those of their clients than encouraging direct investment in the funds they manage. But if managers are now required to make substantial investments in their partnerships as well, they may decide to incorporate or go offshore.

Another perverse element of the legislation is that certain partners will need to demonstrate that they have significant influence over the limited liability partnership’s affairs if they are to avoid paying national insurance on their profit allocations. This seems to strike at the heart of one of the main attractions of partnerships: that they are a partnership of interests rather than a dictatorship.

Traditionally, each partner in a partnership had one vote and no individual partner had the ability to overrule other partners. This model works well in people businesses, as it empowers each partner and gives him or her a real sense of responsibility. The new tax rules are likely to take decision-making within partnerships closer to that of the corporate world.

Over the past few years, smaller investment management partnerships have had to deal with a tidal wave of new regulation. Most of it has been created to avoid disproportionate risk-taking, which was endemic in investment banks, not partnerships.

The cost associated with new regulations always fall disproportionately on small businesses and there is no doubt that smaller investment boutiques have struggled to cope with the changes. For some, the pain is just too great and they have decided to up sticks and move to friendlier business environments such as Switzerland, Singapore or Dubai.

In the foreword to “The UK Investment Management Industry”, the Treasury’s strategy document published in March 2013, George Osborne, the chancellor, stated: “I am committed to making the UK one of the most competitive places in the world for the investment management sector.”

The new tax rules threaten the very existence of partnerships in the investment management industry at a time when their benefits, in terms of aligning investors and their investment managers, are more important than ever.

Magnus Spence is chairman of the New City Initiative think-tank

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