Lee Sharpe looks at the government’s Autumn Budget 2017 announcements in relation to taxing partnership profits.
The government launched a consultation on proposals to clarify the tax treatment of partnership profits in August 2016, to cover areas where the government perceived that the tax rules might be seen as unclear or risked producing an ‘inappropriate outcome’; also to ensure that the rules fit with modern commercial practice.
Helpfully, the original consultation assured the reader that any changes would ‘have no effect on the vast majority of partnerships’. You can guess where this is headed!
The government set out its response to the consultation, along with draft legislation, in September 2017, for inclusion in what will be Finance Act 2018. There were some important changes to that draft legislation when it was included in the Finance Bill published on 1 December 2018. The article covers the main points of interest to general UK firms.
Bare trusts/nominees
Initially, the government held the position that a partner could not act as nominee for another person – a beneficiary. But it seems that the government has been forced to accept that nominees are a commercial reality.
The draft legislation therefore finds that, in such cases where the beneficiary is absolutely entitled to the partner’s share of the firm’s profits, it is the beneficiary who is deemed to be the partner for tax purposes. This is consistent with the approach to bare trusts more generally – they are usually considered ‘transparent’ for such tax purposes.
Partnerships within partnerships
The partners in a partnership may themselves be partnerships. It is conceivable that there can be several tiers of partnerships within a larger partnership structure.
The new legislation calls such persons ‘indirect partners’ and deems them effectively to be partners in the underlying partnership, where they have trading or business profits or losses deriving from that underlying partnership.
Example 1: Indirect partners
Aaron and Adam are partners in the Adon Partnership, a small firm of accountants. Their firm is part of a national network of accountants that is run as a larger partnership of member firms – Adon North West. This network is, in turn, a partner in the Adon UK Partnership.
For tax purposes, Aaron and Adam will be indirect partners of the underlying Adon UK Partnership.
Partnerships within partnerships – reporting (1)
Where a partnership has partners who are themselves partnerships, it will be obliged to either:
- calculate and return the partners’ shares of profit or loss on all four possible bases – income tax and corporation tax, resident and non-resident; or
- return a partnership statement including the allocation of profits and losses for all indirect partners as if they were directly involved with that partnership.
Example 2: Decisions, decisions
The Adon UK Partnership (in Example 1) can either:
- draw up income tax and corporation tax returns covering the possible permutations for its partners as above; or
- ‘drill down’ and include Aaron, Adam, and all other indirect partners on its own partnership statement as if they were, in fact, direct partners in the Adon UK Partnership.
It is difficult to decide which of these is less attractive or time-consuming. It will probably depend on the degree of centralisation versus member firm independence within the overall organisation. It is nevertheless understandable that HMRC might want some consistency within the underlying partnership and its partner/indirect partner firms.
Partnerships within partnerships – reporting (2)
A further part of the new regime is that, where a partnership is a partner in one or more partnerships that carry on a trade, profession or business, the profits or losses from each partnership must be shown separately, and separately from any other income or losses, on the reporting partnership's return.
Example 3: Separate returns
As well as being a firm of accountants, the Adon Partnership also operates as a firm of investment advisers, operating in the larger Nowgon UK Partnership.
The profits and losses from operating as members of Adon UK and Nowgon UK are separate and must be returned separately as two business (trading) streams.
Allocation of partnership profits and losses
The new legislation requires that the allocation of partnership profits (or losses) in the partnership statement part of the partnership tax return is the allocation that applies for tax purposes for the respective partners.
This might seem rather obvious but the main cause of problems in this area is where one partner (or perhaps several) refuses to accept the allocation of profits set out in the partnership statement as reflecting the profit share he or she actually received. In other words, a partnership dispute about profit allocation.
Disputes
It might seem quite unfair that the partners must in future accept whatever is in the statement, but the draft legislation also includes a new structured process for the resolution of disputes between partners over the allocation of taxable partnership profits and losses shown on the partnership return (rather than the overall amount of taxable partnership profits), so that such disputes can be taken to tribunal.
Anyone who has dealt with such disputes will know that they can become extremely acrimonious and time-consuming, often stretching for many years. Whether this new approach will actually assist in such cases remains to be seen (and, of course, it will apply only to the extent of determining tax bills), but the approach seems well-intentioned.
The good news
The original consultation had floated the idea that partners could not decide to change their profit-sharing arrangements part way through an accounting period, but that they would have to be fixed. This would have been a real problem from a commercial perspective, particularly on partner introduction or retirement, and was quickly dropped.
However, the draft legislation issued in September 2017 did provide that, in effect, the profit-sharing ratios between partners would have to be determined by a single percentage – in other words, accounting profits would translate across to taxable profits. Even quite small partnerships will often have several profit bands or ‘calls’ on partnership profits, which may reflect different partner intakes over time, or the extent of participation in different long-term projects.
It would have been impossible to reduce such agreements to a single percentage while working with tax adjustments; thankfully, the draft legislation in the Finance Bill published in December 2017 has removed the offensive sections.
Timing
The above draft rules will have effect for returns made from 2018/19 onwards. There are other provisions in relation to disclosures for overseas partners in investment partnerships, which this article does not cover.
Conclusion
It is welcome news that the government finally saw sense in terms of profit-sharing agreements – albeit at the 59th minute of the 11th hour. The original drafts would have affected a substantial proportion of ‘normal’ commercial partnerships, and it speaks to the government’s ignorance of such standard practice that the suggestion nearly made the statute books.
What is left could be a significant administrative burden in terms of reporting requirements, but at least one can see the government’s logic for the changes. In terms of disputes over profit allocation, I suspect we will have to wait and see the mechanism in practice before deciding if it really is helpful to taxpayers.
