We’re In This Together! Partnerships And CGT

Ken Moody reviews the capital gains tax implications of partnership changes.

Partnerships and CGT

To set the scene, as many readers will be aware, a partnership is fiscally transparent for both income tax and capital gains tax (CGT) purposes. For CGT purposes, the partners are separately taxable on their individual shares of any gain arising on disposal of partnership assets, by virtue of TCGA 1992, ss 59, 59A.

Section 59 applies to a general partnership within the Partnership Act 1890 (PA 1890); and to a limited partnership created under the Limited Partnership Act 1907 (not considered here), while s 59A applies to an LLP. Under s 59A, an LLP is also generally treated as fiscally transparent unless and until the LLP is placed in liquidation. In that event, the LLP is taxed as a company in respect of gains on the disposal of partnership assets; while the members are assessable personally on gains on the disposal of their interests in the partnership.

Partnership property

In England and Wales, a partnership is not a legal entity distinct from the partners and cannot therefore own property in its own right. For tax purposes, each partner is treated as owning a proportionate share of every partnership asset corresponding to their beneficial interests. Legally, however, in England and Wales a partner’s interest in partnership property is not a proprietary interest in each asset but an undivided share of the totality of the partnership property. Where that property consists of land, title cannot be vested in the names of more than four partners; and it is common for the legal title of the business premises, for example, to be held in the names of (say) two of the partners as joint tenants, in trust for all the partners. A Scottish partnership is a legal entity (see PA 1890, s 4(2)) but is treated similarly to other partnerships by s 59.

The question of what is partnership property can be problematic. It is not simply a question of what assets are shown in the partnership balance sheet, though this would be prima facie evidence. The partnership legislation (PA 1890, s 21) states that property bought with partnership funds is partnership property ‘unless the contrary intention appears’. Mere use of an asset by a partnership does not necessarily make it partnership property, and much will depend upon any agreement between, and the intentions of, the parties. The question is, of course, important for inheritance tax, business and agricultural property relief, as well as for CGT purposes.

PA 1890, s 24 requires that, subject to any express or implied agreement between the partners, partners are entitled to share equally in the capital and profits of a business. While, therefore, the terms of such agreement need not be committed to writing, it is clearly desirable to do so since partners’ income and capital entitlements are usually unequal, and if assets in use by the partnership are owned by one or more of the partners, but are not intended as partnership assets, it would obviously be sensible to set this out clearly. It is also not necessarily the case that partners’ interests in the income and capital of the partnership will be in the same proportions and, again, in that case this needs to be set out clearly.

Statement of Practice D12 and partnership changes

Complications arise when an existing partner leaves, a new partner arrives or when there are otherwise changes in the partners’ proportionate interests in the partnership capital. This is where Statement of Practice (SP) D12 becomes relevant. SP D12 was released as long ago as 1975, and is largely unchanged. It is not possible to review all the issues covered by SP D12 as we are mainly concerned in this article to its application to changes in partners’ capital interests. We can identify three basic scenarios:

The partners are not otherwise connected and the change is on arm’s length terms, but no consideration passes between the partners.
The partners are not otherwise connected but either consideration passes between the partners or there has been a prior revaluation of partnership property.
The partners are otherwise connected.

Partners are connected persons for CGT purposes, so that the market value rule applies ‘except in relation to acquisitions or disposals of partnership assets pursuant to bona fide commercial arrangements’ (TCGA 1992, s 286(4)). The above scenarios are perhaps best illustrated by a few simple examples demonstrating the underlying concepts.

Example 1: Partial retirement

A and B are unconnected, and each partner’s interest in the income and capital of the partnership is equal. B partially retires and reduces his interest to 25%.

For CGT purposes, he has made a disposal of half of his interest in his deemed share of the partnership assets. The partnership premises are in the balance sheet at cost of £100,000. The reduction in B’s share of the partnership capital is a disposal for CGT purposes, but as no consideration is involved (see SP D12, paragraph 4) B’s proceeds will be based upon the balance sheet value of £100,000 x 25% = £25,000, which is also equal to B’s share of the base cost and no gain arises. A’s acquisition cost of £50,000 also increases to £75,000.

Example 2: New partner

The facts are as in Example 1, except that C (previously unconnected) is introduced to the partnership who contributes £50,000 to the partnership capital which is credited to his capital account. The ratio of capital shares becomes one third each.

A and B have each disposed of a 16.667% (50% - 33.333%) (or one sixth) interest but as no consideration passes between the partners the disposal proceeds are based upon the balance sheet cost of £100,000 x 16.667% = £16,667, which again results in no gain/no loss. C’s base cost will be £33,333.

If C had paid £25,000 each directly to A and B or via credit to their capital accounts they would have gains of £8,333 (£25,000 - £16,667) each and C’s base cost would be £50,000.

Example 3: Property revaluation

The facts are in Example 1 except that the premises had been recently revalued at £150,000 and B’s capital account had been credited with his 50% share of the revaluation surplus i.e. £25,000.

When B’s partnership share reduces to 25% his potential gain on disposal of the property also reduces. But the £25,000 revaluation surplus credited to his capital account does not reduce. SP D12, paragraph 5 treats B therefore as disposing of the difference between his old and new share i.e. 50% - 25% = 25% for a consideration equal to that proportion of the revaluation surplus of £50,000. B has a gain therefore of £12,500. A’s acquisition cost will also increase by the same amount.

Example 4: Father and son

The facts are as in Example 1 except that A and B are father and son and are therefore connected persons other than as partners and the market value rule applies.

Since the value of the property is £150,000, the disposal by B is treated as being at market value of £150,000 x 25% = £37,500 against his acquisition cost of £100,000 x 25% = £25,000 and therefore he has a gain of £12,500 unless the reduction in B’s interest for no consideration is a genuine commercial arrangement (see SP D12, paragraph 7).

Of course, matters get much more complex where a disposal arises after successive partnership changes/revaluations. The HMRC guidance in its Capital Gains manual (at CG27000 onwards) gives further commentary and examples, and covers partnership mergers and various other scenarios.

Practical Tips :

A declaration of trust is a simple and valuable way of evidencing that an asset always has been held as partnership property or of converting the personal assets of the partners, or some of them, to be held as partnership property. A partnership minute from the other partners accepting and agreeing will put the matter beyond any doubt.
For CGT entrepreneurs’ relief (ER) purposes, the disposal of an asset or share in an asset which is not a partnership asset can only qualify for ER as an ‘associated disposal’ under TCGA 1992 s 169K, which must (as part of withdrawal from the business) therefore be accompanied by a ‘material disposal’ of the whole or part of the partner’s interests in the assets of the partnership. This may be triggered by a reduction in their partnership share.