Lee Sharpe looks at the special rules for property assets within a partnership.
The theory behind partnership taxation is logical and relatively straightforward. But partnerships themselves can be quite complex and mutable animals, so those initially simple rules sometimes become quite contorted as new partners join, others leave and sharing ratios change over time.
Partnership disposals: The basics
Tax law deems partnership assets to be held by the partners directly, in accordance with their underlying interests (TCGA 1992, s 59).
When a partnership disposes of a chargeable asset for CGT purposes, this is first recorded in the partnership’s own tax return using aggregate figures but is then attributed to each partner on their own individual self-assessment return.
Example 1: Tax return entries
Sam and Shapi run a property partnership with five large multi-tenanted properties that require quite a bit of time and attention. Sam and Shapi have always split everything equally. When the partnership sells, for £1m, one of the properties it acquired five years ago at £800,000 (i.e., at a gain of £200,000), it will record the date and proceeds on the partnership’s tax return but Sam and Shapi are treated on their own tax returns as having each disposed of a half-share in the asset, for a gain of £100,000.
NB This was an asset always owned equally by the partnership; it bought and sold the property. The calculation might be quite different if it were a property that a partner had previously owned and introduced to the partnership.
Watch the sharing ratios
What matters from a CGT perspective is the fractional share in an asset; if it rises, the partner has acquired an asset or increased their ownership; if it falls, they have disposed of part or all of their interest in that asset and a disposal has occurred for CGT purposes.
Suppose that some years later, Sam, Shapi and Samina have been sharing their partnership properties (the capital-sharing ratios) as: Sam 3: Shapi 3: Samina 6.
The partners agree that the capital interest in the properties should be split equally going forward, so from now on: Sam 4: Shapi 4: Samina 4.
Clearly, Sam and Shapi have gained 1/12th of the inherent value of the partnership’s property assets so they have not disposed of anything. But Samina has given away a 1/12th interest in the partnership property to Sam and Shapi each; she has made a disposal for CGT purposes. However, this will not always result in a CGT charge.
Statement of Practice D12
HMRC’s original Statement of Practice D12 (SP D12) is about 50 years old now and has been tweaked a little along the way (it was officially revised and republished in 2015). It is a well-written explanation of how HMRC will approach various CGT scenarios involving partnerships and chargeable assets, such as introducing new partners, retirement of partners, etc.
For a basic introduction to CGT and partnership property, the key thing to appreciate is that HMRC will not normally argue for a CGT charge when internal profit-sharing arrangements change unless:
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chargeable assets have been revalued; or
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real money or other valuable consideration also changes hands alongside the changed ratios.
This is because, absent those two factors, SP D12 states that the percentage of value disposed of can be matched with the historic cost on the balance sheet, so proceeds = cost, and no CGT is due.
In most partnerships, revaluations orient around goodwill in the partnership, if at all, but in property partnerships it may actually be the appreciating value in the properties themselves, coupled with borrowing requirements, that make revaluations seem attractive.
We shall now consider further possible complications.
Is it actually a partnership asset?
In many cases, it will be obvious that an asset ‘belongs’ to the partnership. But in England and Wales, a partnership is not a separate legal person and cannot buy or sell things in its own name*; rather, the partners will buy and sell assets on behalf of the partnership. So, the question will sometimes arise
whether the partners bought the property for the partnership or whether they bought it for their personal ownership but potentially for use by the partnership.
The distinction can be important on incorporating the business or when a partner dies. For example, inheritance tax business property relief is available on a partnership interest (and by implication, the share in the partnership’s own underlying assets) at 100%, but for qualifying personally held assets at only 50%.
If the property was originally acquired using partnership funds, the presumption will be that the property was bought for the partnership, so it will rank as a partnership asset (PA 1890, s 21); similarly if the partnership’s balance sheet includes the asset as belonging to the partnership (but this assumes that the partnership accounts actually include a balance sheet, and not all do and many smaller firms do not). The correct position will then have to be established by considering the parties’ intentions.
Assuming it is partnership property, what is the sharing ratio?
Partnership property need not all be split in the same proportions. A more complex partnership agreement might commonly have the more senior partners holding greater proportionate shares in one or more of the older assets.
So, a sharing ratio can be specific down to individual properties, rather than a single sweeping fraction applicable to all partnership properties. Likewise, the partnership can have fixed capital-sharing arrangements but different income profit shares that can change from one year to the next.
Example 2: New partner
Sam, Shapi and Samina share their partnership property equally, so 33.3% each. They take on a new partner, Fred, who has only a small number of low-value properties to contribute to the partnership portfolio. But Fred is a qualified lawyer, whose vast experience in dealing with tenants and contracts means his contribution to the profits of the partnership is very valuable.
Annual profits are split Sam 1: Shapi 1: Samina 1: Fred 1.
But the capital-sharing ratio is split: Sam 5: Shapi 5: Samina 5: Fred 1.
Even so, the partners agree that any future properties will be shared equally, in recognition of Fred’s significant ongoing contribution to the business.
Two years later, the partners agree to split the business income profit sharing ratio more towards Fred: Sam 4: Shapi 4: Samina 4: Fred 5.
But this has no effect on the capital sharing arrangements for the ‘old’ properties, which remain at Sam 5: Shapi 5: Samina 5: Fred 1.
What if there is no agreement?
HMRC’s position is that a partner’s fractional interest should be determined by reference to:
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specific agreement in relation to the particular assets, if there is one; absent which
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any agreement or evidence in relation to capital-sharing ratios more generally; absent which
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any agreement or evidence in relation to how income profits should be shared; absent which
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the assets should be treated as held in equal proportion (PA 1890 s 24(1)).
(NB given that income sharing ratios will almost certainly have been determined in previous years’ partnership return statements, it is practically difficult to get all the way to 4).
*The rules differ in Scotland and advice should be sought as appropriate to the circumstances.
Conclusion: Beware seemingly innocent requests from lenders!
The rules for CGT and partnerships are sensible and flexible but can be complex to administer with large or long-running partnerships, where there have been numerous changes over the years. Partners in property partnerships should be particularly careful about the implications of asset revaluations that may trigger taxable disposal events if capital sharing ratios subsequently change.
Many partnerships will carry on for years without needing even a balance sheet, let alone wanting to revalue the balance sheet assets. But a property partnership will commonly want to recognise the increased value in their properties as it seeks additional borrowings; the partners need to appreciate the possible long-term consequences for adopting revalued assets in their business balance sheet for the next time a partner is admitted, or they otherwise decide to re-work their capital-sharing ratios.
