As expected, following a consultation at the end of 2016, the draft legislation published on 13 September includes provisions aiming to remove uncertainty and provide clarity on the taxation of partnerships. Here are our thoughts on the main proposed changes, and steps that firms might wish to take.
Allocation of firm’s profits between partners
Perhaps the most significant change proposed is to the way profits or losses are allocated between partners for tax purposes.
The government’s stance is that it does not want to undermine the flexibility in profit allocations within partnerships, but it wishes to reduce the scope for profit allocations being driven to achieve a tax advantage.
The draft legislation does not restrict flexibility to allocate profits between partners on a commercial basis. However, it does stipulate that profit allocations for tax purposes must be made on the same as basis as the allocation of commercial profits between partners.
Each partner’s share of tax adjusted profits will be based on a percentage, calculated as the partner’s share of the firm’s total commercial profits for the relevant period.
Many partners in receipt of a fixed share of profits are currently taxed on the fixed amount without bearing the burden of tax on disallowable expenses. Under the draft legislation, fixed share partners would be required to bear a proportion of the tax-disallowable expenditure based on their overall percentage of the firm’s profit. This may be seen as a fair outcome. However, for those businesses looking to incentivise senior employees to take the next step into partnership, they may need to re-think their remuneration policy to ensure there is sufficient financial motivation.
Amendments to profit allocations and disputes between partners
The proposed legislation makes it clear that the profit share returned on the partnership return is conclusive for tax purposes. However, where a partner disputes the share of profits returned there will be a mechanism allowing this to be resolved by referring it to the Tribunal for determination. This may help provide certainty and protection for partners, in particular outgoing partners, and partnerships should now place even greater emphasis on their agreements. The methodology behind allocation of profits should be accurately documented and applied consistently across all levels of partner. Firms that don’t currently have a robust agreement in place should ensure that one is put place.
Business structures that include partnerships as partners - additional information to be included on partnership returns
It is welcome that the government has revised its initial proposals to ‘look through’ arrangements involving partnerships as partners – ie to the ultimate ‘indirect’ partners. However, the draft provisions require additional information to be reported by such firms on their partnership return.
Firms with this type of tiered structure, which can be common for international partnerships, will be required to prepare computations and report profits and losses under four different bases:
- UK-resident individual;
- non-UK resident individual;
- UK resident company; and
- non-UK resident company.
There is, however, an exception to reporting under all four bases if the reporting partnership return shows the name of every indirect partner and ultimate recipient of the profits or losses, and it is clear which basis of calculation is appropriate.
A partnership which is allocated profits or losses from another partnership will also be required to report this source separately on its own partnership statement to distinctly identify this source as separate from other sources.
Partnerships, in such tiered structures should discuss the requirements with their partners and take advice on whether to report profits using the four different bases above or to simply declare each indirect partner’s interest.
Overseas partners in investment partnerships
The government has recognised that investment partnerships regarded as financial institutions report under the OECD’s common reporting standard (CRS).
To prevent double reporting, the draft legislation removes the requirement for the tax reference number of overseas investment partners, who are not chargeable to income tax or corporation tax in the UK, to be reported on the partnership tax return. This is provided they have already reported the details under the CRS.
The government has focused on relaxations for financial institutions; however there is still room for improvement in other areas such as changing tax returns to make it easier for partnership statements to be prepared for both income and corporation tax bases - currently only one partnership statement can be prepared. There is also an increasingly urgent need for an update to property income and expense reporting with the introduction of FRS 102.
Overall, the proposed legislation is welcome and will provide clarity for some partnerships. However, some may argue that the changes will place an increased administrative burden on partnerships, their agents and HMRC itself, without substantially improving the status quo. It also remains to be seen how significant changes to the way profits or losses are allocated between partners for tax purposes will impact on partners and firms’ partner remuneration strategies.