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Back to basics: The taxation of partnerships

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The taxation of partnerships is a complex area. With no separate tax code, the legislation is spread over various taxes acts and statements of practice. However, partnership structures offer flexibility and that makes them a popular choice as a business structure. Recent years have seen an increase in the number of individuals becoming partners in businesses and variants on the traditional structure. This has resulted in HMRC consulting on proposed rules to be introduced in April 2014 and the widening of the loan to participator rules in Finance (No.2) Bill 2013.

According to Business Population Estimates, there were an estimated 448,000 partnerships in the UK at the start of 2012. While partnerships offer flexible business structures and the benefit of limited liability, where a limited liability partnership (LLP) is used, the taxation of partnerships can be complicated. The difficulty is that there is no separate tax code for partnerships; the legislation is not located in one place which makes it difficult to get an overview.

The capital gains charging provisions for partnerships are based on an old Inland Revenue statement of practice from 1975, rather than legislation. There is a universal approach – the same rules apply to a small firm of two partners as they do to large businesses with hundreds of partners.

Current developments

The proliferation of variants on the traditional partnership structure with the use of corporate partners and ingenious profit and loss sharing arrangements has resulted in HMRC issuing a consultation paper on 20 May 2013. This consultation document, A review of two aspects of the tax rules on partnerships, focuses on:

  • disguised employment; and
  • profits and loss allocations, including the use of corporate partners.

Legislation is expected to come into effect on 6 April 2014.

This consultation is in addition to the Finance (No.2) Bill 2013 changes in relation to the ‘loans to participator’ rules and the way they apply to LLPs and partnerships. Where a close company makes a loan or advances money to a partnership or an LLP in which one or more of the partners is a participator in the company, the company will be liable to corporation tax at the rate of 25% on the amount of the loan or advance. The provisions are extended to situations where a close company is involved in ‘tax avoidance arrangements’.

The purpose of this article is to give an overview of the existing tax rules applying to partnerships and to highlight the areas of risk. It is based on a recent talk given by Richard Mannion, national tax director of Smith & Williamson, to the London branch of the CIOT.

Income tax

Partnerships and LLPs are treated as transparent for tax purposes (ITTOIA 2005 ss 846–863). Each partner is taxed on his share of the trade or business and is treated as carrying on a ‘notional business’. Partners and members are taxed on the amounts attributable to them as their profit share regardless of whether the profits have been drawn down from the business. Both class 2 and class 4 NIC are payable on the profits.

Income tax is applied on a current year basis, i.e. the profits in the accounting period which ends in the tax year. The general rule is that the profits are calculated as a self-employed business, but there is no deduction for salaries paid to equity partners and interest paid on loans from equity partners.

Salaries paid to salaried partners and the related employment costs are deductible in calculating taxable profits and salaried partners are subject to PAYE. However, under the current tax rules a member in an LLP is treated as self-employed, so there are no salaried partners in the traditional sense. The consultation document sets out to change that; meanwhile, the current provisions in ITTOIA 2005 s 863 state that:

  • ‘For income tax purposes, if an LLP carries on a trade, profession or business with a view to a profit then all the activities of the LLP are treated as carried on in partnership by its members.’

Therefore, profit shares received by a member of an LLP cannot be treated as remuneration even if it is a fixed share.

Under the proposed changes, the presumption of self-employment will be removed and ‘salaried partner’ status will apply where there is an employment type relationship or where there is no real commercial risk to the partner.

Other expenditure is deductible against profits where it is incurred wholly and exclusively for the purposes of the business and it is not capital.

In some partnerships, individual partners are responsible for their own expenses. However, claims for these expenses must be made on the partnership return, as it is not possible for the individual partner to make a claim for these expenses on their return.

Contentious area

The expenses which very often are the subject of an enquiry include motor expenses and private use adjustments, travel and subsistence, disbursed client lunches, legal and professional (capital/revenue) and recruitment costs for new equity partners.

In recent years, there has been a lot of debate between the tax profession and HMRC in relation to the allocation of partnership profits where there is a dispute between the partners. The statutory assumption is that all the partners are in agreement on the calculation and the allocation of profits. This is not always the case, particularly where a partnership ceases or a partner has left. The result is that a partner could end up paying more tax because there is no mechanism where a partner, other than a nominated partner, can appeal. HMRC has always taken the view it would only negotiate with a nominated partner about the computation of the firm’s taxable profits and it firmly took the view that any dispute between an individual member and the firm had to be sorted out between them in accordance with the partnership agreement. The view was that the nominated partner had to file the partnership tax return showing the total taxable profits allocated between the individual partners and that the individual partner is obliged to include that figure on his tax return.

However, in the past few years there have been two cases. First was the case of Graham Morgan and Heather Self V HMRC (TC00046) in which the taxpayers left Ernst & Young with a retirement package that they argued should be treated as a capital payment for tax purposes. The case ended up in the First-tier Tribunal (FTT), which firstly had to decide whether the retirement package was income or capital and secondly, in the event that they found that the package was capital, it would have to decide whether an individual partner had the right to return a figure that was different to the partnership tax return. In the event, the FTT decided that the retirement package was assessable as income, which meant it did not have to decide on the second point. However, Dr Brice went on to give an analysis of the statutory provisions in TMA 1970 relating to partners and partnerships. She said:

‘although the provisions of s 8(1)(b) and 8(1B)  impose a clear statutory obligation to provide the partnership statement with the return and to include the amounts in it in the return, those sub-sections have to be read within the context of the whole of s 8 which includes s 8(1)(a). It seems to me that the language of s 8(1)(a) fairly admits of the interpretation that the totality of the information referred to must ensure that the return is complete and so must include any additional information needed to supplement the partnership statement in order to comply with the purposes of the section which is to establish the right amount of tax’.

While HMRC initially took the view that Dr Brice’s remarks were obiter dicta, and so could be safely ignored, another case forced a change to HMRC’s prevailing practice. In the case of Raymond John Phillips v HMRC (TC00276) the FTT reached very similar conclusions to that of Dr Brice:

‘In summary, a partner who is not the nominated partner can bring an appeal against a consequential amendment of his own return under s 28B(4) because s 31(1)(b) gives him this right. He can also appeal any assessment made against him because s 31(1)(d) gives him this right. I also conclude that those appeals can put in issue the correctness of any assessment of a partnership in which the taxpayer is a partner, or the correctness of any amendment to a partnership return. This follows because, firstly, there is nothing in the Act to limit the scope of the taxpayer’s appeal. Secondly, as stated above, a contrary conclusion would not be consistent with the European Convention for the Protection of Human Rights and Fundamental Freedoms or the Bill of Rights. Thirdly, as stated above, it seems the Taxes Management Act would allow any partner to appeal against an assessment or amendment against the partnership itself.’

Following the Raymond John Phillips case, HMRC’s guidance (at HMRC’s Enquiry Manual EM7026) was revised so that now, where there is a genuine disagreement that cannot be resolved between the partners, individual partners can enter, as their share of partnership profits, the amount they consider to be correct and advise HMRC that they have done so by making an entry in the white space.

Capital gains

The way in which capital gains are dealt with for partnerships is not straightforward. There is no set legislation that deals with partnership gains. Under TCGA 1992 s 59(1)(a)(b), partnership dealings are treated as dealings by the partners and not by the firm as such. This applies the ‘see through’ principle. Where a partnership sells an asset which falls within the CGT regime (a chargeable asset), each of the partners is treated as disposing of his proportionate share of the asset.

On the face of it, this may seem logical but it can give rise to difficulties. Under general CGT principles, the partners in a partnership are connected persons. This means that any transactions between them for CGT purposes must take place at market value. Statement of Practice D12 seeks to disapply this rule where there are transactions between the partners in relation to the partnership assets. HMRC accepts whatever value is placed on the transaction by the partners.

When an individual is appointed to the partnership and no consideration passes, that individual will be treated as acquiring a share in the partnership’s chargeable assets, and the other partners will be treated as making a disposal of part of their share in the assets. This is achieved by a reallocation between the partners of the base cost of the chargeable assets.

Where consideration passes, either within or outside the partnership, the disposals and acquisition will be computed under normal CGT principles. This also applies where assets are revalued in the partnership accounts, whether or not consideration passes. See examples 1 and 2.

Partnership loans

Incoming partners are usually required to contribute capital to the firm. In many cases, the partner will borrow the funds. There is tax relief where an individual borrows money to lend to or acquire an interest in a partnership, subject to the cap on reliefs introduced with effect from 6 April 2013. The interest paid is relievable against income. The partnership typically pays the partner interest on the loan, which is taxable on the partner. If the interest rate on both is the same, the transaction is tax neutral provided the conditions to obtain relief are met.

Throughout the period from the application of the loan to the payment of the interest, the payer must have been a member of the partnership and during that time the member must not have recovered any capital from the partnership. If capital is recovered, the amount of relief is correspondingly reduced. This can be an issue where a partner’s current account is overdrawn.

Profit sharing

The profit sharing arrangements vary from firm to firm. Some firms favour transparency, while other firms still shroud the process in secrecy. Partners are free to agree the profit sharing arrangements between themselves and these can change from year to year. While there is no requirement for the arrangements to be set out in writing, this can avoid disputes at a later date. Most partnerships operate a system of fixed shares and a sharing of the extra profits. This method of sharing profits can cause some partners to have negative shares of profit. Where this arises, the tax treatment does not follow (see example 3).


There are three main routes to incorporation:

  • the sale of the partnership’s net assets for cash consideration, usually left outstanding on directors’ loan accounts;
  • the gift of the partnership’s chargeable assets to the company (TCGA 1992 s 165); and
  • the sale of the partnership’s net assets in exchange for shares in the company (TCGA 1992 s 162).

Where there is value in the partnership, the favoured approach tends to be a sale. If the individual has been a partner for at least a year, the partnership carries on a trade or profession, and the assets being transferred have been used in the trade, the individual should be eligible for entrepreneurs’ relief, meaning that a 10% tax rate can be achieved. This can give considerable cash flow advantages, with the future profits in effect being drawn out at 10%.

Use of corporate partners

Instead of incorporating, many partnerships have opted for a hybrid and introduced a company as a partner. The company is owned by some or all of the existing partners. Some of the profits are allocated to the corporate partner and used as working capital in the partnership. Corporate partners have also been used to acquire businesses so that a write down is claimed for the amortisation or impairment of goodwill. The consultation document is looking to tackle these structures by reallocating the profits back to the individual partners.

As mentioned earlier, for partnerships with individual and corporate partners, there is a proposed counteraction for all or part of the profits allocated to members not within the charge to income tax to be allocated to members within the charge.


The taxation of partnerships can be complex. The increased use of targeted anti-avoidance for partnerships will increase complexity going forward and create bear traps for the unwary. While the proposals contained in the consultation document are primarily aimed at the large professional partnerships, it is inevitable that other partnerships will be caught by the new rules.