Partnerships – draft legislation

In a break from Unitary Taxation, I’ve been looking at the new Partnerships rules in the draft Finance Bill 2014 and it seems to be a clear case of the unfair imposition of tax.

There are two main bits to the new rules, one covering LLPs and whether members should be treated as self-employed or not, and the other looking at mixed partnerships (where at least one partner is a company, and normally at least one is an individual).

The former isn’t too bad, though I’m wary of the way that the rules it brings in are purely mechanical rather than having room for judgement in them.

The latter seems to be rather unfair, because of the way that the rules it brings in are purely mechanical rather than having room for judgement in them.

The issue

The issue to be addressed is that if you have an individual partner he is taxed on partnership profits at income tax rates of up to 45%, plus NI; a corporate partner is taxed at corporation tax rates of 20%-odd.  So if you divert profits to a company you save tax, and if you divert losses to an individual ditto.

The losses rules are aimed at marketed avoidance schemes where substantial losses are made in year one and allocated to individuals out of proportion to their economic loss.  They include a condition that the arrangements have to be for tax avoidance purposes, whcih seems fair enough.

The profits rules however include no condition about tax avoidance: they simply say that if the corporate member receives profits that HMRC thinks could have been received by an individual had the partnership been set up differently, or that will eventually be received by an individual, then those profits are attributed to that individual (I paraphrase here).  The company can keep a profit share based on the assumption that any cash it invested can earn interest, but anything above that is automatically redirected to the individual.

Problem – losses

The problem is that HMRC have assumed that partnerships simply produce a profit stream, so diverting it from one person to another is a simple matter.  But to take a simple example, if a mixed partnership (one company, one individual) makes a loss of 100 in year 1 and a profit of 100 in year 2 (net result nil), then the company gets a loss of 50 and no profits, and the individual gets a loss of 50 and 100 profits.  The individual has to pay tax on a profit of 50 which doesn’t exist in economic terms, it is purely an artifact of the tax regime.

HMRC’s response is, essentially, that those who try to avoid tax should expect to get burned.  But this isn’t exactly fair nor reasonable.

Take a position (based on an actual case I know of) where we have several companies in partnership, including one which was set up by an individual so that he would have the same limited liability as all the other partners.  It makes a large loss in year one, due to  capital allowances on a large investment coupled with a low level of actual sales (not unusual for the first year of a venture).  In later years it is expected to make comfortable profits.

The new rules will leave all the losses in the company, but all the profits will be attributed to the individual: he is most definitely double-taxed, and the losses are completely wasted.

The obvious solution is to disclaim capital allowances to reduce (but not remove) the wasted losses.  If however the allowances are 100% first year allowances, if we disclaim them we replace 100 of losses carried forward with 8 or 18 of allowances per annum on a reducing balance basis.  If we make 20 of profits per year after the first, then in the ordinary course of things we would expect not to have to pay tax for five years but the partnership rules will give us increasing taxable profits.  They completely negate the enhanced capital allowances that Parliament has said should be available for worthy investments, purely because the individual wanted limited liability like his fellow partners.

That is a fairly fortunate case, in that it is possible to disclaim the losses at risk.  Had the capital allowances been claimed a few years ago that may be out of time – and if the losses are economic losses then there is nothing that can be done.

I note that the House of Lords is looking at this area, and I shall certainly be feeding back on their call for evidence.

Further problem – limited liability

The new rules apply only if a company is a partner in a mixed partnership, or one that HMRC thinks could have been mixed.

This leads to absurdities.  If Mr A and Mr B want to go into business together with their liability limited by shares, they have a few options.  They could form a company to carry on the business, where each owns 50% of the shares, or they could each form their own company and have those companies carry on the business in partnership.  In the former case the profits are clearly subject to corporation tax in the company; in the latter, the new rules would say that they are clearly attributable to the individuals and subject to income tax.  Very different tax results, in an almost identical economic and legal position.  What is the policy reason for this?

Worse: if Mr A has a trading company, and Mr B has a trading company, and they trade independently for several years, their profits are taxed in the companies.  If they then decide to get together and pool their businesses, so the companies are in partnership, do we suddenly have the profits shift over to being attributed to the individuals and taxed as income?  Possibly not, as it should be possible to argue that if the trading comapnies are established then it would not be reasonable to suppose that the individuals would have become members of the partnership.  But this is far from clear, and in any case what is the policy reason for treating this corporate partnership differently from the previous one?

Boiling it down: the draft rules would allow HMRC to lift the corporate veil in some situations, but not in others which are practically identical.

That seems a dramatic step to take, especially when one bears in mind that the best a corporate partner can do, even if it is trying to reduce a tax bill, is normally to defer it.  The Exchequer will get the tax eventually (when the profits are distibuted to the shareholder), so what is the problem?  All the rules seem to do is allow HMRC to take a greater cut of profits which would otherwise be reinvested in the business, which doesn’t seem to be very helpful to a small business sector which is trying to get out of recession.


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