Firms should urgently review their existing profit sharing arrangements and how proposed legislative changes could potentially affect them and, in particular, the impact on their current tax reserving policies.
On 13 September 2017, legislation was published for the draft Finance Bill to remove uncertainty and provide clarity on a number of areas of partnership taxation.
One particular area of confusion that the draft legislation aims to clarify is the allocation and calculation of partnership profit for tax purposes, which “must be allocated between partners in the same ratio as the commercial profits.”
If firms have always allocated partnership and commercial profit for tax purposes in the same way, the change may be unclear.
Current legislation (s.850 ITTOIA 2005) provides that, for any period of account, a partner’s share of a profit or loss of trade carried on by a firm is “determined for income tax purposes in accordance with the firm’s profit-sharing arrangements during that period.”
The draft legislation proposes to substitute this with “for income tax purposes, the partner’s percentage of the profits or losses…” The ‘partner’s percentage’ refers to their share of the firm’s total profit or loss for the period of account, which includes any fixed proportion of their profit share, expressed as a percentage.
It remains unclear as to what impact this will have on firms with discretionary profit-sharing arrangements that are not exercised until after the particular accounting period has ended.
The proposed change could fundamentally affect those firms that do not allocate a share of the tax disallowable expenditure (such as client entertaining) to their ‘fixed share’ partners. It could also affect firms that currently allocate all of the tax disallowable expenditure to another class of partner, such as a corporate partner, which is subject to corporation tax.
Below is a hypothetical case to illustrate the proposed change, where a partnership has accounting profit of £1m and taxable profit of £1.1m:
- Partner A is currently allocated a fixed share of £100,000 of both the accounting and taxable profit, subject to income tax at 40% and Class 4 National Insurance Contributions (NICs) at 2%
- This would give rise to an income tax liability of £40,000 and NICs of £2,000 making total take home pay of £58,000
- After allocating £1m of taxable profit to all individual partners in accordance with their share of the accounting profit, the partnership allocates the remaining taxable profit of £100,000 (i.e. the tax disallowable expenditure) to the corporate member, which is subject to corporation tax at 20%
After proposed changes
- Partner A will continue to be allocated a fixed share of £100,000 of the accounting profit, for profit distribution purposes (i.e. a 10% ‘partner percentage’)
- For income tax purposes, Partner A will be allocated 10% of the taxable profit, i.e. £110,000, which will be subject to income tax at 40% and Class 4 NICs at 2%
- This would give rise to an income tax liability of £44,000 and NICs of £2,200 meaning a reduction in total take home pay of £4,200
- The corporate partner has no share of taxable profit subject to corporation tax at 20% and it would see its tax bill fall to nil. This gain would be easily outweighed by the increased tax on all the remaining individual partners
How could this affect your partners?
Depending on your current profit-sharing arrangements, the requirement to allocate a share of the tax disallowable expenditure to all partners in accordance with their ‘partner percentage’, could result in fixed share partners seeing a reduction in their total take home ‘pay’.
The change will take effect for accounting periods starting on, or after, the date of Royal Assent. The draft legislation is set to be laid before Parliament shortly, with confirmation of the Finance Bill to be announced in the Autumn Budget 2017 on 22 November 2017. The Finance Bill may receive Royal Assent prior to April 2018.
For firms with a 30 April year-end, the change could have an impact on the allocation of profit for income tax purposes as soon as the next accounting period commencing on 1 May 2018.
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of publication.