Capital Gains Tax and Partnerships
A partnership is defined in the Partnership Act 1890 s.1(1) as, “the relation which subsists between persons carrying on a business in common with a view to profit”. HMRC have not developed their own statutory definition of partner or partnership for capital gains tax (CGT) purposes and so these take their normal meaning under the Partnership Act 1890.1
It follows from the statutory definition of a partnership that a partnership is not a legal entity separate from its partners (although the position in Scotland is different). The position is simply that the partners have agreed between themselves to pursue a common business and that they are seeking to generate a profit. If there is any question as to whether the relationship existing between parties is a partnership, the rules in the Partnership Act 1890 s.2 are relied upon. These rules differentiate a partnership from other kinds of relationships, such as co-ownership of property.
Limited liability partnership
In response to increasing pressure from professional firms, in particular large accountancy partnerships as their practices grew in size and expanded across the globe, on April 6, 2001 the limited liability partnership was introduced by the Limited Liability Partnerships Act 2000. The limited liability partnership shares some of the characteristics of the traditional (general) partnership, although there are two key differences. First, the limited liability partnership has separate legal personality. It is a body corporate and is an entity in its own right. Second, the participants in a limited liability partnership have their liability limited to the extent of their capital contribution (except in limited circumstances, for example, where they have assumed personal duties of care). Participants in limited liability partnerships are known as members, rather than partners, but in the interests of simplicity for the purposes of this article, “partner” will be used to describe both partners of partnerships and members of limited liability partnerships, as the context permits.
Despite some fundamental differences, partners of limited liability partnerships are treated as partners for tax purposes because references to partners and partnerships are deemed to refer to members and limited liability partnerships in the chargeable gains legislation.2 This treatment ceases upon the appointment of a liquidator or the making of a winding up order (or the equivalent in a non-UK jurisdiction) at which point the limited liability partnership is treated as a body corporate.3
Types of partner
Many partnerships and limited liability partnerships organise their partners into different classes, which usually reflect their remuneration rights, voting rights, hierarchy and other constitutional matters. Often, partners with limited rights are known as “salaried partners” or “fixed share partners”. HMRC are not directly concerned with the internal categorisation or a partner's rank, rather it needs to understand the person's status within the organisation. HMRC will consider whether a salaried partner, for example, is a true partner who shares in the profits of the business or whether that person is in fact an employee, receiving a salary and simply attributed the title of partner for prestige.4 Such a person could be classified as an employee even where such employee's salary might be determined by reference to the profits of the business.
This article examines the position of partners, rather than employees who have been given the title partner and, although partners can be corporate entities, this article only examines the CGT position of individuals.
As the use of trusts as a tool for a family wealth management and succession planning has been gradually eroded over time, in particular as a result of the changes introduced by the Finance Act 2006 and the Finance Act 2008, families are increasingly considering the use of partnerships and limited partnerships as wealth management vehicles. Although an option, limited liability partnerships tend to be less popular as family wealth management vehicles due to the disclosure requirements of the Companies Act 2006 and to other statutory obligations, such as filing UK GAAP-compliant accounts.
Families often consider limited partnerships, which offer limited liability protection to the limited partners provided that they do not participate in day-to-day management. There must also be at least one general partner with unlimited liability. Typically, a senior family member will be involved in regular decision-making and so he or she cannot be a limited partner. In order tomitigate the unlimited liability risk further, a corporate vehicle (the shareholder of which has limited liability) is often used as the general partner.
Basis of taxation of chargeable gains
Partners responsible for tax
Where two or more persons carry on a trade or business in partnership:
• tax in respect of chargeable gains on disposals of partnership assets is assessed and charged on the partners separately; and
• partnership dealings are treated as dealings of, or by, the partners, and not of those of the firm.5
The principle that partners are responsible for gains arising on the disposal of partnership assets and for the dealings of the partnership, i.e. that tax is levied at partner level, rather than at “entity” level, is often referred to as the tax transparency of partnerships.
Impact of a partner's individual circumstances
It follows from the tax transparency of partnerships that the partner's residence status will impact on his or her liability to CGT.
Individual partners must disclose chargeable gains in their self-assessment tax return each year.
Chargeable gains can arise in a number of situations, whether the partners are transacting with the world at large or simply re-arranging the partnership internally. The potential CGT implications of these situations is set out below.
To illustrate the scenarios, let us use a simple case study. Gordon, Alistair and David are in partnership. Gordon and Alistair each contributed £4,000 of capital and David contributed £2,000. They have agreed that income and capital profits (and losses) will be divided 40 per cent, 40 per cent and 20 per cent.
Disposal of partnership assets
Disposal to third parties
Where a partnership asset is disposed of to a third party and that disposal generates a gain (or a loss), HMRC consider that a partner's share in that asset is his or her fractional share of the asset in relation to that partner's partnership interest. Expenditure on the asset is also shared according to the partners' shares. Unlike some US partnership arrangements, no discount is made accordingly to the size of a partner's share.6
In our case study, if the sale of the asset by the partnership generated a gain of £1,000, with £100 of allowable expenditure. Gordon and Alistair would each be allocated a £400 gain (and £40 of allowable expenditure) and David would be allocated £200 (and £20 of allowable expenditure).
It is therefore important that partners clearly indicate how income and capital receipts are to be shared among the partners. If no agreement is in place, regard will be had to the accounting treatment or the profit-sharing ratios agreed (whether in writing or by practice) between the partners. Adjustments may be needed where partners join or leave the partnership.7
Disposal to partners
If a partnership asset is disposed of to one of the partners, for example by a distribution in specie on the dissolution of the partnership, a notional calculation is made to establish the gain that would have arisen had the disposal been at market value. On distribution, the non-recipient partners will be attributed their fraction of that “gain” and this is chargeable. The partner receiving the distribution will not realise a chargeable gain, instead the tax cost will be the asset's market value reduced by his “gain”.
Contribution of assets to the partnership
HMRC would consider a disposal of an asset to the partnership to be a part disposal by the contributing partner of the fraction of the asset attributable to the other partners.
Until January 21, 2008, it had been HMRC's practice to apply the rules set out in Statement of Practice D12 so as effectively to apportion the contributing partner's base cost amongst the partners, meaning that there was no gain or loss for CGT purposes, unless the parties were connected. However, HMRC have since stated that the practice was erroneous and that a gain will arise if it exceeds allowable costs.8 HMRC treat the sums contributed to the capital account as the consideration for the disposal.
Therefore, if a new partner, Ed, joined the partnership and was given a 10 per cent share of capital (the shares being adjusted to 40/40/10/10, the effect of which is discussed below) and contributed an asset worth £1,000, he would dispose of an asset worth £900 to the other partners. Assuming a £100 base cost and £100 of allowable expenditure, Ed's chargeable gain, before utilising exemptions and reliefs, would be £720 (having deducted nine-tenths of the base cost and allowable expenditure). As Ed and David are brothers, they are connected persons9 and the market value rule would apply.10
Changes to partnership shares
Partnership shares may change following the addition of new partners or the departure of retiring partners. Alternatively, the partners may remain the same, while deciding to change their partnership shares. The latter is likely in a family partnership arrangement where a parent or parents wish gradually to transfer the family assets (managed as a partnership business) to their children as their children become more mature and therefore more able to cope with increased financial/business responsibility.
Where the partnership capital sharing ratios change during the continuation of a partnership, including the changes arising from a partner joining or leaving a partnership, the partner reducing his share is treated as having made a disposal of the relevant fraction of the partnership assets and the partner whose share increases is treated as having acquired such fraction. If there is no adjustment in the accounts (such as a revaluation and corresponding amendment to the capital accounts) there would be no gain and no loss at that point,11 unless the partners are connected or a payment is made outside the accounts.
Taking an example, suppose that the partners decide that Gordon should be less involved in the business and therefore that half of his share should be transferred to Ed. No adjustment is made through the accounts, but Ed makes a payment to Gordon outside the accounts in respect of goodwill (which is not included in the balance sheet). The payment by Ed represents consideration for the disposal by Gordon, but Gordon is unlikely to be able to set it against any CGT cost.12
However, the position is different where connected parties are concerned. When Ed joined the partnership above, the partnership sharing ratios changed so that Ed received half of David's share. Transfers between partners are not treated as transactions between connected persons if they are pursuant to genuine commercial arrangements13 unless the partners are connected other than by partnership. A partner is however still connected to a partner who is their spouse, civil partner, brother, sister, ancestor or lineal descendant. Accordingly, for the transfer of the 10 per cent share to Ed, market value will be substituted unless £1,000 represented the sum that would have been paid in an arm's length transaction.
The connected persons rules require careful analysis in the context of family partnerships, as market value or arm's length transactions seem unlikely. There may however be some scope for use where the amounts involved are such that regular partnership share readjustments could be made resulting in incremental disposals so as to maximise annual exemptions and available reliefs without significant charges to CGT.
Losses, exemptions, reliefs and indexation
A partner may set allowable losses against chargeable gains when calculating his or her liability to CGT. The allowable loss available to a partner is computed in the same way as the chargeable gain attributable to that partner, namely by looking at that partner's fractional share.
Annual exempt amount
Individuals are entitled to an annual exempt amount for capital gains tax each year, which is £10,100 for the tax year ending April 5, 2010. This can be used by an individual to reduce the CGT payable on chargeable gains and accordingly could be used against chargeable gains resulting from that individual's participation in a partnership.
For disposals prior to April 6, 2008, taper relief was available to reduce the amount of chargeable gain. The disposal of both partnership assets and a partnership share could qualify as business assets, with the more significant reductions, although careful consideration was needed where assets were used partly in the partnership14 and partly as a non-business asset, requiring a pro-rata apportionment.
From April 6, 2008, entrepreneurs' relief15 effectively charges CGT at 10 per cent for the first £1,000,000 of qualifying gains. For high net worth individuals, this is of little benefit as the 10 per cent rate is only available for £1,000,000 of chargeable gains throughout a person's lifetime, with any excess over £1,000,000 being charged at the usual rate, currently 18 per cent.
This relief is of particular relevance to partners when disposing of a partnership interest, or in some circumstances when making a contribution on entering a partnership16 (for example, when making a chargeable disposal on contributing assets, as Ed did above). However, there are pitfalls where an asset has been used (however long ago, and however briefly) for non-business purposes, and access to the relief may be restricted in these circumstances.
Assets held by the partnership at March 31, 1982 are treated as if acquired at their market value on that date. The detail of the provisions is beyond the scope of this note, but Revenue & Customs Brief 09/09 sets out the rebasing rules for partnerships following the changes introduced in Finance Act 2008.
Where partnership assets are disposed of, it may be possible to defer the CGT liability by using roll-over relief. This will be available where qualifying business assets replace the disposed-of assets and provided that replacement is made either within 12 months before the disposal of the original asset or within three years after the disposal.17
Other reliefs might be available, such as principal private residence relief upon the contribution of a property by a partner. This seems most likely in the context of family partnerships. Residential property is however rarely suitable for family partnerships where the partners are domiciled in England and Wales, as the donor's continuing residence in the property can give rise to a number of gift with reservation of benefit IHT issues.
The term “LLP conversion” has been frequently used to refer to the process whereby the partners of a partnership have decided to run their business through a limited liability partnership, typically due to the liability protection for partners, and have therefore transferred the partnership's business, assets, staff and so on to the limited liability partnership. HMRC have confirmed that where a business is transferred to a limited liability partnership, then that transfer will not of itself constitute a disposal by the partners of their interests in the old partnership's assets.18 This follows logically in a situation where there is no change in the partnership shares. The position would be less straightforward if the partnership sharing ratios changed at the same time, usually due to the admission of new partners and retirement of old partners as LLP conversions are often timed to coincide with the business year-end date. Careful consideration should be given before changes to the partnership aremade as thismight prejudice the availability of the stamp-duty exemption on conversion to a limited liability partnership.19
So far as non-family businesses are concerned, there are both advantages and disadvantages to the transparency of partnerships for tax purposes. From April 6, 2010, when the top rate of income tax is proposed to rise to 50 per cent, partners in partnerships with a significant turnover are likely to find it inconvenient that there is no automatic means of sheltering the profits of the business from higher-rate tax, as is the case with limited liability companies. However, the transparency of partnerships for CGT purposes may be more beneficial, enabling partners to recognise profits on disposal of partnership assets at 18 per cent, and with the benefit of their annual exempt amount, rather than at corporation tax rates.
Family partnerships have been much discussed as an alternative holding structure for family wealth since the Finance Act 2006 made changes to the IHT treatment of trusts, making them comparatively less attractive than under the earlier rules. The principal practical difficulty encountered by many families looking to arrange their affairs is that their assets are not of a kind which inherently lends itself to running a business--looking back to the beginning of this article, the essence of any partnership is that the partners conduct a business in common with a view to profit. Family homes, for example, are rarely suitable, and yet represent the main challenge for many wealthy families in estate planning. Simply holding assets would not be sufficient to discharge a requirement for a business. Even if suitable assets can be identified, so that there is a genuine business in which the various members of the family can be engaged (albeit in varying degrees), CGT on disposal of the assets to the partnership can be a deterrent to some (although it is worth noting that the CGT should not, at 18 per cent on a fraction of the gain, prove as significant as the 20 per cent IHT entry charge payable on disposal of the same assets to a trust). In addition, the continuing charges to CGT as the older generation gradually cede their partnership shares to the younger generation need to be carefully managed, taking advantage of annual exempt amounts and entrepreneurs' relief (where available), in order to ensure that the partnership continues to be a tax-efficient mechanism.
This article, by Arabella Saker and Corinne Staves, first appeared in Private Client Business 2010, 1, 29-37 published by Sweet & Maxwell.
HMRC's Capital Gains Manual at CG27020.
Taxation of Chargeable Gains Act 1992 s.59A(2).
Taxation of Chargeable Gains Act 1992 s.59A(4).
HMRC's Business Income Manual at BIM72025.
Taxation of Chargeable Gains Act 1992 s.59(1).
Statement of Practice D12, paras 1 and 2.
Statement of Practice D12, para.2.
HMRC Brief 3/08.
Taxation of Chargeable Gains Act 1992 s.286(1).
HMRC Brief 3/08.
HMRC Statement of Practice D12, para.4.
HMRC Statement of Practice D12, para.6.
HMRC Statement of PracticeD12, para.7 and Taxation of Chargeable Gains Act 1992 s.286(4).
Careful consideration should be given if the partnership has not started to trade, see Chappell v Revenue and Cutoms Commissioners  S.T.C. (S.C.D.) 11.
Taxation of Chargeable Gains Act 1992 ss.169H et seq.
Taxation of Chargeable Gains Act 1992 s.169I(8).
Taxation of Chargeable Gains Act 1992 ss.152 et seq.
Tax Bulletin December 2000.
Finance Act 2003 s.65
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