The implications of the Budget 2015 tax changes for UK law firms
By Louis Baker, Head of Professional Practices, Crowe Clark Whitehill
The UK government's last two Budgets have introduced a raft of new tax avoidance rules directly relevant to law firms and law firm partners. The March Budget included yet another attack on structuring arrangements which some firms have used in recent years. Meanwhile, in the July Budget, the Chancellor announced changes to the taxation of dividends, in part to negate the lowering of corporation tax rates when considering how to structure a firm.
So, what does this mean for law firms and their partners? Since 18 March 2015, the disposal (including liquidation) of a corporate partner of a partnership or limited liability partnership (LLP) has no longer had the benefit of Entrepreneurs' Relief for capital gains tax (CGT) purposes. That is, unless the company is conducting its own trade beyond simply being a member of a LLP.
In looking at the cause and effect of this legislation, we need to go back some years and consider the impact of the government's anti-avoidance attack on the way that many professional firms have structured themselves of late.
Prior to 2000, professional firms were either partnerships or limited companies. The main rate of corporation tax, at 30 per cent, meant that it was more tax efficient for large firms to be run as partnerships.
The Limited Liability Partnership Act 2000 introduced a new vehicle that held the prospect of the best of both worlds: the flexibility and tax efficiency of a partnership with the limited liability protection of a company.
Initially, firms simply converted from partnership to LLP status and left it at that. Reduced corporation tax rates and increased income tax rates following the financial crisis changed the structuring environment.
Some firms transferred their staff into service companies to take advantage of transfer pricing legislation. Some partners set up companies ('corporate partners') to shelter profits suffering corporation tax rather than income tax and, in many cases, reinvest as working capital in their firms.
Some firms incorporated as companies claiming CGT Entrepreneurs' Relief on the goodwill recognised on the conversion and had the company claim corporation tax relief on writing off the goodwill it acquired from the predecessor firm.
In October 2013, the government changed the transfer pricing legislation to close the tax advantage that could be obtained through a service company structure.
From April 2014, profits allocated to corporate partners were taxed on the partners themselves, meaning there was no tax benefit in allocating profits to a corporate partner rather than to the individual partners themselves.
The salaried member legislation introduced in April 2014 made it harder for fixed-share members of LLPs to be taxed as self-employed members rather than as deemed employees subject to pay-as-you-earn tax and employers' National Insurance contributions.
From December 2014, Entrepreneurs' Relief stopped being available on the incorporation of a firm as a company, and the company was no longer able to claim tax relief on the write-off of goodwill.
In the March 2015 Budget, the Chancellor denied Entrepreneurs' Relief on the liquidation/disposal of a corporate partner that does not have its own separate trade.
The July 2015 Budget proposes to increase the tax rate on dividends. This is to make it more expensive to receive substantial income from a company by dividend than to earn the underlying profit within a partnership or LLP.
Those firms which set up service companies to obtain the transfer pricing benefit that used to be available will be considering what to do with their service companies.
To ensure the new transfer pricing rules do not impose a tax penalty on the firm, the service company will have to charge a real margin to its parent firm on the services it provides. This will generate a profit after corporation tax in the service company.
The tax which partners suffer on a modest (at the individual partner level) dividend from the service company (after taking into account the corporation tax suffered within the company) is roughly the same as the tax which partners would suffer on the profit that would accrue within their firm if there were no service charges being suffered.
This means that operating a service company can be done tax neutrally (no tax benefit, but no tax cost). However, there is the administrative inconvenience of producing an extra set of accounts, dealing with an extra business tax return and declaring dividends every year. In addition, from 6 April 2016, the tax suffered by partners on large dividends will mean that the service company, in such cases, will become marginally tax inefficient.
If the firm decides that this means there is no point in continuing with the service company, then it should liquidate it. As the company has traded in its own right, those partners with an ownership of at least five per cent of the company, and who were either an officer or an employee of the company for at least a year upon the cessation of trade, would benefit from CGT Entrepreneurs' Relief on the liquidation. This would result in an effective 10 per cent tax rate on their share of the service company's reserves. Other partners would suffer a 28 per cent CGT charge.
We should also bear in mind that most service companies only have modest reserves and much of any gain may be covered by partners' CGT annual exemptions, such that there may be little or no CGT upon liquidation.
Partners will no longer be diverting profits to the corporate partners in their structure. However, past profits already held within the corporate partner can remain within the company (and continue to be reinvested as working capital in the parent firm).
For many of those using corporate partner structures, the objective was to provide working capital for the main firm after only suffering corporation tax on those profits (rather than income tax). In such situations, partners may decide that their corporate structure should remain in place.
However, as and when partners retire, they will wish to unwind their corporate partner - so, at some stage, the question will be how to do so. Entrepreneurs' Relief is no longer available, so the options are simple:
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either a liquidation with a capital distribution subject to ordinary CGT rates; or
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a pre-liquidation dividend subject to dividend rate income tax, followed by a liquidation with no capital distribution.
Which is better will depend on the difference between the rate of income tax on the dividend and the rate of CGT on any capital distribution in the year of distribution. At present, the tax regime would favour a capital distribution rather than a dividend in most cases.
Louis Baker is head of professional practices at national audit, tax and advisory firm Crowe Clark Whitehill (www.crowehorwath.net/uk/)