Lee Sharpe points out that there is a potential ‘penalty’ for putting assets into a partnership structure.
Generally, changes in partnership ratios do not trigger a capital gains tax (CGT) charge. Strictly speaking, however, changes in capital-sharing ratios are disposal events for CGT purposes, by reference to the underlying chargeable assets.
While changes in partnership capital sharing ratios for ongoing members tend to be uneventful, HMRC has decided that introducing chargeable assets into a partnership should be dealt with differently, and it is much more likely that CGT will be triggered.
Statement of practice D12
TCGA 1992, s 59 applies to treat partnership assets as being disposed of by the individual partners, by reference to their respective interest or fractional share in the assets in question. TCGA 1992 s 59A makes similar provision for limited liability partnerships.
Practitioners will be familiar with statement of practice D12 (SP D12), which governs most aspects of how CGT applies to partners and partnership assets. In particular, section 4 deals with changes in partnership sharing ratios, including when partners join or leave a partnership. Where a partner reduces their fractional share of a partnership chargeable asset, a disposal has taken place; where partners’ fractional shares increase, they have made an acquisition.
Usually, the disposal value of the asset will be by reference to the carrying value in the balance sheet – which may also be its cost. This is why changes in membership and/or in capital-sharing ratios will often be considered ‘no gain/no loss’ transactions; the same fraction of balance sheet value will be both proceeds and cost. However, there are several reasons why this may not be the case, such as:
revaluation of an asset in the accounts, such that carrying value no longer equates to acquisition cost
CGT base cost differing from historic cost in the accounts, due to tax adjustments/reliefs
where consideration has also been received outside of the accounts – such as personal cash transfers between individuals
where the transfer is not at an arm’s length and TCGA 1992, ss 17 or 18 apply to require proceeds to be aligned with market value, regardless of what is in the accounts – but noting that transfers between partners are not considered to be between connected parties if under genuine commercial arrangements (TCGA 1992, s 286(4))
Section 4 is relevant because, for many years, HMRC and agents thought that these principles applied also to assets introduced into a partnership, and – again – such transfers might often be considered ‘no gain/no loss’.
While SP D12 was introduced in 1975, it was not until 2008 that HMRC decided section 4 did not apply to assets contributed to a partnership, and Business Brief 03/08 set out HMRC’s new approach. It should be noted that not all practitioners agreed that HMRC’s new interpretation was correct, but this is certainly how HMRC expects to apply the rules – hence the new section 5 in the recently updated SP D12.
New(er) guidance in SP D12
The updated SP D12, section 5 now says that introducing a capital asset to a partnership will be a part disposal of the asset for CGT purposes by reference to the fractional shares passed to the other partners; this time, however, while HMRC is happy to use the same apportionment of fractional shares as in section 4 above for the purposes of CGT costs, it argues that the balance sheet value cannot also be used to gauge proceeds because the asset does not have a balance sheet value until after the disposal.
It follows that the no gain/no loss transfers typically found under section 4 transactions (as above) are therefore less likely to be found on initial introduction.
HMRC instead expects either market value to be used for disposal proceeds if the transfer is between connected persons or is other than by bargain at arm’s length, or to look at any amounts received in exchange for the disposal of the fractional shares – typically, amounts credited to the partner’s capital account on introduction, but potentially including sums received separately from the accounts. Here again, partners will not be considered connected simply by reason of their being in partnership, provided they are genuine commercial arrangements, so some other connection is required to trigger the market value proceeds rule.
How to avoid triggering a CGT charge
There are various possible opportunities, as outlined below.
Keeping it while giving it away!
Retaining a 100% interest in the capital of the asset transferred in, such that no fractional shares are disposed of to other partners.
This could be affected by way of an update to the partnership agreement, such that the particular asset is not shared in accordance with the usual capital-sharing ratios. Note that, in the absence of a formal agreement, or similar good evidence of a differential split of capital, capital assets will be shared equally by default (in accordance with PA 1890, s 24(1)).
Practically speaking, therefore, a formal agreement would be essential in such cases – HMRC would probably want good evidence that the asset had, in fact, been transferred to the partnership if a partner retained 100% of the equitable interest. See Example 2 in HMRC’s Capital Gains manual at CG27940.
Where the partner has already used the asset for a qualifying purpose (such as in support of the partnership’s qualifying activity), a transfer for nil consideration would potentially be eligible for gift relief (under TCGA 1992, s 165).
Depending on the nature of the relationship between the partners, transferring a valuable asset for nil proceeds may not be attractive, even if it potentially saves (or postpones) CGT. The statement of practice itself confirms that gift relief will be available on such transfers (see SP D12, at 14.8).
Relief on the replacement of business assets may be available under TCGA 1992, s 152, if the partner receives fractional shares in chargeable assets from other partners, in exchange for introducing his or her own asset. This is a hugely flexible and often overlooked relief and, although HMRC does not acknowledge it in terms of asset introduction in SP D12, HMRC guidance at CG61150 confirms that TCGA 1992, s 152 applies at the individual partner level anyway, by reason of TCGA 1992, s 59 (as mentioned above).
HMRC’s statement of practice SP D11 also confirms that a partner will be able to claim rollover relief on assets previously let to his or her partnership for the purposes of its qualifying activity.
There are, of course, numerous qualifying criteria for holdover relief, notably that both the old and the new assets – or fractional interests therein – must fall within the prescribed classes of qualifying assets – typically land and buildings, certain fixed plant and machinery, goodwill, and…spaceships! Also, that the assets be used in a qualifying activity, such as a trade or furnished holiday lettings.
Spouses and civil partners
While it may not be a wholly tax-centric issue, there will be no charge to CGT where one partner introduces an asset to a partnership with his or her spouse or civil partner, by virtue of TCGA 1992, s 58. This is confirmed in HMRC’s guidance (see CG27940, at Example 3).
It is quite common for partners to introduce assets to a partnership, particularly when a partnership is first formed or when a new partner joins – typically land and/or goodwill. The CGT implications of such transfers are often missed because advisers are used to the ‘no gain, no loss’ principle through SP D12, which generally applies in the absence of revaluations or real money or consideration changing hands; likewise, where the partnership comprises spouses or civil partners, who can avail themselves of TCGA 1992, s 58.
Partnership agreements are arguably essential, in that they can act to precisely regulate the shares in any assets that are then deemed to be transferred between partners.
To the extent that the new section 5 of SP D12 has not been settled by case law, it remains open to challenge HMRC’s approach, if appropriate. But HMRC’s position is clear; introducing chargeable assets to a partnership is likely to result in a CGT charge, without proper planning.