The merger of two accountancy firms created a row about the value of working in progress (WIP) included in turnover, and thus whether the taxable profits were corrected stated.
Firm vs partners
Partnership taxation has never fitted snugly into the self-assessment machinery. The profits to be taxed are those of the firm as a whole, but the firm itself is not a taxable person – the individual partners are liable to tax on their share of the profits.
The partnership profits or losses must be first reported on the partnership tax return, this is the responsibility of the 'designated partner'. Then the profits/losses must be apportioned to the individual partners on the partnership statement, who each report their share on their own personal tax return, to be taxed under self-assessment. This principle also extends to Limited Liability Partnerships (LLPs).
This system works well, as long as the individual partners agree with the amounts assigned to them in the partnership statement. In the recent case of Robert King and others (TC05163), the First Tier Tribunal (FTT) looked at what happens when one or more of the partners believe that the partnership statement is wrong.
Mr King and eight others were partners in an accountancy LLP. The firm’s accounting policy required unbilled work in progress (WIP) to be recognised within turnover “only where it could be reliably measured and where the recovery of that work in progress was probable”.
As a result, the partners periodically assessed the recoverability of their WIP to exclude any which was doubtful. The accounts for the period ended 30 April 2011, which were prepared on this basis, were certified by the auditors as giving a true and fair view and fully in accordance with UK GAAP.
The nine partners were less than happy when the designated partners (two corporate bodies which were not controlled by the individual partners) submitted the partnership statement that included add-backs of “provisions against unbilled income” totalling £1,449,862.
As the firm was in the process of being taken over by a larger accountancy firm, and the majority of these nine partners would not become partners in the acquiring firm, the likelihood of this dispute being settled internally was quite low. The nine partners chose to report on their own tax returns their partnership profit shares omitting the disputed adjustments, and to explain themselves fully in the white space on those personal returns.
HMRC could see the total of profit on the partnership tax return did not match the partners’ returns, and concluded that the partners had understated their income from the firm. HMRC demanded additional tax from the partners.
Taxes Management Act 1970 (TMA), s 8 (1)(a) requires an individual’s tax return to include “such information as may reasonably be required” to establish “the amounts in which a person is chargeable to income tax… and the amount payable by him by way of income tax.”
For partners, the information required includes: “each amount which, in any [partnership] statement, is stated to be equal to his share” (TMA 1970 s.8(1B)).
The tax return must include a declaration that the return is to the best of the taxpayer’s knowledge “correct and complete” (TMA 1970,s.8(2)).
Oddly enough, HMRC did not disagree with the partners over whether the add-backs made in the partnership statement were wrong. Instead, HMRC relied on three procedural arguments:
- Any dispute over what should or should not be included in the partnership statement ought to be settled within the partnership. The system works by the partnership return and the partners’ individual returns using the same figures.
- To comply with TMA 1970, s.8(1B), the amount shown in the partnership statement – whether right or wrong – ought to have been entered in box 7 (share of partnership’s profits) of the individual’s tax return. Putting any other number in this box would also fail to comply with TMA 1970, s.8(2).
- If a partner felt this figure was too low, the difference ought to be included as “other income”. If (as here) he felt it was too high, he should explain this in white space.
Since the partnership accounts already excluded any WIP which was of doubtful recoverability, the “provision” adjustment for unbilled income made no sense. It was wrong in law. If partners had simply used the amounts shown in the partnership statement while knowing them to be wrong, they would not be able to make a declaration that their returns were correct and complete.
By including details of the disputed figures within the white space of the returns, the partners were complying with TMA 1970 s.8(1B). This approach taken by the partners would be equally effective in circumstances where a partner believed he had been under-assessed by the partnership statement.
The judge was clear that “the statutory provisions do not slot easily into place and do not appear to deal with the case where a partnership and individual partner disagree”.
However, the clear objective of TMA 1970 s.8 is that a person’s tax return should show the correct amount of taxable income, and that the taxpayer should be able to certify this.
Since, on the evidence given (not disputed by HMRC), the firm’s accounts already showed the correct turnover, “there was no basis for the adjustment”, and “it must follow that the ‘correct’ figure from which to establish the right amount of tax” is what the partners showed on their returns.
The partners’ appeals were upheld.
HMRC has withdrawn its application to appeal this FTT judgement to the Upper Tribunal. This may have something to do with proposed new legislation in Finance Bill 2018, which states that the only correct taxable figure for a partner’s profit share will be the amount shown in the partnership statement. This will give statutory force to HMRC’s argument at 2) above, and will prevent cases such as this arising in the future.
If there are disagreements about the allocation of profits and losses between partners, the new
legislation will allow these to be settled by tribunal. Unfortunately for partners like Mr King and his colleagues, tribunals will have no power to settle disputes over the actual level of partnership profit (as was the case here) unless the partnership’s tax return itself is under appeal.
HMRC are effectively closing the doors on partners who find themselves in similar circumstances going forward: they will have to litigate against the designated partner if no agreement can be reached.