Follow up

Detailed commentary on revaluations and changes in profit-sharing ratios

[Memo]

Statement of Practice D12

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Partnerships: tax consequences of changes in ownership

Partnership assets and CGT

Partnerships are transparent for capital gains tax (CGT) purposes, meaning the individual partners pay tax on their share of any gains relating to partnership assets. The sharing ratio for capital disposals is often included in the partnership agreement and may or may not match the profit sharing ratio.

Pro advice. In the absence of any written agreements, the Partnership Act 1890 treats each partner as having an equal share in partnership assets.

In your client’s case, you know that there have been several changes since it started trading. Let’s consider these, and the tax implications, as this will inform any advice you give clients in a similar position.

Origins

The partnership was formed by Mr and Mrs A more than 20 years ago. Initially, all profits and losses were split equally.

The partnership agreement states that incoming partners may be required to make a payment on joining, at the discretion of the existing partners, but that no payments are required on a change in partnership ratios. It also states that capital sharing ratios are considered to be identical to profit sharing ratios.

The main partnership asset is the premises from which the partnership trades. The property was initially acquired for £100,000, funded by cash introduced by Mr and Mrs A. Small items of plant and machinery were also acquired and have been periodically replaced over the years.

Incoming partners

Several years after commencing, Mr and Mrs A brought their daughters (Miss B and Miss C) into the partnership, with each daughter receiving a 10% partnership share in exchange for an agreed payment of £9,000 in respect of the property. For CGT purposes, Mr and Mrs A were treated as having disposed of 10% of their interest in the property, which was still shown at £100,000 in the accounts at that date, as required by Statement of Practice D12 (see Follow up ).

Mr and Mrs A were deemed to have received 10% of the book value of the property each (10% of £100,000 = £10,000), plus the two cash payments, making total proceeds of £19,000 each. A proportion of their acquisition costs were then deducted, being (10%/50% x £50,000 = £10,000).

So, each parent made a gain of £9,000; effectively the cash element received. The parents’ base costs were updated to £40,000 each and the daughters were treated as then having a base cost of £19,000 each, i.e. the total proceeds of the parents as above.

Pro advice. As all four partners are related (and so connected), HMRC could argue that the £9,000 paid should be replaced with market value. However, D12 suggests that HMRC would only do so if the amount paid was less than would have been paid by an unconnected third party. The partnership should ideally retain evidence to demonstrate that this was the case.

Change in ratio following revaluation

Shortly thereafter, the partnership decided to revalue the property and the accounts were updated to show a value of £500,000. The £400,000 increase was credited to each partner’s capital account based on their profit share, so £160,000 each for the parents and £40,000 each for the daughters. This revaluation did not have any immediate CGT consequences.

However, as time went by, the parents became less and less involved in the running of the partnership and the daughters took on more responsibilities. It was therefore agreed a few years ago that the profit sharing ratio should be adjusted to reflect this. The parents’ share was reduced to 10% each, Miss B’s increased to 45% and Miss C’s to 35%.

This had a similar effect for CGT purposes as to when the daughters first joined, except now the proceeds were based on the revalued property figure, meaning a chargeable gain arose despite no actual payments being made.

Mr and Mrs A were each treated as receiving proceeds based on the reduction in their shares of the property and the revalued amount in the accounts (therefore (40% - 10%) x £500,000 = £150,000).

The base cost available to be set against this part disposal was (30%/40% x £40,000) = £30,000. An overall gain of £120,000 was therefore deemed to arise for each parent on the change in the profit sharing ratios and each parent had a remaining base cost of £10,000.

As before, the daughters’ base costs were increased by the proceeds. For Miss B this was an additional £175,000 (£300,000 x 35%/60%) and for Miss C £125,000 (£300,000 x 25%/60%). Their new base costs were £194,000 and £144,000 respectively.

Pro advice. The parents needed to fund the CGT on their £120,000 gains despite not having received any actual cash; however, remember that their capital accounts had been increased by £160,000 each on the revaluation and so part of this was withdrawn tax free to meet their liabilities.

Tax Memo. For detailed commentary on revaluations and changes in profit-sharing ratios, visit https://www.tips-and-advice.co.uk .

Outgoing partners

Now let’s turn to the query regarding the imminent retirement of Mr and Mrs A. Rather than their combined 20% interest going to the daughters, the plan is to sell the share to a family friend. The partners meet with Mr D and agree he will make a payment of £200,000, being £160,000 in respect of the property, £30,000 for goodwill and £10,000 for miscellaneous assets.

On their retirement, Mr and Mrs A will each receive proceeds for CGT purposes of £95,000, i.e. the amount for the property and the goodwill, leaving a gain of £85,000 after deducting the remaining £10,000 of base costs.

Pro advice. This should qualify as a material disposal for business asset disposal relief (BADR) purposes. It would be prudent to review the position to ensure relief will apply to the two outgoing partners.

Pro advice. As no goodwill is reflected in the accounts, Mr and Mrs A do not have a base cost they can set against the goodwill proceeds.

Mr D will become a 20% partner with a base cost for the property of £160,000 and for goodwill of £30,000.

Planning

Assuming a retirement in the 2024/25 tax year and the meeting of the BADR conditions, Mr and Mrs A will have CGT due of £8,200 each, payable on or before 31 January 2026. They could of course simply defer their retirement until at least 6 April 2025, delaying the tax payment until 31 January 2027.

Alternatively, they could each transfer 5% in one tax year and the remaining 5% in the next, both delaying part of the payment and benefitting from an additional pair of annual exemptions. This would give the lowest overall liability, £7,900 each, assuming BADR was available for both sets of disposals and that there are no further changes to the annual exemption.

Pro advice. Carrying out the disposal in this manner should still allow the 10% BADR rate to apply, on the basis the partners are disposing of part of their business each time.

While Mr D is wealthy, he will need to finance £100,000 of the buy-in using a loan. Don’t forget that any interest paid will qualify for relief.