Traders have always had to calculate their profits for tax purposes on the basis of earnings during an accounting period, but professionals have been allowed, in certain circumstances, to account for profits on the basis of cash received and cash paid.
The withdrawal of this cash basis will mean two major changes. In future, professional income will have to include amounts invoiced to clients, whether or not payment has been received. Also, a realistic valuation of work in progress will need to be brought into account.
For many professional partnerships, this will mean significant increases in the profits chargeable to income tax for the tax year 1998/99 when a catch-up charge will be made to bring profits in line with the earnings basis concept of accounting. There is to be an option to spread the catch- up charge over three years.
For professional partnerships which have not previously recognised debtors and/or work in progress, these proposals will mean that an additional tax bill will need to be funded in 1998/99 or spread over this and the next two financial years. The tax bill will be based on:
the full value of debtors at the accounting date which ends in the period 6 April 1998 to 5 April 1999;
the value of work in progress at the lower of cost and net realisable value at the same date. This will generally include direct expenses incurred and not yet billed and the employment cost of staff who have worked on jobs in progress at that accounting date.
To put this into perspective, a partnership with 100 partners and fee income of pounds 100m could be subject to additional tax of pounds 100,000 per partner.
The Revenue has said that these proposals will provide a level playing field for all businesses. If this is the motive, it could be argued that no one should be penalised by the changes, and no catch-up charge imposed. Professionals could move to the new basis by simply restating their opening position, with the resulting uplift left out of account for tax purposes. There is a suspicion, however, that the real motive behind these proposals is the tax windfall for the Treasury, which over three years could amount to as much as pounds 200m.
Though this change is not an additional charge to tax in the long term, in the short term it will have a significant impact on the cash flow requirements of professional partnerships. Larger professional firms have generally arranged outside finance for most of their working capital. This will now need to be renegotiated, or partners will have to introduce capital or restrict drawings. For some smaller firms who have operated up to now on the cash basis, these proposals could be a bitter blow. Financing working capital is always a problem for a small partnership.
The complications that these proposals pose for professional partnerships, particularly the larger ones, are all too obvious. Partners who retire in 1997/98 will escape the catch-up charge; new partners admitted after 5 April 1998 will be subject to the catch-up charge in their first year.
If these proposals become law, smaller partnerships will have little option but to seek to improve cash flow by turning work completed into cash in the bank in a shorter timeframe. Combined with self-assessment, the current year basis and stringent regulation, life is becoming increasingly difficult for the small firm. It remains to be seen, however, whether this move signals the beginning of the end for the professional partnership.
The author is a tax partner at Pannell Kerr Forster, specialists in advising partnerships.Reuse content