Law: Taxing time ahead for partnerships: Sharon Wallach reports on the new Finance Bill, which will change the way law firms calculate and submit their returns

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The Independent Online
Law firms, in particular medium-sized practices, are in danger of showing complacency over the new partnership tax arrangements contained in the 1994 Finance Bill, according to Denise Catterall of accountants Coopers & Lybrand. Failure to prepare in time for the new rules could cause firms a great deal of unnecessary inconvenience and expense, she says.

The key features of the rules are changes to self-assessment and a move to a 'current year basis' for paying tax. At present, partners (and other self-employed individuals) are taxed on their preceding year's income, but under the new rules, they will be taxed on their share of the profits of the firm's accounting period ending in the year of assessment.

Beginning in 1997/98, individuals will have to submit tax returns by 31 January - a mandatory date, with penalties for non-compliance - following the end of the tax year. In their returns, partners will have to include their share of the firm's taxable profits and self-assess the tax due on their total income and capital gains.

Payments on account of income tax liability will be due on 31 January in the tax year and the following 31 July. The payments will each be half of the previous year's tax liability - excluding capital gains - with any balance due, plus capital gains, to be paid on the following 31 January.

Under the current year basis rule, capital allowances will be treated as a trading expense for an accounting period, as is now the case for companies. New businesses starting after 5 April this year will come immediately within the scope of the new rules. Partners will, in future, share profits for tax purposes on an accounting period basis.

One of the most significant aspects of the reforms affecting partnerships will be the need for them to file tax returns and statements of profits, and the allocation of such, within 10 months of the fiscal year end. Partners will have to include their share of the partnership's profits in their returns, calculate the tax they owe and pay it by a pre-determined date. The reforms also include specific obligations requiring partnerships to maintain accounting and other records, and affecting the disclosure of information in partnership tax returns.

Firms will need to be able to tell their partners what figures to include in their tax returns due on 31 January. If the firm's tax year ends 31 March, they have only 10 months in which to prepare their accounts, and agree the allocation between the partners. Many firms will need to improve their systems to be able to produce the figures on time.

The first areas of the new arrangements come into effect in 1996/97 for returns and tax due on 31 January 1998. According to Ms Catterall, partnerships should consider long before then issues including the first return. 'If partners are to avoid facing significant problems in finalising their first partnership and personal tax returns under the new system, they need urgently to clear any arrears in the firm's fiscal arrears, or those of individual partners, before 5 April 1997,' she says.

From that date, partners will be individually responsible for paying income tax on their own shares of partnership profits, so firms need to consider arrangements for providing for the tax due by each partner, and for releasing money to allow partners to make payments.

In addition, they need to work out the consequences of the new rules on their working capital and other financial arrangements, and whether to move their accounting dates to earlier or later in the year. They need to consider the appropriate time for partners to retire or for new ones to be admitted, and if they decide to provide for the tax payable by its partners, whether to recognise deductions available to individuals on retirement for overlap relief.

Business will be taxed on profits for the accounting period ending within the year of assessment. A transitional period between the preceding year and the new current year basis will be allowed in 1996/97. 'Inland Revenue will take the profits for the two years up to that period and average them,' Ms Catterall explains.

'A lot of people are homing in on the fact that if the tax is to be assessed over the results of two years, there are possibilities for avoidance, for instance ensuring that one-off items of income fall within the transitional period. We are not talking about anything illegal: actions of this nature must be commercially justifiable.

'The Inland Revenue is going to introduce anti-avoidance legislation, although at this stage we do not know its provisions.' Research Ms Catterall carried out before the Finance Bill was published in January, suggested that law firms were not, at that stage, planning ahead. 'Now,' she says, 'they are realising there are significant opportunities, albeit without knowing exactly what the anti-avoidance provisions will be.'

Many professional partnerships are behind in agreeing their figures with the Revenue, Ms Catterall believes. 'If a partner has had to include any estimates in his tax return, he has one year in which to notify Inland Revenue of the correct figures,' she says.

'A lot of partnerships have quite a number of 'open years' (those including uncorrected estimates). Clearing the arrears is going to be absolutely critical between now and 1997/98. If it is left too long, it will become extremely difficult to get everything resolved. It is unreasonable to expect the Inland Revenue to do it all at the last minute.'

This is where complacency exists, she says. 'I'm not talking about firms deliberately delaying for sinister reasons. They have paid what is due and are just arguing about individual items. The problem is that the Inland Revenue is not sufficiently staffed to deal with a last- minute surge of work.'

She stresses in which areas law firms should now act. 'First, clearing arrears; secondly, plan for the transitional period so that expenditure and income arising within the tax period can be justified on commercial grounds; and thirdly, sorting out the firm's systems to produce accounts and to provide the partners with the figures they need for their own accounts.'