Given the general view of partnership taxation – “they’re just transparent, right?” – it is somewhat surprising that how a partnership interest is accounted for, or whether a pre-sale profit distribution is made, or even possibly whether that distribution is income or capital, could make a difference to a partner’s tax position. And, indeed, could result in a partner being taxed on more than their economic profit or, conversely, realising a tax loss bigger than any economic loss they might make. But that is an unfortunate consequence of a fairly fundamental area of taxation still being ‘work in progress’ (as per Rose LJ in Investec Asset Finance PLC and Investec Bank PLC v HMRC)!
Company A, a financial trader, buys some shares for 80, receives a dividend of 15 and sells the shares for 85. In its GAAP compliant accounts it records the net profit of 20. The calculation of trading profits follows the accounts, subject to adjustments required or authorised by law (section 46 Corporation Tax Act 2009). So its taxable profit is 20.
Company B is a 50% partner in Partnership X. Partnership X is a financial trader and also buys some shares for 80, receives a dividend of 15, sells the shares for 85 and records a net profit of 20 in its accounts. Section 1259 CTA 2009 tells us that, to find Company B’s taxable profits, we calculate what Partnership X’s taxable profits would have been if it were a company – 20, like Company A above – and then take Company B’s appropriate share, being 50%, to give taxable profits of 10.
So far so good.
But what if Company B is also a financial trader? And what if it had paid 40 to acquire its 50% interest in Partnership X, if it had received a profit distribution from the partnership of 7.5 (its share of the dividend) and then had sold its 50% interest in Partnership X for 42.5 such that it also recorded a net profit of 10 in its own accounts?
In that last example, is Company B subject to tax on a total of 20: 10 as its share of the 20 taxable profits of Partnership X’s trade and 10 as the taxable profits of its own trade, in line with the net accounting profit at both levels? Or is there an adjustment to be made to reflect the fact that there is clearly some double taxation here? And if there is, how much? Should it just be the 7.5 which is distributed as profit to Company B, on the basis that is more clearly the same profit as the profit arising in Partnership X itself, or should it include the 2.5 that arises on selling the partnership interest itself at a profit? Does it matter how Company B accounts for its partnership interest and, in particular, whether it treats it like a share, and recognises only the profit distribution, together with the acquisition and disposal of the partnership interest, or whether it looks through to its underlying share of Partnership X’s activities?
The Investec case
It frequently surprises people that there are often no clear answers to these sorts of questions, given that partnership taxation is not exactly a new concept. Indeed, it was considering exactly these sorts of questions that led Lady Justice Rose to describe HMRC’s approach to section 42 of the Finance Act 1998 and section 114 of the Income and Corporation Taxes Act 1988 (now rewritten as sections 46 and 1259 CTA 2009) as “to put it kindly, ‘work in progress’”, in delivering the Court of Appeal’s unanimous judgment in Investec.
What that judgment – and the earlier judgments in that case – show is that there is clearly a principle of no double taxation which should, in theory, prevent a company partner being taxed, in its own trade, on profits already taxed as part of a partnership trade, but that the scope of that principle, and what constitutes the same profit or income at both levels, is often still unclear, may depend on the accounting treatment adopted at each level and might possibly depend on the form of any distribution.
If Company B applies a look through treatment, and simply recognises its share of underlying partnership profits in its accounts, then that principle is likely to allow it to leave out of account the full 10, on the basis that what Company B is recognising is clearly the same income as the partnership, namely its 50% share of both the dividend received of 15 and the profit of 5 on sale of the shares.
But if Company B’s accounts instead recognise the distribution of 7.5, and the profit on sale of 2.5, the position is less clear. Certainly the 7.5 profit distribution can be left out of account. The decision of the Upper Tribunal in Investec would suggest if that distribution were not a profit distribution, but a repayment of capital of 7.5 instead, the same exclusion of double taxation principle may not apply although in an obiter passage the Court of Appeal casts doubt on that and I believe it should still apply. What of the 2.5? On our simplified facts, that too looks like clear double taxation. But life is rarely that simple and in practice the purchase price for the partnership interest is likely to reflect many other variables. It would certainly be open for HMRC to argue that Company B should be taxed on a total of 12.5 on the basis that only the 7.5 is excluded under the no double taxation principle, the remaining 2.5 is profit on selling the partnership interest and that, by definition, is not the same income or profit as that arising to the partnership. Or, to put it another way, you can’t leave the full 10 out of account in calculating the profits of Company B’s trade because only 7.5 of the 10 is really brought into account upstairs.
A partner being taxed on more than their economic profit or, conversely, realising a tax loss bigger than any economic loss they might make, is an unfortunate consequence of a fairly fundamental area of taxation still being ‘work in progress’