Mark Lee looks at how partnerships can maximise their tax savings despite the clampdown on changing year ends
Far from being a minor bureaucratic change, the Inland Revenue's new tax rules contain a bombshell for many practice partners, as well as a good opportunity to maximise partnership profits.
Unnoticed by many, the end of the present basis of assessing tax on partnership profits was announced in the Government's 1994 Finance Act.
The changes remove the flexibility – the Inland Revenue might say latitude – allowed under the current 'previous year' tax basis, where a partnership can select its own accounting year-end date and change it as necessary to minimise or delay paying tax. Under the same rules, when a partner left or retired, the partnership could be wound up and restarted with a new financial year.
Designed to close tax avoidance loopholes for partnerships and sole traders, the new legislation effectively introduces a new financial year ending 31 March for all firms. Transitional rules will apply for two years from next April until April 1998, when the new rules come fully into effect.
The principal danger for legal practices is that they could end up paying considerably more tax than necessary. Partners could also face a tax bombshell on leaving, retirement or winding up the business, due to the restrictive new rules for granting 'overlap relief'.
Some consider that the new rules also give firms a chance to minimise tax liabilities through well-timed changes of accounting year ends or notional cessations between now and 1997. But there is a risk involved: a partnership may adversely affect its recent – from April 1994 – present, and future tax position.
Being alert to the threat is one thing, exploring the myriad profit and tax-saving possibilities and permutations is quite another and may require a hefty investment in accountants' and partners' time. However, a simple tool developed for the task is making it possible for a firm's accounting partner, or simply a solicitor with a standard personal computer, to see all the options and to choose the best strategy for their firm.
At Clark Whitehill's City head office, a team of analysts and tax specialists produced a computer model in order to study the effects of the new rules across a full range of possible permutations.
The result was the development of a computer program, Cybertax, for the firm's own use, which analyses the strategic options open to a partnership and calculates the best solution. Simple to use, the work involved in assessing tax options for a partnership is reduced from a week or more to an hour or two.
To cover the development costs, the company made the program available to other accountants, and it has since been snapped up by more than 300 accountancy firms including Pannell Kerr Forster, as well as several leading practice partnerships in the know.
A simple test case shows how, for one legal practice, a judicious change of financial year-end was able to reduce profits of £178,000 by more than £9,000 – a useful windfall for the four partners against an outlay of £345 for the program.
In operation, once past figures and future forecasts have been entered, CyberTax makes an informed choice from 20 strategies. On each equation, one strategy shows the lowest level of profits without a change of year end, the other the best time to switch to a 31 March year end, if appropriate. The software allows what-if calculations, carries out extensive comparisons in seconds, and prints out clear reports.
The program is supplied with detailed instructions and technical explanations of all strategies. Should you need it – next to nobody has so far – there is also a telephone hot line service for advice and help.
CyberTax lets law practices consider their range of tax options and reach a decision about the way ahead.
While it is a good idea to run the conclusions past a firm's professional advisers, the program makes it possible to look at the options and reach a detailed conclusion.
Mark Lee is a tax partner at Clark Whitehill.