Revenue's 'magnificently provocative' tax windfall

After self-assessment come changes to the way in which professional partnerships are taxed. Leo Schulz adds up the costs of compliance.

At 5.30pm on 22 December 1997, the Inland Revenue issued a press release announcing a change in the way professional partnerships are to be taxed.

At first glance the changes seemed fairly innocuous, with the release referring to the effect on firms with £100m-plus turnovers.

But as managing partners arrived back at work last week, it became apparent that the proposals will have profound implications.

Partners in established regional firms could see their tax burden for the years 2000 to 2003 rise by up to £20,000.

In metropolitan firms, the increase is likely to be close to £30,000.

Barristers, working as sole traders, could experience a rise of 50 per cent in their tax bill.

The vast majority of firms will be forced to install costly, computer-based, centralised time-keeping systems and to pay for full-scale formal audits.

Joining and leaving partnerships will also become more complex.

According to several commentators, the changes are sufficient to put struggling firms out of business.

Although extra payments will not be due until 31 January 2000, under the proposals they are due to be included in the next finance bill and will be effective from 5 April this year.

And although the Revenue's press release says 'comments on the proposals are welcome', these have to be in by 14 February and there is no schedule for public debate either on the comments or on the Revenue's response.

Nigel Cobb, chief executive of 13-partner Bath firm Thrings & Long, said: 'I think it is appalling that reforms on this scale should be announced so casually, without provision for proper consultation, and effectively on the day before Christmas.'

The primary change will be the removal of the 'cash basis' for calculating income tax. Instead, tax will have to be calculated on an 'earnings basis', with the value of work in progress estimated against current expenses.

Curiously, while this should result in an immediate windfall for the Treasury, the most significant long-term effect may be to reduce the overall revenue take.

The windfall will result from tax being paid for work as it is being done rather than on receipt of the actual cash payment. This may be worth as much as £200m, with work being taxable, on average, about two months earlier than in the past.

According to Ron Downhill, chair of the Law Society's revenue law committee, this is effectively a one-off 'disallowance' of eight to nine weeks of expenses.

Mark Lee, a tax partner in the professional practices group at BDO Stoy Hayward, said this would hit especially hard given the change to 'current year' taxation necessary to comply with the rules for self-assessment, introduced only last year.

He commented: 'The proposals increase accounting profits and tax liabilities without any extra cash being generated or received by firms.'

Ironically, the worst affected will be those who to all intents and purposes work for the government lawyers doing legal aid.

Since the general election the government has been leading a crusade against the late payment of debts to small businesses, which has included threats of legislation. Yet legal aid lawyers claim the government itself is one of the worst offenders, delaying payment for as much as nine or even 12 months at a time.

Allan Maidment, senior partner at eight-partner Manchester criminal practice Maidments, cites a recent example of a £350,000 bill paid 180 days after it was due in contrast to government insistence that bills should be paid within 30 days.

According to Maidment, 210 days is 'typical'. Moreover, this is from the time the bill is submitted, as opposed to the time when expenses began to be incurred at the start of the case, which is when the money would be taxable on an earnings basis and which is likely to have been several months earlier.

'Legal aid firms already face so many difficulties, with strict rules applying,' said Maidment. 'This will certainly slow down our expansion. It will leave a substantial cash hole.'

'It is magnificently provocative,' commented Christopher McCall QC, a revenue law specialist based at Michael Lyndon-Stanford QC's 13 Old Square chambers, 'that the government should insist on taxing money which it is itself, for its own convenience, neglecting to pay.'

What may be of more significance, however, is the effect the reforms are likely to have in raising the costs of running a practice and in the process reducing taxable revenues. This will be a result of the increased administration necessary to produce earnings-based accounts.

Cash-based accounts are relatively simple, being not much more than an addition of cash received and spent. An accountant's letter is usually enough to satisfy the Revenue that the additions are correct, while an untrained but conscientious managing partner can be broadly confident that he understands them.

Earnings-based accounts, by contrast, require 'true and fair' estimates of current work in progress. This would mean full and accurate estimates of all current expenses, from assistants and paralegals to secretarial and other support staff benefits as well as salaries, and also building, marketing, transport costs and the like.

According to experts in partnership management, this can only be done by way of a centralised time-keeping system, entailing computer hardware and software and the staff to maintain it.

More importantly, the only way to render true and fair accounts is through standard accounting practices, what is known as SAP 9.

Neither could an untrained managing partner be generally expected, regardless of intelligence or diligence, to understand the SAP 9 process. Rather than a letter from an accountant, SAP 9 would almost certainly require the considerable expense of a full and formal audit.

'True and fair accounts come from an auditor's knowledge,' said Sue Chisman, head of the KPMG professional business group in the south of England. 'How comfortable will a managing partner be in signing off something he does not fully understand?'

'Even in a relatively straightforward business such as a legal partnership, the compliance burden of a full audit is something that will have most people throwing up their hands in horror,' said Michael Womack, a tax partner at Cambridge firm Taylor Vinters.

'The thought of it gives me the willies.'