Tax planning. Conquering the dragon of tax law
16 April 1996
8 February 2010
10 February 2009
30 July 2007
9 October 1996
5 April 2010
It seems that many partners have not yet fully appreciated the effect and potential impact of overlap relief, especially on younger members of a partnership. To some, it is perhaps difficult to understand why a relief can present a problem at all, while others are put off taking action by the complexity of the legislation.
In simple terms, partnerships that began before 6 April 1994 and were subject to the old rules of assessment will soon be subject to new rules. The old rules apply up to 1995/96, the new ones start for 1997/98 and in the meantime - 1996/97 - a set of transitional rules apply.
If your year ends on 31 March or 5 April you should be safe, but if it is at the end of April, or any other time, you may have a problem. And the nearer your year end is to the start of the tax year ( for example 30 April) the bigger your problem will be.
The problem stems from the way overlap relief works and the fact that the basis of taxation of your final year in the partnership has changed. It makes no difference if a partner is retiring.
Imagine a partner, aged 30, who has a 5 per cent profit share worth £50,000 per annum. By the time of his or her retirement, that share may have increased to 10 per cent, 15 per cent or even 20 per cent. Factors such as inflation may well increase the real value of the share.
By this stage, £250,000 per annum is not entirely out of the question. For a junior partner, such a figure may seem a long way off but it is realistic nonetheless.
Take a 30 April year end, a profit share of £50,000 in the year ending 30 April 1997 and a profit share of £250,000 in the year ending 30 April 2027, the anticipated date of retirement.
Under the old rules, your taxable profit for 2027/28 would have been one twelfth of £250,000, or £20,833. This would have actually been based on the profits for the year ending 30 April 2026, so let's assume they are the same. Under the new rules, you will be assessed on the whole of the year ending 30 April 2027, less overlap relief. This may sound fair, until you work out just how little that overlap relief is. In this case, it is a mere £45,833, calculated from 111/212 of £50,000, which is the 11 months of profit taxable in 1997/98. So your final year's assessment, based on one month's 'real' profit of £20,833 will be £204,167, approximately 10 times your actual profit.
There are several reasons why this problem has arisen:
Your overlap relief was based on your profit share in the year ending 30 April 1997. That profit share has now significantly increased.
Inflation has increased your profit share throughout your career as a partner. There is no indexation for overlap relief. The figures will be determined in 1997/98 and will never increase.
The period covering the overlap (1 May 1996 to 31 March 1997) drops out of the tax net entirely when you leave. In addition, you only pay tax on half the profits earned in the years ending 30 April 1995 and 30 April 1996, effectively dropping out one year thanks to the transitional provisions.
These periods are replaced by 111/212 of the profits for the year ending April 2026 and the profits for the year ending 30 April 2027, all of which would have previously escaped tax on your retirement. So you are exchanging relatively low earnings for the higher ones nearer your retirement.
The younger the partner, the steeper the earnings curve, and the nearer the year end is to the beginning of the tax year, the bigger the problem.
But what about the older partners - would a change of year not disadvantage them? Not necessarily, because the principles are the same and, depending on past profits, a change can often benefit the older partners too.
Even if there are minor financial penalties, a change is probably worthwhile to remove uncertainty for the partners who aren't retiring soon.
It is important to remember that is is the partnership that normally funds the partners' tax liabilities, even if these will later be the responsibility of the individual partners.
Don't let this monster creep up on you. Act now.
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