Aspects of Partnerships and Intangibles

Aspects of Partnerships and Intangibles

DAVID NICKSON and DAVID MURPHY look at the knotty issues of corporate partnerships and the taxation of intangibles.

WE ALL KNOW about companies. The Joint Stock Companies Act and subsequent legislation make their existence and legal capacity quite clear. Partnerships have been around de facto , if not de jure for even longer, but are not so easy to pin down. When does a partnership exist and what distinguishes a partnership from a simple contract or joint venture? Once you have a partnership (or think you have), how do you tax it? We are in the territory of Lord Denning's comment 'I know an elephant when I see one'. There is guidance to be had but it is not always definitive.

Contrast this with the relatively recent development that is Schedule 29 , and how it deals with the taxation of a company's intangible assets. This Schedule is intended to do for intellectual property what Finance Act 1996 did for corporate debt. So how does Schedule 29 cope, when applied to corporate partnerships and similar structures?

Since the taxation régime of Schedule 29 is heavily based on the accounting treatment, the starting point for our analysis is the different types of partnerships and how they are treated under United Kingdom generally accepted accounting practice.

English general partnership

This is defined in the Partnership Act 1890 as '… the relation which subsists between persons carrying on a business in common with a view to profit'. Partners' rights and duties are generally documented in a partnership deed and partners have joint and several unlimited liability in respect of the partnership's obligations. Limited liability may be achieved in effect by the use of corporate partners. A general partnership cannot hold title to assets and has no legal personality separate from its members.

Scottish partnership

This is similar to an English partnership but constituted under Scottish law and has legal personality. It may therefore own assets in its own right.

Limited partnership

A limited partnership is governed by the 1907 Act of the same name. One partner (or more) limits its liability in respect of the obligations of the partnership (limited partners) and the remaining partners retain unlimited liability (general partners). The general partners manage the business of the partnership. The limited partner may not participate in the management of the partnership and is restricted as to its use of partnership tax losses. In the corporate environment today there is usually one general partner and it is often only a lowly-capitalised company.

Limited liability partnership

Limited liability partnerships are a recent business development in the United Kingdom, taking effect from 6 April 2001 under the provisions of the Limited Liability Partnerships Act 2000. They are a corporate form designed to provide limited liability for all partners, yet retain the flexibility of partnership structure. They are bodies corporate for commercial law purposes but partnerships for tax purposes.

Accounting

The relevant United Kingdom accounting standard dealing with associates and joint ventures is Financial Reporting Standard 9, and the international standards are 28 (accounting for investments in associates), and 31 (financial reporting of interests in joint ventures). The headline difference between United Kingdom generally accepted accounting practice and international accounting standards is the treatment of joint ventures. The United Kingdom requires equity accounting, i.e. as an investment, in many cases, whereas international accounting standards generally require proportional consolidation. Other detailed differences are beyond the scope of this article.

Financial Reporting Standard 9 deals with not only associates and joint ventures, but also joint arrangements that are not entities (known widely as 'JANEs' though that acronym does not appear in the standard) and structures with the form, but not the substance, of a joint venture.

A joint venture is an entity in which a reporting entity holds an interest on a long-term basis and is jointly controlled by the reporting entity and other venturers under a contractual arrangement. No venturer can control the venture and key decisions require co-venturers' consent. The governing arrangement need not be written, but is a matter of practical reality.

A joint venture must be an entity, whereas a joint arrangement that is not an entity is not. For these purposes 'entity' includes body corporate, partnership, or incorporated association carrying on a trade or business with or without a view to profit. Furthermore, carrying on a trade or business means a trade or business of its own rather than just a part of the trades or businesses of the entities that have interests in the joint venture.

A JANE, by contrast, is a contractual arrangement, under which participants engage in joint activities that do not create an entity because it would not be carrying on a trade or business of its own — and an arrangement that predetermines all key policy matters is not an entity because the policies are those of its participants, not of a separate entity. While this could appear to encompass a partnership, because a partnership is governed by an agreement to carry on business in common, it is far more likely to be seen as a separate entity and thus be treated as a joint venture. In general terms, a JANE might be seen as inconsistent with a typical trading partnership.

However, that is not the end of the matter. Financial Reporting Standard 9 recognises that there will be cases where a JANE will be constrained within a legal entity, such as a company (or partnership). Furthermore, while the form of the arrangement is that participants have an investment in another entity, the substance is that each is carrying on its own business through that entity and the accounting should be driven by the substance not the form.

In summary, a joint venture will be equity accounted and participants in a JANE, including structures with the form but not substance of a joint venture, will account for their own assets, liabilities and cashflows within the arrangement measured according to the agreement governing the arrangement.

So what does this all mean for partnerships? If the accounting followed the logic of the legal status of the various kinds of partnership (see earlier) one might expect to be able to look through to the underlying intellectual property assets of partnerships not having legal personality to apply Schedule 29 and not expect to do so in relation to partnerships that do.

This is not so. What United Kingdom generally accepted accounting practice appears to say is that if a partnership is run as a separate business, it is an entity and it should be equity accounted as an investment without any look through to underlying assets. In practice therefore, all but the most passive of partnership arrangements are likely to be equity accounted.

We will explore in detail in a subsequent article the implications for intangibles of the introduction of International Accounting Standards 38 and 36 to replace Financial Reporting Standard 10, the current United Kingdom accounting standard dealing with goodwill and intangible assets. In the context of partnerships, though, International Accounting Standard 31 refers to three types of joint venture: jointly controlled operations, assets, or entities. The last will generally be equivalent to a joint venture under Financial Reporting Standard 9 and equity accounted, and the other two generally equivalent to a joint arrangement that is not an equity where proportional consolidation would apply. The expectation is that more JANEs will arise, and thus more proportional consolidation will feature under international accounting standards.

The lesson here is quite clear. Make sure you know what entities you are dealing with and consider the accounting issues early on.

United Kingdom taxation

The taxation of partnerships in the United Kingdom recognises the transparency and lack of distinct legal personality by taxing income and gains of an ordinary (as opposed to limited or limited liability) partnership on the partners according to their profit sharing ratios set out in the partnership agreement. Limited liability partnerships are likewise taxed as an ordinary partnership, although their participation in partnership losses is limited to their partnership capital at risk (capital contributions plus any undrawn profit share) as are limited partners in a limited partnership.

The finer detail of how partnerships are taxed is not codified in statute but is largely contained in Inland Revenue Statement of Practice D12 , updated most recently in October 2002 following the Limited Liability Partnership Act 2000. Being extra-statutory, it is something not to be relied heavily upon in tax planning. There are also many tricky questions surrounding the treatment of partnership transactions and a number of important issues have never been formally resolved through legislation.

Sections 114 to 116, Taxes Act 1988 govern the tax treatment of corporate partners. Broadly, the effect of these provisions is to treat a company's share of partnership income as income of its current accounting period. The measure of income is the profits for the partnership accounting period(s) that correspond with the company's accounting period. In relation to a limited liability partnership, the same restriction on participation in partnership losses applies for corporate partners as it does for individuals.

Schedule 29

Schedule 29 to the Finance Act 2002 introduced a régime for the taxation of the intangible fixed assets of companies that swept away the previous plethora of individual provisions governing various categories of intangibles. To quote the Inland Revenue consultation document of November 2001 that initiated the legislative changes:

'The present state of the law derives from a series of historical accidents rather than any overall plan.'

In summary, new intangible fixed assets are now taxed on a consistent basis in accordance with a company's accounts, i.e. acquisition, disposal, and amortisation are dealt with on a revenue rather than capital basis. That is not to say that differences between the tax and accounting treatment of a company's intangibles have disappeared. For example, differences will continue to arise because of the election to write down assets at a fixed rate, ( paragraphs 10 and 11 of Schedule 29 ).

The change of most significance to United Kingdom corporate businesses is that goodwill amortisation arising on 'new' assets is now tax deductible. The régime applies from 1 April 2002 to a company's intangible fixed assets that are created after that date, acquired after that date from an unrelated party, or acquired from a related party if the asset is already within the new régime.

Paragraph 2 states that, for the purposes of Schedule 29, 'intangible asset has the meaning it has for accounting purposes and in particular includes any intellectual property'. Intellectual property is further defined in paragraph 2 and Part 10 which set out what assets are excluded from the tax treatment set out in the Schedule in either whole or part. Excluded assets include, for example, rights over tangible assets, oil licences, financial assets dealt with by other legislative codes such as derivatives and loan relationships, research and development expenditure, and expenditure on computer software elected out of certain provisions in the Schedule.

The operative provisions of Schedule 29 apply to intangible fixed assets, defined in relation to a company as intangible assets acquired or created for use on a continuing basis in the course of the company's activities and include options to acquire or dispose of such assets. Note that the Schedule also applies to intangible fixed assets whether or not they are capitalised in the accounts. This is another reason for potential differences between accounting and tax treatments, especially because there can be no accounting amortisation if the asset is unrecognised. Note also that many of the operative provisions of Schedule 29 apply only to expenditure that is actually entered in the accounts in the first place, so any tax planning must have regard to the anticipated accounting treatment.

In relation to an ordinary partnership, one would have thought that because a corporate partner would itself generally account for taxation on the profits of a partnership it should be able to claim tax relief in relation to partnership intangibles under Finance Act 2002 (clearly Schedule 29 does not apply to the partnership per se , because it is not subject to corporation tax). However, as we have already discussed, for all but the most passive of arrangements Financial Reporting Standard 9 requires equity accounting, thus effectively ruling out the availability of tax relief. Ironically, the arrangements most likely to attract tax relief are passive structures treated as JANEs.

It is not clear to us that the Revenue fully understood this issue at the time of drafting the legislation, as typified by the wording of paragraph 76(1) which provides a specific exclusion of the interest of a partner in a partnership, except to the extent that the assets of the partnership consist of intangible assets (the good news) and those assets are treated for accounting purposes as held directly by the company holding the partnership interest (the bad news). See, for example, Corporate Intangibles Research and Development Manual at paragraph 25060.

Example

To illustrate some of the difficulties these structures create in practice, let us look at an example of some tax issues that might arise if we assume that it is possible to achieve a look through as envisaged by paragraph 76(3) of Schedule 29 , i.e. joint arrangement that is not an entity treatment.

A and B are companies which wish to enter into an equal partnership (ordinary partnership as referred to earlier) to exploit an intangible owned by B. We shall first assume that the companies are unrelated and that both are United Kingdom incorporated and tax resident. A contributes £2 million cash and B contributes intangibles with a base cost of £0 and a market value of £2 million.

What has happened? In simple terms A has exchanged £2 million cash for £1 million cash and £1 million of intangible, B has likewise exchanged £2 million of intangible for £1 million of intangible and £1 million cash.

Provided that the intangible meets the recognition criteria of United Kingdom generally accepted accounting practice, the partnership accounts will show a £2 million intangible asset at fair value, £2 million cash and partners' capital of £4 million. Each corporate partner will show its interest in the partnership as a share in the underlying assets.

Is there any tax depreciation on the partnership intangible? If the asset is not already a new asset, it is not a chargeable intangible asset within Schedule 29 in B's hands. But could it be one now?

Solving this is not particularly easy. Firstly, consider the timing of events as well as the relationship between A and B as partners. For capital gains purposes, partners are not considered to be connected in relation to acquisitions or disposals of partnership assets pursuant to bona fide commercial arrangements. It is presumably also on this basis that Extra-statutory Concession D12 states that, in normal circumstances, there is no chargeable event on a change in profit sharing ratio or admission of a new partner because such an event is assumed to be pursuant to a bona fide commercial arrangement. In that case, the general market value rule for connected parties does not apply. Schedule 29, however, contains detailed related parties tests in paragraph 95 et seq which we must consider. These include specific reference to the control of, or major interest in, a partnership. Secondly, who is a 'person' for these purposes? As discussed earlier, some partnerships have legal personality and some do not. Depending on the permutations of partnership interest and partnership vehicle, you can arrive at varying results.

Conclusion

The interaction of partnerships and Schedule 29 is a relatively complex area, and in the space available we have only touched upon a small number of issues from the many which could arise in practice. We trust that this will stimulate more debate and discussion in the future.

David Nickson is a tax partner and David Murphy is a senior tax consultant at Ernst & Young.

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