Tax Doctor:
Mark McLaughlin
ATII ATT TEP

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March 2004

Q:

I am a self-employed professional, earning about £35,000 per annum from consulting services. I pay 40% tax on all this, as I also have a £40,000 pension. My wife is a housewife with no significant income. If she and I formed a consulting partnership, are there rules about how the partnership profit must be divided? Obviously I would like the bulk of the profit to go to her, so that income tax is only paid at the basic rate. However, she would not be able to take anything other than a trivial role in the partnership, such as taking occasional telephone calls and opening letters, so that actually all the income would be generated by myself.

A:

Your query does not indicate the type of profession you are in. Some professions (e.g. doctors) have their own rules to prevent partnerships admitting those without the necessary skills and qualifications. Assuming that your profession does not restrict the admission of partners in this way, there is nothing to stop a new partnership with your wife, and the apportionment of profits to her. The Inland Revenue's own Inspector's Manual states the following:

'You cannot challenge the apportionment of profits, as you can a wage, by reference to the value of the partners' contribution to the firm's activity. It may be possible in these cases to challenge the spouse's status as a partner, but such a challenge is often very difficult to sustain. It is sometimes overlooked that there is no need for the spouse to contribute capital; or to participate in management; or, in a trading context at least, to be capable of performing the main activity of the business. Indeed to be a partner one need not take an active part in the business at all.'

The Revenue's guidance acknowledges that a partnership is not a 'sham' even if has been set up to save tax. However, there has been recent publicity regarding a different line of challenge by the Revenue, which can affect husband and wife partnerships among others. There is tax avoidance legislation concerning 'settlements' (see Tax Doctor 9). This legislation is intended to prevent an individual from achieving tax savings by diverting income to another person who is liable to tax at a lower rate, or who is not liable to tax at all. If the settlements legislation was to apply to a partnership with your wife, the profit share allocated to her could be treated as your own income and taxed accordingly.

The Revenue's interpretation and approach regarding the settlements legislation is set out in its 'Tax Bulletin' publication (Issues 64, April 2003 and 69, February 2004), which can be accessed via its website (www.inlandrevenue.gov.uk/bulletins). The Revenue are looking for situations involving 'Income being transferred from the person making most of the profits of a business to a friend or family member who pays tax at a lower rate'. Tax Bulletin 64 includes an illustration (Example 5) of a partnership consisting of husbands and wives, where the wives receive a profit share but do no work in the partnership. The Revenue states the view that the settlements legislation applies in those circumstances.

The settlements legislation will not apply to every husband and wife partnership, for example where the 'non-earning' spouse contributes a substantial amount of capital to get the business started (see Tax Bulletin 64, Example 13) or takes on a significant level of risk in respect of partnership liabilities (see Example 14). However, it seems unlikely that these exceptions would apply in most partnerships involving the provision of consulting services.

The Revenue's view of the way the settlements legislation applies has created some controversy. Indeed, there is an acknowledgement in Tax Bulletin 69 that many accountants and tax practitioners do not accept that view. However, you should be aware that there is a risk of challenge by the Revenue if you form a partnership with your wife, in which she receives a disproportionate share of profits, such that your income is effectively being diverted to her. The test is broadly whether the allocation of partnership profits could be considered to form part of a genuine commercial arrangement.

Further information on the nature of your professional activities and the terms of a proposed partnership with your wife would help when assessing the risk of possible challenge by the Revenue under the settlement rules. Taking specific professional advice should help to reduce that risk.

Mark McLaughlin

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