Taxation of Partnerships

• Taxation of Partnerships is the topic of discussion.
• Focus is on the concept, taxation and income of partnerships.

What is a Partnership?

• Under Section 5 of the Partnership Act 1891 (Qld), a partnership is defined as the correlation between persons carrying on a business in common with a view to profit.
• Each partner is an agent of the others.
• Partners are jointly and severally liable for the partnership's debts.
• A partnership has no legal status separate from its partners.
• Under section 995-1 of the ITAA 1997, a partnership is an association of persons carrying on business as partners or in receipt of income jointly, or a limited partnership.
• A taxation partnership exists if partners operate a business or if two persons earn income jointly.
• A partnership tax return only needs to be lodged if the partners are carrying on business.
• Joint income is typically split between the parties with each individual reporting in their tax returns.
• General law partnerships involve carrying on a business, while tax law partnerships may include joint income receipt.
• This distinction impacts the deductibility or assessability of transactions.

Does a Partnership Exist?

• The Commissioner has issued Taxation Ruling TR 94/8, which outlines factors to determine whether a partnership exists.

Factors include:

• Formal partnership agreement
• The intention of the parties
• Sharing of profits and losses
• A partnership bank account
• Contributions of capital, services, labor, and/or expertise
• Participation in control and management of the business
• Maintenance of business records
• Registration of a business name
• Joint ownership of assets
• Authority to act on behalf of the partnership
• The Commissioner requires a partnership tax return be lodged (refer below)
• Examination of these factors determines the existence of a partnership.

Partnership v Joint Venture

• Businesses usually carry on partnerships with a view to profit.
• Joint ventures are for specific projects.
• JV participants get a share of the final product.
• Partnerships can have more partners than Joint Ventures.
• Joint ventures do not have a separate legal entity; resources are predetermined by an agreed contractual arrangement.
• Venturers handle their liabilities, and aren't bound by co-venturers.
• Joint Venture must have the ultimate goal of profit.

Advantages of Partnerships

• Pooling of capital, talent, and resources for business
• Easily understood and operated structure
• Relatively simple, straightforward, and low cost
• Income splitting to reduce taxable income
• Offset of partnership losses against other income
• Deduction of employee salaries and business expenses
• Superannuation contributions for partners
• Relative ease of dissolution

Disadvantages of Partnerships

• Unlimited liability
• Inflexibility in distributions
• Conflicts between partners
• Dissolution and creation of a new partnership with changes in partners

Taxation of Partnership Income

• Partnerships are not separate taxable entities.
• Partnerships are considered taxpayers for taxation purposes because they derive income.
• Partnerships must lodge an income tax return (P form) under section 91 of the ITAA 1936.
• The return includes assessable income and allowable deductions as a resident taxpayer.
• A partnership cannot have a taxable income.
• The difference between assessable income and deductions is called the “net income of the partnership".
• The following deductions cannot be claimed: prior-year losses, personal super contributions, and capital gains/losses.
• These deductions are included on the partner's return.
• The partnership profit is distributed to each partner.
• Each partner pays tax on their share at their marginal rate.

Partnership Loss

• Partnership losses are distributed to partners to offset against other assessable income (section 92(2)).
• Division 35 ITAA 1997 contains the non-commercial loss provisions.
• These provisions will quarantine a partner's loss in certain circumstances.

Determining Each Partner's Share of the Net Income of the Partnership

• Partners are assessed on the derived net income.
• Allocation is based on the individual interest.

Resident Partner

• Resident partners include their share of the net income in their tax return (section 92(1)(a)).

Foreign Resident Partner

• Foreign resident partners are assessed on their share of Australian-sourced income and are entitled to a deduction for Australian-sourced losses (section 92(1)(b)).

Partner's Salaries

• Partners are not considered employees.
• Partner salaries are not deductible to the partnership under section 8-1 of the ITAA 1997.
• Salaries paid to partners are regarded as distributions of profit and are confirmed in Taxation Ruling TR 2005/7.
• There must be a documented agreement signed by the partners.
• The salary must be reasonable and appropriate.
• The agreement must be entered into before the end of the income year.
• A partner's salary cannot increase a partnership loss.

Interest on Partner's Capital

• Partners may be paid interest on capital contributions.
• This interest is not deductible to the partnership.
• It is regarded as a distribution of profit.

Interest on Partnership Borrowings

• Interest paid on monies advanced by a partner is deductible if used for income-producing purposes.
• The partner lends as a lender, not as a partner.
• Interest paid on money borrowed to repay loans is deductible if used for working capital purposes under section 8-1 of the ITAA 1997.
• The “purpose” is of primary importance rather than the ‘use'.
• The ‘refinancing principle' applies when funds are borrowed to refinance earlier debts and the interest is deductible.

Interest Deduction Limitations

• Deduction for interest on financing is limited to the capital of the partnership including partner contributions and retained profits.
• Borrowings to replace capital from asset revaluation are not deductible.
• Taxation Ruling TR 95/25 provides ATO views on Roberts and Smith.
• Partners are not entitled to a deduction under section 8-1 for interest on borrowings to pay personal income tax.

Partner's Drawings

• Drawings are not taken into account in determining the net income.
• Drawings are neither assessable nor deductible.
• A partner's drawing reduces equity.

Specific Taxation Issues for Partnerships

• A dissolution or reconstitution of a partnership occurs when there is a change in the membership.
• A partnership may be dissolved by agreement, death/bankruptcy, or court application.
• A partnership may be reconstituted if there is a change in the partners.
• A partnership tax return is required for both the old and new partnership.
• The ATO allows partnerships of at least 20 partners to forgo lodging a tax return at the time of reconstitution if the change represents less than 10% of the interest
• The partnership can continue business with its existing tax file number.

Major Taxation Consequences of Dissolution

• Trading stock
• Depreciation
• Capital gains tax

Trading Stock

• Section 70-90 of the ITAA 1997 states that the disposition of trading stock outside of ordinary business requires the taxpayer to include its market value in their assessable income.
• Section 70-100 of ITAA 1997 says, a partial change in the ownership of the trading stock is treated as a notional disposal at market value on the date of dissolution.
• The election can be made in writing to treat the trading stock at its book value if at least 25% of the partner's interests in the old partnership continues into the new partnership,

Depreciation

• Change impacts balancing adjustment, ie. gain or loss on sale
• Without rollover relief, depreciating value is disposed of at market value and becomes the starting value for the new partnership.

Capital Gains Tax

• Only the partners incur the tax on a CGT event in relation to partnership CGT asset because a partnership is not a separate legal entity.
• Any capital gain is shown in the individual tax returns of each partner.
• Each partner has a separate cost base and reduced cost base for their interest in each CGT asset of the partnership.
• On admission of a partner, current partners each dispose of interest in assets for consideration share.
• It an assessable capital gain will arise if capital proceeds exxceeds cost base.
• If a partner retires, they dispose of assets, and create an assessable gain.
• Individual partners can choose CGT asset they are disposing.

Assignment of a Partner's Interest in a Partnership

• The High Court decision in FCT v Everett (1980) 80 ATC 4076 says that a partner may assign his/her share in a partnership.
• The net income is attributed on assigned share is derived beneficially by the assignee.
• In Everett's case, the taxpayer assigned 6/13ths to his wife.
• Everett's wife was not entitled to be a member, according to the case.
• Tax was impacted because the taxpayer became a trustee of the partner share. The beneficiary was assessable on the full amount.
• Largely ended due to introduction of gains tax, has limited relevance.
• If the above were to take place now, the result would be the disposal of a CGT asset, and will activate Section 104-10 of the ITAA 1997.
• Cost base of partnership interest is the consideration amount, and the assigned partnership interest usually deemed to be market value.

Work in Progress

• Work in progress (WIP) needs to be considered for tax, whether it is trading stock or billable hours.
• Commonly recorded as accounting billable hours that haven't been invocated.
• A "work in progress amount” means any entity must pay an amount to another entity.
• Related to work has been done but not completed
• Entity paying will try to complete it and invoice for it.
• If the debt is recoverable, a deduction for the work in progress payment if available to taxpayer in the particular year.
• If not recoverable, the amount will be available on the following income year.
• The entire amount is deductible in the following income year, including if no recoverable debt is expected in the future.
• A work-in-progress is included in the assessable income during the year it is received.