Professional Practices News: A Briefing On Topical Issues

Smith and Williamson survey shows confidence among the professions rising for the fourth consecutive year

For the fourth consecutive year, business confidence is on the up. In fact, 94% of all the firms we polled were either very or reasonably confident about the business outlook for the coming year compared to 88% last year, 83% in 2003 and 78% in 2002. There also appears to be increasing interest in acquiring teams from other practices. Meanwhile, a third of the firms we spoke to had converted to LLP status.

However, two clouds are looming on the horizon. First, the Age Discrimination Act which applies from 1 October 2006; and secondly, the issue of staff retention. Both are key areas for professional firms of all sizes.

All but one of the firms we contacted specified a retirement age in their partnership/LLP agreement. Similarly, just over a third of firms reported that promotions to partner level were infl uenced by age and seniority and a half said that these factors influenced salary levels.

Although these statistics may not be surprising, the introduction of the Age Discrimination Act later this year will make it illegal for employers to differentiate on the basis of age. In view of this, professional firms should urgently review their partnership or LLP agreement to conform to the new rules. Perhaps surprisingly, however, less than half of the firms we interviewed were aware of the need to change their agreement.

Virtually all those we interviewed (97%) thought the level of merger activity would increase or remain the same in the year ahead; and as if to confirm this, 90% of this year’s respondents said they would consider an acquisition.

We also asked respondents if they had approached or been approached by another firm with a view to a potential merger or acquisition in the last two years – about three quarters said they had!

There appears to be particular interest in acquiring specific practice areas from other firms, and almost half of property firms said they had acquired a team from another business in the last year. 32% of law practices claimed to have done this.

Most firms are open to the idea of merger – but the key to success is getting the right cultural match. It also requires the careful integration of business practices which in turn needs an appreciation of the respective firms’ business rationales.

Our survey reveals growing interest in acquisitions and this is arguably because it is far easier to integrate a profitable practice area into the culture of a firm than merging two large organisations. Acquiring small, established teams, usually feeds positive results to the bottom line more quickly.

We asked people about the practice areas they had acquired, and for law firms, private client teams were the most popular, followed by litigation teams. Real estate and tax tied for equal third place. Among property practices, commercial property teams were clearly the most sought after.

Property practices have acted more swiftly than law firms to limit liability, and we found that almost half of those we spoke to had converted to become a company, while a little under a third had taken the LLP route. In contrast, none of the law firms had incorporated, while a third had become LLPs. Of those law firms which were still traditional partnerships, 92% saw conversion to LLP as ‘likely’.

The Regulations (Employment Equality (Age) Regulations 2006) which come into force on 1 October 2006, make it unlawful to discriminate against employees or partners on the grounds of age. They will override any agreements between the parties (including a partnership agreement). Both old and young will be entitled to bring a claim for breach of the new legislation. However, claims for both direct and indirect discrimination can be defeated by showing that the discrimination is a proportionate means of achieving a legitimate aim. Proportionality involves balancing between the discriminatory effects of the measure and the importance of the aim pursued.

Firms should review their recruitment procedures. It will be unlawful for an employer to discriminate against a person in the arrangements made for the purpose of determining who should be offered employment. Advertisements for recruits at either employee or partner level should avoid creating the impression that only candidates above or below a certain age need apply – words and phrases such as ‘aged 28 to 35’, ‘dynamic’, ‘mature’ or ‘gravitas’ should be avoided.

Any potentially discriminatory criteria for internal promotion to partnership – such as a requirement for a certain length of experience – will also need to be justifiable. Criteria such as candidates being required to be of a certain age or having a certain length of service with the firm should be avoided. The promotion process will be as important as the criteria themselves.

Remuneration systems for partners will require review. A system which is wholly or partly lockstep (based only on length of service as a partner) is potentially discriminatory although there is an exemption where the lockstep disadvantages partners whose length of service (defined as doing work at or above a particular level) is five years or less. Where the length of service of the disadvantaged partner exceeds 5 years, it must reasonably appear to the firm that the particular lockstep system fulfils a business need of the firm.

Lockstep undoubtedly discriminates indirectly against younger partners. It may promote legitimate aims – retention of older partners, encouraging loyalty, rewarding long term contribution to goodwill – but is it reasonable in fulfilling a business need of the firm? The greater the difference in remuneration between those at the top and bottom of the lockstep, the more difficult it will be to justify the system as reasonable.

Lockstep may also discriminate against older partners. In some systems, there is

an automatic and staged reduction in profit share in the years immediately preceding retirement. Firms will need to consider whether this is justified regardless of continuing contribution to the business.

The imposition of a retirement age for partners of 65 is not legitimised by the Regulations (although it is for employees). If the partnership agreement is to set any default retirement age, careful consideration will need to be given to both the aim the firm wishes to achieve and whether the importance of that aim justifies compulsory retirement at the particular age set.

Older partners have sometimes been expelled not on grounds of performance but because room has to be made in the equity for younger partners. These older partners may be unable to secure partnerships in other firms, so that the loss they suffer may equate to their profit share for the balance of their anticipated working lives. It is sobering to note that the compensation that can be awarded for age discrimination is unlimited.

Records of partner appraisals will become key to defending a claim that an older partner who has been compulsorily retired was discriminated against on grounds of age.

Every firm should begin to review both its partnership agreement and its recruitment, promotion, reward, appraisal and expulsion procedures. Discussions with older partners for retirement before 1 October (with appropriate compensation) might be apposite now, to avoid a potentially longer term succession planning problem.

Clare Copeman sets the record straight on operating and financial disclosure and what, if anything, applies to professional practices.

There has been a good deal of confusion over the requirement for Operating and Financial Reviews (OFRs) on business performance. Firms can be forgiven for failing to understand exactly which disclosure requirements apply.

In November, the Chancellor made a surprise announcement that the OFR will in fact not be a mandatory requirement for fully listed companies. This apparent u-turn contradicted legislation (Statutory Instrument 1011 2005) which came into force in March last year, stating that quoted companies were obliged to publish an OFR providing a range of backward and forward looking analysis on factors underlying their business’ position and performance. This requirement was effective for accounts for financial periods beginning on or after 1 April 2005 (so, in most cases, for yearends on or after 31 March 2006).

In addition to the requirements for quoted companies, the legislation required all but the smallest non-quoted companies and LLPs to include in the directors’ or members’ report an ‘analysis using key performance indicators’ to provide the reader with ‘an understanding of the development, performance or position of the business’. The rules are more onerous for companies classified a ‘large’ than for those which are ‘medium’. The Chancellor’s announcement did not change this part of the legislation.

However, a further Statutory Instrument (SI 2005 1989), which came into force on 1 October 2005, removed the need for an OFR or enhanced members/directors’ report for LLPs.

So the current position is that whilst they do not need to prepare an OFR, all companies, whether quoted or unquoted (except those classified as ‘small’) will be required to make additional disclosures in their directors’ report. LLPs, on the other hand, will not be required to make equivalent disclosure by law.

Just to make things more complicated, the EU is proposing that accounting firms that audit listed companies should be required to provide additional disclosure concerning their corporate governance and professional standards. This will apply to LLPs as well as companies and the largest firms are already doing so voluntarily.

Regardless of the rules, however, market pressures may in any case give rise to increased levels of disclosure. The Chancellor’s November announcement caused consternation among many in the business world who support greater disclosure. Many commentators, including the Financial Reporting Council, are in favour of OFR-style reporting and many organisations have already produced OFRs or are a long way down the road towards them.

As a result, in spite of Gordon Brown’s apparent concession – which many saw as a sop to head off criticism over increased red tape – best practice may evolve such that LLPs make additional disclosure. Those LLPs that wish to be progressive should consider the extent to which they wish to make voluntary disclosure off an OFR nature in their forthcoming financial statements.

Government concedes need for spreading relief but inequalities remain In response to pressure from various consultative bodies with whom we have been actively involved, the Chancellor has accepted the need to introduce a ‘spreading relief ’ to help firms combat the negative tax effects resulting from the change in accounting practice under UITF 40.

Prior to the concessions announced in the Chancellor’s Pre Budget Report, all affected businesses would have been obliged to pay the advanced tax charge in a single installment. Clearly, this could have been very damaging for some firms bearing in mind that no additional cash would actually have been generated in order to pay the advanced tax.

Research carried out by the CCAB (Consultative Committee of Accounting Bodies) has showed that following the introduction of UITF 40, a quarter of businesses face an increase in their tax bill of more than 50 per cent, and about one in six will see their tax bills more than double. If a firm’s ‘normal’ tax bill is in the region of £100,000, then to be suddenly faced with a tax bill of £200,000, could be extremely detrimental from a working capital perspective.

Final details are expected in the Finance Bill, however HMRC has indicated that the additional tax resulting from the adoption of UITF 40 will be spread over three years or, for those firms most severely effected, over up to six years.

Each year, one-third of adjusted trading profit will be taxable, subject to an upper limit of one-sixth of that year’s taxable trading profits. This continues for up to five years or until the adjustment has been fully taxed. After five years, any untaxed balance will be fully taxable in the sixth year.

On the whole it is hoped that this new spreading relief will alleviate the problem that would have otherwise caused some firms considerable hardship.

The flipside is that, ironically, the proposed spreading relief does not apply to ‘early adopters’ of UITF 40. (i.e. those firms which have implemented the new accounting policy in accounting periods ending prior to 22 June 2005). This seems somewhat unfair for those firms which have acted in good faith and implemented the change ahead of the 22 June 2005 compulsory deadline. It is worth noting that UITF40 encouraged early adoption! Such firms are understandably aggrieved and it seems wholly unreasonable that the tax system should seek to penalise them.

Another consequence, which seems to have been overlooked by the Government, is the interaction of these new spreading rules with the payments system for selfassessment. In the case of a firm spreading the charge over three years, the tax payments will actually only be spread over an 18-month period, with 50 per cent of the liability being paid as a first installment.

We continue to petition against these inequitable decisions by the Government and we remain closely involved in the talks with the CCAB and Association of Partnership Practitioners who are trying to ensure that all firms, regardless of when they implemented UITF 40, qualify for the spreading relief.

We are working with a number of clients affected by these changes.

Firm A’s adjusted turnover is increased by 20%, from £100,000 to £120,000. The taxable profit uplift will be £6,667 for three years (the lower of one-third of the total uplift (£6,667) or onesixth of total profits (£20,000)). No further spreading relief applies as the adjustment has now been fully taxed.

Firm B is more severely affected by the adjustment required by UITF 40: adjusted turnover increases from £100,000 to £150,000, with taxable profits for years 1 to 6 of £75,000 per annum. The profit uplift for years 1 to 5 will therefore be £12,500 pa (i.e. the lower of one-third of the total uplift (£50,000) or one-sixth of profits (£12,500). In year 6 the balance is £87,500 (upward adjustment of £150,000 less £62,500 already paid)).

The pensions regime for the self employed has changed radically from 6 April 2006 (A-Day). This may have a major impact on the way firms make provisions for tax.

Since A-Day, individuals are able to obtain tax relief on contributions of up to £215,000 into a pension scheme in any one tax year (subject to having sufficient net relevant earnings available). In the year of retirement the limit of £215,000 will not apply and relief will be restricted only where there are insufficient net relevant earnings to cover the premium. A lifetime value rule overrides these limits.

All pension payments will now be paid net of basic rate tax so that a £100,000 contribution would cost the individual partner £78,000 and a further £18,000 tax relief can be obtained via a reduction in the individual’s personal tax payments. It is no longer possible to make pension payments gross.

Currently many firms operate a policy whereby a full tax provision is made using a straightforward tax calculation. Where individuals make personal pension contributions and provide evidence of the premium paid, a release is made from tax reserves to help finance the premium. This release may be in advance of when the tax relief would normally be given through a reduction in the tax liability payable.

If the normal policy adopted by most firms were to continue, a situation could arise where a large number of partners decide to make the maximum contribution into their pension schemes. This would result in tax relief on each £215,000 at 18% becoming due to the partners from within the firm’s tax reserves. This could have a significant cashflow effect since tax reserves form part of the overall cash resources of the firm for its day to day management.

Equally, existing policy may produce an inequitable position between a partner who makes no pension contribution and a partner who makes the maximum contribution. An individual making no pension contribution will be funding the firm for longer through his tax reserves compared to an individual who makes the maximum pension contribution and who would therefore have smaller tax reserves to assist with the funding of the firm.

Firms are recommended to reconsider their policy in relation to releasing tax reserves where pension contributions are made. An appropriate policy should continue to encourage partners to make maximum pension contributions, but should reflect both the cashflow requirements of the business and equity between partners.

Included amongst the Budget Day Press releases was an announcement on the removal of SDLT charges where there is a transfer of an interest in a partnership, if the partnership property includes land.

This applies only to partnerships whose main activity is the carrying on of a trade (other than a trade of dealing in or developing land) or a profession.

The changes for partnerships whose main activity is the carrying on of a trade or profession are particularly welcome and an area where we have, through the Association of Partnership Practitioners and other bodies, been actively lobbying for a practical solution. The rules which accompanied the introduction of SDLT were devised to counteract avoidance schemes, but caught many other areas where a charge was either illogical or inappropriate.

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