FOREWARD - BACK IN BLOOM?
By Giles Murphy
As the green shoots of recovery appear to be coming into bloom, the challenge for professional practice firms is how to take advantage of the improving economic weather to ensure they continue to blossom.
Improving economic activity may alleviate one concern for management, but our newsletter focuses on a number of others that firms are currently facing.
The initial deadline to comply with new HM Revenue & Customs (HMRC) tax rules has passed, but uncertainty remains. As your business blossoms, you will need to consider reseeding for the future, so we look at how best to deal with succession planning for the firm and retirement planning for partners.
Cyber crime and fraud may not have been on your management risk agenda a few years ago, but they most definitely should be now – not least if you are looking to expand overseas.
Finally, if you want to know your fellow managing partners' views on how they are tending their own metaphorical gardens, copies of our 19th annual law firm survey research reports are available.
Enjoy the warmer economy – and weather – and good luck with your cultivation.
HERE TO STAY - IGNORE MULTI-DISCIPLINARY PRACTICES AT YOUR PERIL
By Giles Murphy
The world used to be simple. A lawyer worked for a law firm, an accountant worked for an accountancy firm, an architect did architecture and a surveyor surveyed. Not anymore, says Giles Murphy.
The lines that defined the boundaries between professions have become blurred. In the past, restricting membership of the professions was considered important to maintain standards, but it's now possible to combine virtually any profession with another if the desire is there.
Extending the service range
In an increasingly competitive marketplace, professional firms are facing the challenges of how to differentiate themselves in the market to win work that will generate the financial return they desire. One way to differentiate is to extend the range of services that the firm can offer.
Real estate practices now provide a far greater range of services than just surveying. Similarly, some architectural firms provide interior design, law firms provide HR consultancy or trademark advice and – probably the best example – some of the Big Four accountancy firms now openly talk about their legal services.
These developments might attract new clients, but with more services available, the real opportunity is to provide a greater range of services to the current client base.
The real value of most firms is in their client base and the firm's relationship with those clients. The theory is that on the back of a strong relationship, a firm should be able to sell other services far more easily than winning a brand new client. We see this theory working in practice on the high street all the time – because we trust Marks & Spencer (M&S) to produce good quality clothes, we decide they must be trustworthy to provide household insurance.
A strategic response
To date, additional service offerings in the professions have generally been built up on a piecemeal basis. But if the multi-disciplinary model works, why not propel a business forward by merging, say, a large law firm and accountancy firm, and then bolt on a real estate practice and wealth management business.
However, while M&S might be good at 'cross-selling', the vast majority of professional services firms are poor at this. Therefore, the risk is that a multi-disciplinary practice may end up as essentially just two firms working side by side, without realising the benefits of the synergies between them.
The response from some may be to stay niche and specialised as a way of differentiating themselves. Whatever your view, multi-disciplinary practices are here to stay and will only develop further. Firms therefore have a choice between joining forces and focusing on making it really work or beating the competition by staying as they are. Whichever path you take it needs to be a conscious strategic decision, not one that you sleep walk into.
For the avoidance of doubt, Smith & Williamson's own strategic response to the continuing development of multi-disciplinary practices is firmly that we have no intention of providing legal services. We continue to believe that our existing multi-disciplinary practice, combining an accountancy firm and investment management business, is fit for purpose.
LLPs AND SALARIED MEMBERS: WHAT NOW?
By Pamela Sayers
Pamela Sayers discusses the immediate and longer-term implications of the changes to LLP taxation.
Despite intense lobbying, even in the last few days leading up to 5 April 2014, the new proposals for the so-called 'salaried member' rules went ahead. While revised guidance published by HMRC on 27 March provides greater clarity on some aspects, uncertainty remains for many firms as to whether they might 'fail' one of the conditions to allow their partners to remain as self-employed for income tax purposes.
Firms looking for additional comfort by applying to HMRC's non-statutory clearance team are unlikely to receive a response until late summer. HMRC has stated that it will not respond to applications until the Finance Act 2014 has received Royal Assent, probably in mid-July.
In the meantime, some firms could be storing up significant penalties for incorrect completion of real-time information (RTI) returns and application of PAYE from April 2014.
All firms should ensure that they are clear whether their 'salaried members' should now be paid through their payroll and that their LLP payroll records and RTI returns are accurate from April 2014 or face unintended consequences and potential penalties.
Welcome grace period
Existing partners who have committed to contribute capital have been allowed an additional three months, to 5 July 2014, to make payment. This is welcome news, especially for banks, which have been inundated with requests for loans for additional partnership capital.
Many firms have sought to proceed with Condition C, the capital contribution route, as it is an arithmetical test and so provides the greatest certainty. The other routes involve more subjectivity, relying on interpretation of phrases such as "reasonable to expect" and "significant influence".
Many firms are concerned that HMRC may look to make the rules more onerous in the future. For example, it may decide that partners would need to 'fail' two conditions to remain as self-employed for tax purposes. If this is the case, for many partners the only other easily accessible route is Condition A – the quantum of profit share by reference to the overall profitability of the business. For large firms, Condition B – the significant influence test – is still largely unworkable.
Partnership capital levels
Now that firms are operating under the new regime, they will need to be more organised about reviewing the adequacy of partnership capital levels (see opposite). Partners may need to increase capital levels if, for example, there is an increase in the fixed profit share, bonus award or other so-called 'disguised salary'. Additional capital must be introduced immediately from the date of change – i.e. there is no grace period – by reference to a formula. However, new partners being admitted to the partnership will have two months from the date of admission to provide capital.
Additional capital – what are the options?
Many firms are asking partners to introduce additional capital as a result of the recent LLP tax changes and face the unusual dilemma of what to do with it.
While the additional capital introduced by partners may strengthen the balance sheet, in many cases there may be no obvious need for it at the present time.
One route firms may choose is to reduce or repay debt. However, there is a possibility that this could trigger the Government's targeted anti-avoidance provisions (TAAR). We understand that the TAAR will not be triggered if the capital contribution is deposited in an account with the same bank. But it will be triggered if the loan provided to the member causes the bank to reduce the amount available to the LLP.
Firms may be planning to use the additional capital for projects such as an IT upgrade, an office move or to open a new office. However, firms with a service company and which, from 25 October 2013, are charging the marked-up price for the provision of services, will be accruing profits in the company unless dividends are being paid up to the LLP and out to partners. Undertaking such projects in the service company may be more tax efficient.
Impact on the partnership model
The new capital requirement may prove to be a disincentive for new partners, especially if they have plans to take out a new mortgage. The tax changes could therefore have a negative impact on the ambition of individuals coming through and their desire to become a partner.
Where firms have made a conscious decision not to ask partners for additional capital and are seeking to meet Condition A – more than 20% as variable profit – we could see a move towards a single class of partner.
Partnership or company?
While it is proposed that the main rate of corporation tax be aligned with the small companies rate by 2017, it is not expected that there will be a rush to convert partnerships to companies, as the partnership model is still a very efficient and flexible business vehicle. No doubt there will be some conversion to limited companies but each will need to be decided upon its own merits.
A serious review will be required by firms that have both individual partners and corporate partners, with an urgent decision needed as to whether to cease the corporate partner as a partner altogether, or to reconsider the allocation of profits.
THE SECRETS OF SUCCESSION PLANNING - Q&A WITH RICHARD GREEN
By Richard Green
Professional Practices Newstalks to Richard Green, head of professional practices for the South East, about the importance of succession planning and the dangers of leaving it too late.
Q Why is succession planning such a big issue for firms?
A. Whenever I meet with a new professional practice, one of my first questions is always about the age profile of the partners. The answer tells you a lot about the practice and whether it has a good succession plan in place.
In our most recent survey of law firms, 62% said they have an informal succession planning process. About a third said they have something more formal. If you add that to the fact that the average age of partners at nearly three-quarters of professional firms is between 46 and 55, you can see why the issue of succession should be high up on the agenda.
Q How should firms tackle the issue of retirement age?
A. It's important to put yourself in the shoes of the retiring partner. Many are reluctant to give a definitive date because of concerns about the amount of money they'll have for their retirement. Age is not the critical factor – it's the partner's ability to continue working at the high level required.
But someone has to decide when it's the right time – is it at 55, 60, 62, 65 or maybe even later? In our survey, a quarter of firms said they don't have a set age, half still have a default retirement age of 65, and one in ten set 60 as the default.
Q What's the best way to deal with non-performing partners?
A. Firms need to avoid the partner 'cruising zone'. They may have to consider some form of non-performing partner process if the partner isn't prepared to have a sensible conversation.
It's best to have a conversation about succession issues in a non-threatening environment. The individuals concerned are your fellow partners – you know them well, you know their families, they may even be your friends. So the best solution may be to get outside help from someone who can ask direct questions without it feeling confrontational.
One way is for an outside adviser to hold a series of one-to-one meetings with the partners. The crucial thing is that these can be confidential. Some issues can probably be resolved internally, but others might need further assistance from outside parties.
People usually know if they're not performing, so a solution that saves face can be a good result for all parties. For example, they could reduce their pay to match their output and stay on as a partner for longer than might have been the case otherwise. The part-time route is another option and can work well in certain circumstances.
Q How can firms achieve a smooth transition from old to new partners without losing clients?
A. One recent example involved a firm agreeing a three-year plan for a partner with a very large fee following, which the competition was keen to get its hands on. In year one the senior partner charged his time but the junior partner didn't. In year two it was vice-versa. In year three the senior partner's role was to act as ambassador to cement the relationship, where he was called in to look at one-off pieces of work and attend major client meetings. By the time he actually retired and the opposition was chasing the clients, they were all secure for the practice.
When there's no plan in place it can be devastating for the firm – for example, if a partner has a sudden change in health or makes a quick decision to retire. You also shouldn't underestimate the client's view – they will often decide that someone isn't up to the job before anything can be done.
It's still a challenging marketplace out there, so it's very important to look after your existing client base. You can't do that without a detailed succession plan, so it's really a case of ignore at your peril!
HOW TO CHOOSE THE RIGHT MERGER PARTNER
By Ian Cooper
Do your homework and take a good look at your business strategy before approaching a potential merger partner, says Ian Cooper.
In many ways, it's easier to describe how not to choose a merger partner.
Let's be clear, a merger is not a strategy in itself. Many mergers fail, usually with one party citing generic reasons such as 'cultural differences'. In fact, the real reason for failed mergers is usually that the firms involved didn't have a clear view of what they wanted to achieve or hadn't done their homework properly.
Understand your own business first
Before looking for a merger you need to be clear about your own strategy and why a merger is part of that strategy. It's important to understand what you're trying to achieve and how a merger will advance your firm. In order to identify the characteristics of a suitable merger partner it's essential to have a clear view of your own firm. Here are some key issues to consider.
Your strategic aims
Be clear about your strategy and whether you can achieve it through organic growth. If not, work out what's missing to help identify the ideal merger partner.
What's the culture of your firm? Is it corporate, collegiate, partnership, 'eat what you kill' or something else? Understanding this will help you focus on who would potentially make a suitable 'partner' and also identify who is never going to 'marry' you.
Your strengths and weaknesses
Be honest with yourself – are you doing this from a position of strength or relative weakness? In reality, the truth will always come out and it won't help if your new potential merger partner feels let down – this will end in tears. But remember, if your weakness is, say, a lack of succession planning or management capability, this can be sold as an opportunity for your new partner and vice versa.
Have a good idea of the potential benefits to another party – why should they consider merging with you? Ultimately, the challenge is to assess how two plus two will equal more than four, rather than something closer to three, and be able to articulate this to the other party.
A clear understanding of the above factors will immediately help you to focus on the characteristics of a potential merger candidate and eliminate a whole raft of firms with whom a merger is never going to work.
Remember some basics – if your profits per equity partner (PEP) are a lot higher or lower than the PEP of your merger partner, then in an outright merger you're asking one party to dilute its PEP. This is unlikely to be acceptable. However, a merger partner where PEPs are comparable, with the possibility of shared cost savings, will be a more palatable proposal.
So, in summary, think very carefully about why you're looking for a merger, be clear about your own position and do some basic homework, and you'll be well on the way to choosing the right merger partner.
FIGHTING CYBER CRIME IN THE PROFESSIONS
By John Holden
Glenn C. Davis explains what professional service firms need to know about cyber security.
In today's highly digitised world, cyber security has become an important issue for individuals and businesses alike. But despite the evolving technology of firewalls, malware detectors and so on, security breaches still occur every single day.
Even a cursory perusal of the business press will reveal reports of cyber attacks against countless well-established businesses, involving loss of customer data, credentials and credit card information. The financial costs to these firms are vast. And these attacks are just a glimpse of what the future may hold.
Professional services firms, with their massive electronic repositories of confidential client data, are increasingly viewed as high-priority targets. Firms often lack the finances, technology and manpower to implement widespread and efficient cyber-security defences. This, coupled with the inherent vulnerabilities of the emerging technologies and trends within the industry, such as mobile computing and use of the cloud to store data, places further stress on a firm's IT defence strategy. Firms also need to consider the industry's interconnectedness, the risks of working with third-party suppliers and the adequacy of their IT risk-defence practices.
With all these issues potentially leaving a professional services firm open to attack, the importance of a top-level, cyber-security defence strategy is greater than ever.
Understanding the issues
While the sophistication of cyber attacks has increased at an alarming rate, unfortunately the efforts of legal and other professional services firms to mitigate these risks have often fallen short. Managing partners and finance directors are not expected to be IT experts, but they should have a sound understanding of the topic, enabling them to help establish a co-ordinated and robust cyber-incident response plan alongside the firm's IT management.
Managing partners should be at the helm of these strategies. After all, they could be held accountable for the proper governance of the firm's cyber-security defence and incident response strategies.
Don't let your firm become the next victim
By developing, implementing and maintaining robust yet adaptable IT risk-management programmes and performing periodic due diligence reviews of third-party partners and providers, firms can insulate themselves against cyber-security breaches.
Before moving forward with any other IT risk-management efforts, managing partners and finance directors should:
Glenn C. Davis is a partner at CohnReznick LLP in New York, a fellow member firm of Nexia International. He is the former national director of the firm's governance, risk and compliance practice.
PUTTING THE SPOTLIGHT ON FRAUD
By David Alexander
David Alexander explains what to do when you suspect an employee may be involved in fraud.
In the past few years there have been several high-profile cases of fraud in professional services firms. However, these headline-grabbing cases are probably just the tip of the iceberg – most fraud in professional practices is likely to go unreported.
The sluggish economy of recent years has put increased pressure on the professions, and partners are not immune to the temptation to 'put their hand in the till' by inflating results to protect profit share. In its 2012 survey, the Association for Certified Fraud Examiners identified manipulation of results as the most financially damaging type of fraud suffered by any business. This, together with the increasing regulation of UK plc, has put the spotlight on fraud in professional practices.
A successful fraudster can often perpetrate the crime for years without being detected. However, more often than not, the fraudster will become greedy and/or start spending his or her ill-gotten gains. Fraudsters are often then caught because someone close to them questions their sudden wealth or growing addiction to gambling or a chemical dependency.
As an investigator, when I visit a firm that has suffered a fraud the indicators are often quite obvious. But, of course, this is with the benefit of hindsight. The challenge for professional services firms, as with any business, is to recognise any indicators as early as possible. It's not uncommon for businesses to exhaust every other explanation before finally admitting that an apparent discrepancy in the financial records might be fraud. By that time the loss may have multiplied and the survival of the practice may be at risk.
Put your fraud hat on
When faced with an unusual discrepancy, a complaint from a client or supplier, or an unexpected financial variance, there may well be an innocent explanation. However, you'll only identify fraud if you're looking for it. You can then test your theory by looking for other fraud indicators to prove or disprove your hypothesis. Smith & Williamson is often called in to carry out this triage process, which allows practice managers to move on if further investigation is proved unnecessary.
Fraud response planning
When fraud does occur, it's important to mitigate the loss and bolster the confidence of clients by showing that the partners are still in control. How you handle the situation is as important as the underlying event that caused it. A well-thought-out fraud response plan is the key to ensuring your attempts to limit the damage do not have the opposite effect.
Key elements of a fraud response plan
With the introduction of the UK Bribery Act in 2011 and the new corporate criminal offence of failure to prevent bribery, professional practices need to make sure they have these robust anti-financial crime procedures in place.
SETTING UP IN... EUROPE
By Rajesh Sharma
Rajesh Sharma highlights the options for professional firms looking to expand into Europe.
A considerable number of professional firms are considering expanding operations outside the UK to reach out to their global clients in Europe. Many European organisations, meanwhile, demand a global presence from their professional services providers.
Branch v subsidiary
The options available for a permanent presence are the establishment of a local branch of the UK entity or a new entity, such as a local subsidiary or a partnership structure. To determine the appropriate entity, it's important to consider the local rules for the establishment, registration and taxation of the profits derived by the entity.
Many European jurisdictions have a highly regulated procedure for the registration and approval of professional services firms looking to establish a local presence. Generally, a locally qualified professional is required to assume responsibility for the entity. It is recommended that assistance is sought from local advisers so that the registration process is completed efficiently.
Local accounting and auditing requirements depend on the entity selected. A compulsory audit may not be necessary unless a local subsidiary is established, is material, and the size of the group is considered to be in excess of the thresholds for small and medium-sized enterprises.
Treatment of profits
Profits are subject to tax depending on the nature of the entity. In the case of a local subsidiary, the adjusted taxable profits are taxed at the corporate income tax rate. The repatriation of profits to a UK holding company should benefit from the EU Parent Subsidiary Directive, so withholding taxes shouldn't be applicable.
However, if the overseas subsidiary is held by a UK partnership or an LLP, the repatriation of profits is subject to withholding taxes, typically 15%, although a credit should be available against the UK taxes payable on the profits. While the withholding of taxes is a cashflow issue, it could lead to irrecoverable tax, particularly in countries where tax rates are higher than those in the UK.
Use of a UK holding company
A number of professional firms choose to set up a UK holding company as an intermediary company for the overseas entities, in order to secure exemption from withholding taxes in the overseas territory. There is also a dividend exemption available to those subject to corporation tax in the UK for dividends paid from overseas profits – such a structure could be particularly tax efficient.
In addition to direct taxes, the local entity will be subject to payroll and indirect taxes. Local advice to ensure proper registration and filing of the relevant returns on a timely basis is recommended.
WHAT NOW FOR PENSIONS?
By Kevin O'Shea
Kevin O'Shea looks at the latest plans for pensions following the shake-up announced in the Budget.
Perhaps as a prelude to the skills on show at this summer's World Cup, we've recently been given a glimpse of our domestic talents with George Osborne's punt at the pensions political football.
The changes announced by the Chancellor in his spring Budget aim to offer pension savers more freedom, choice and flexibility than ever before in how they access their pension savings. Gone is the need to annuitise pension pots and a clear intention has been set out for anyone of pension age to be able to draw as much (or as little) from their pension pot as they choose at any time. A quarter of the pot would still be tax-free and the balance would be taxed as income in the year it is taken.
Immediate changes to income limits
The proposals will be consulted on this year, but some immediate changes have been introduced.
Capped drawdown income limits have been increased by 25% (to 150% of an equivalent annuity) and the secured income hurdle has been reduced from £20,000 to £12,000 to enter flexible drawdown. The intention is to remove income limits completely in 2015.
The future of annuities
The removal of annuity purchase requirements is a welcome step, but annuities still have a place for many retirees. Annuities provide insurance against longevity risk and ensure that retirements do not extend beyond financial means. As we live longer and fuller retirements, it's important to ensure that lifestyles can be maintained and that, on death, the surviving spouse is catered for.
This new flexibility will raise some important issues for those reaching retirement, such as the level of a policyholder's disposable income in retirement and what happens when he or she pre-deceases their spouse. Annuities provide guarantees against these uncertainties, but this is reflected in their cost.
Those opting for drawdown will often benefit from professional advice on tax-efficient withdrawals of income, income sustainability, investment risk and cashflow planning to guide them through the options.
Pension death benefits
Annuity death benefits will be determined by the terms at outset and can be written on a joint life basis in differing proportions (e.g. 33%, 50%, 100% reversion to spouse on death).
Under drawdown, a spouse may inherit the pension fund in the current 'wrapper' and continue to drawdown or may purchase an annuity without triggering a tax charge. Income taken will of course remain subject to their marginal rate of income tax. Alternatively, the spouse can opt to receive the value of the pension, but will be subject to a 55% tax charge (at current rates) – although this may be reduced after the current consultation.
This punt at pensions 'liberation' has launched the political football skywards and only time will tell whether it was a David Beckham-style stunning strike or a socio-economic own goal. Either way, it's clear that many will require professional advice to protect their retirement goals.
We have taken great care to ensure the accuracy of this newsletter. However, the newsletter is written in general terms and you are strongly recommended to seek specific advice before taking any action based on the information it contains. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. © Smith & Williamson Holdings Limited 2014. code 14/518 expiry 30/11/2014