Limited Partnerships and UK Real Estate

• For the holding of UK real estate, a limited partnership has a number of attractions. These are principally:

• Limited partnerships are simply a special sort of ordinary partnership. All the normal rules applicable to ordinary partnerships apply to limited partnerships, except as modified by the 1907 Act.
• The main rules applicable to partnerships generally are contained in the Partnership Act 1890 (the 1890 Act) and a large volume of associated case law.
• For a partnership to exist, two or more persons (which includes companies) must be "carrying on a business in common with a view of profit". Simple joint ownership of assets does not of itself create a partnership, whether the owners share profits from the use of the common asset or not.
• A partnership is not a separate legal entity in the same way as, for example, a company. In law, when action is taken by or against a partnership, it is being taken by or against the underlying partners collectively.
• If a partnership exists, then the partners collectively are known as a "firm". Any act of any partner which is done for "carrying on in the usual way business of the kind carried on by the firm" will generally bind the firm collectively and each partner. Consequently, each partner is liable jointly with all others for all debts and obligations of the firm incurred while he is a partner. This extends to liability for any loss or injury to third parties caused by any partner acting in the ordinary course of the business of the firm, or for misapplication of a third party’s money by the firm or a partner.
• Partnership property is held on trust for the partners, to be held and applied exclusively for the purposes of the partnership and in accordance with the partnership agreement.
• The partners owe a general duty of good faith to each other in relation to the business of the partnership.

Modifications of the normal rules for limited partnerships

• The 1907 Act provides for the creation of limited partnerships. The essential distinctive feature of a limited partnership is that it has two categories of partners - limited partners and general partners. There must be at least one partner of each category to make up a limited partnership.
• The general partner(s) are liable without limit for all debts and obligations of the firm in the usual way. The limited partners must, at the time of entering into the partnership, contribute (in cash or in kind) partnership capital but they have no liability for the debts or obligations of the partnership beyond the amount so contributed. A limited partner may not withdraw its capital from the partnership during the life of the partnership, on pain of being liable for the firm’s obligations up to the amount withdrawn.
• For this reason, it is common for limited partners to inject a nominal amount of capital, the bulk of their contribution to the assets of the partnership being by way of loan.
• A limited partner is prohibited from taking part in the management of the partnership business, on pain of becoming automatically liable for all debts and obligations of the firm while it does so. It is permitted to inspect the firm’s books, "examine into the state and prospects of the partnership business" and "advise with the partners thereon". It has no power to bind the firm.
• A limited partnership must be formally registered as such at Companies House, in default of which the limited liability of the limited partners is lost.
• There is no longer any restriction on the number of partners who can participate in a limited partnership.
• There are certain obligations to publish accounts of a partnership where all the partners (or, in the case of a limited partnership, all the general partners) are limited companies or the equivalent. See the Partnerships and Unlimited Companies (Accounts) Regulations 1993 (SI 1993/1820).

Key benefits of limited partnerships

• Limited partnerships provide a means of potentially delivering a combination of tax transparency and limited liability.
• Whilst the tax rules are fairly complex, their essence is that each partner is taxed separately on its share of the income and capital gains of the partnership. If a partner is also a member of a group of companies, there is the potential for using the group relief provisions to shelter partnership profits from tax using other group losses and vice versa. The maximum trading loss of a limited partner which will be recognised for tax purposes is the amount of the limited partner’s capital contribution and undrawn profits.
• In some circumstances it may be possible to avoid having to show any partnership debt on the balance sheet of investors in the partnership.
• Whilst the obvious use of a limited partnership is to permit a "sleeping partner" to inject finance into a project without becoming involved in its management, it can also be used as a joint venture vehicle for two or more parties who wish to be actively involved in a project, or as a syndication vehicle.
• There is a great deal of flexibility in how a limited partnership can be constituted. The partners can set whatever rules they like on matters such as sharing of profits (where capital and revenue profits can be treated differently), dealings with shares in the partnership and how the partnership business is to be conducted.
• A limited partner may be able to borrow against the security of its share in the partnership, although it remains true that few banks are familiar or comfortable with this type of lending.

Limited partnerships and the Financial Services and Markets Act 2000 (FSMA)

• If each partner in a limited partnership carries on a business other than an "investment business" (within the meaning of FSMA) and it becomes a partner for commercial purposes related to that business, then the limited partnership will not be a "collective investment scheme" (CIS) for the purposes of FSMA. In any other case, it is extremely likely that the partnership will amount to a CIS.
• The significance of this is that FSMA requires anyone who establishes, operates or winds up a CIS to be appropriately authorised under FSMA. Failure to obtain authorisation may result in criminal sanctions and the unenforceability of agreements made by that person. The presumption is that the general partner(s) of a limited partnership are "operating" the partnership for these purposes. However, by way of an appropriate agreement with a person authorised by the Financial Services Authority it is possible to delegate responsibility for much of the management of the partnership, thereby rebutting that presumption. This avoids the need to obtain and maintain a separate FSMA authorisation for the general partner(s), which is a fairly onerous process.
• There are companies in the market, authorised by the Financial Services Authority (generally associated with the large firms of chartered surveyors) who are prepared to provide this service for a fee.

Contexts for use of limited partnerships

Apart from the straight commercial joint venture structure mentioned above, typical situations in which a limited partnership might be used in relation to UK real estate include:

• a joint venture between a developer and an institution which holds property ripe for major redevelopment. The institution wishes to retain a significant interest in the property, and the developer is prepared to put up some cash and also its development expertise to acquire an equity stake in the project and carry through the redevelopment to enhance its value. Once the redevelopment is completed, the parties may contemplate selling down part of their investment to other investors.
• a situation where the institutional owner of a large property or real estate portfolio wishes to release some of its cash investment and reduce (but not eliminate) its equity stake in that real estate. The real estate can be placed in a limited partnership structure with part of the acquisition cost funded by bank borrowing and part by contributions from other investors who become limited partners.
• a vehicle for the creation of a portfolio of UK real estate investments, where non-UK resident limited partners want to retain the advantages of falling outside the UK tax net but do not want to exclude UK resident investors from participation in the venture.

There are many other possible variations on the theme.

Taxation of limited partnership - general

In order to provide a general overview, the following gives a very general summary of the principles behind the taxation of limited partnerships. It is assumed that the partnership is established for investment in UK real estate rather than to trade in property.

The partnership profits are calculated basically as if it was a legal entity in its own right and are then allocated amongst the partners for tax purposes in accordance with their entitlements. The partners are taxed directly on their respective shares of the overall profit.

Each partner is treated as owning an appropriate share of the underlying partnership assets and any transaction by the partnership involving one of its assets is treated as a transaction by each of the partners in relation to its share of the overall asset.

The partnership is treated for VAT purposes as a separate taxable entity and is required to register for VAT if it is making the requisite level of taxable supplies. Where an election to waive VAT is made and the partnership is making only supplies of land, all input VAT should be recovered.

In practice, this mainly relates to real estate. To avoid difficulties, real estate is commonly held by nominees on behalf of the partnership, so that no transfers are required on a change of partners, only when the partnership as a whole deals with an asset. Transfers on dealings by the partnership nominees are subject to stamp duty in the normal way.

Stamp duty is currently being modernised. The Finance Act 2003 will provide a new tax (stamp duty land tax or SDLT) for real estate transactions. It is expected to be implemented on 1 December 2003. Legislation to impose SDLT on transactions in partnership interests is expected to be enacted in the Finance Act 2004. In the meantime current stamp duty rules will apply to such transfers.

Taxation of limited partnerships - more detail

The creation of a limited partnership does not of itself give rise to any tax liabilities. However the acquisition by the partnership of its property will have consequences for direct tax purposes. These are different depending on how the property is acquired:

• if property is bought from an external seller, then each partner is treated as acquiring a proportionate share of the asset for capital gains purposes, and incurring a proportionate part of the cost of acquisition;
• if a partner transfers a property in satisfaction of its obligation to contribute partnership capital, the partner is treated as disposing of a part of the asset proportionate to the share in it which is being passed over to other partners. That disposal will take place at partnership book value, adjusted to take account of any payments made by the other partners outside the framework of the partnership accounts. So, if a partner contributes a property with a low historic base cost but a much higher current value to the partnership in satisfaction of its obligation to contribute capital equal to the current value of the property, it will be treated as disposing of the share in the asset which effectively vests in the other partners, and consequently realising a proportionate part of the gain locked into the property. If the incoming partner is credited only with a capital contribution equal to the base cost of the property and there are no adjusting payments made outside the partnership accounts, then the disposal by the incoming partner will not trigger any capital gain for it. Thus, if all the partners make their capital contribution in the form of property at its historic base cost, then a partnership portfolio could be assembled without triggering any capital gains.

Where existing investment property is transferred into a partnership, there will generally be no supply for VAT purposes, subject to the partnership first electing to waive exemption from VAT if the transferor had previously done so. All the usual VAT planning considerations will apply to such a transfer.

In relation to stamp duty, and subject to its modernisation (see "Stamp duty" above), if property is transferred into the partnership in satisfaction of a partner’s obligation to contribute capital, then the transfer of that property is not subject to ad valorem duty. If however it is sold into the partnership then ad valorem duty (at rates up to 4%) is payable on the purchase price. The potential saving in stamp duty by using the "capital" route must be assessed against the prohibition on withdrawing the capital originally injected (see first full paragraph on page 2 above). Where a property which is already owned is being placed in a partnership, it should be possible to arrange matters so that stamp duty is only payable on the value of the share in the property transferred to the other partners.

Income of the partnership (net of allowable expenses such as rent payable, interest, expenses of management and capital allowances on eligible capital expenditure) has to be calculated centrally and a return of it made to the Inland Revenue by the partnership. For tax purposes the income is then allocated to the various partners and each of them is liable for tax only on its share in accordance with its own individual tax position. There is thus only a single level of taxation, in the hands of the partners. There is no general liability for the tax of other partners.

UK resident companies are subject to corporation tax on their profits derived from the investment business of the partnership. Individuals are subject to income tax, as are foreign companies (unless they are carrying on a trade in the United Kingdom through a branch or agency, in which case they are also subject to corporation tax) and foreign individuals. It should be possible to arrange matters so that the non-UK resident partner’s liability to tax on income is limited to basic rate income tax.

The tenant is under a general "deduction of tax at source" obligation in relation to rent paid to a landlord whose usual place of abode is outside the United Kingdom. There is debate as to whether this applies to the payment of a share of net letting income from the partnership to an overseas limited partner but, by following the appropriate procedures with the Inland Revenue, it should be possible to obtain a dispensation from the requirement in any event. A potential indirect residual liability continues to subsist for the other partners, and in these circumstances, it is common to provide contractual protection for the consequences of this within the limited partnership agreement.

Upon a disposal of a property by the partnership, each of the partners is treated as making a disposal of its fractional share of the property in question, and any capital gain (subject to usual allowances and reliefs) crystallising on that disposal is charged to tax in the hands of the partner, dependent upon its particular tax position. A non-UK resident partner will not suffer UK tax on any such gain unless it is carrying on a trade in the UK through a branch or agency. Property investment is not a trade for these purposes. There are anti-avoidance provisions designed to recategorise as income any capital gains arising on a disposal of land which was acquired or developed with the sole or main aim of realising a capital gain on disposal.

VAT may be chargeable, on general principles, on lettings, acquisitions and disposals of properties by the partnership. Whilst the matter is not free from doubt, it may also be chargeable on transfers of shares in a partnership.

Stamp duty will be payable on any document effecting or evidencing a sale of a share in the partnership which is executed in or brought into the United Kingdom, and on any sale by the partnership of any of its real estate. In practice, this liability falls on the buyer.

Upon its implementation, SDLT will be due on any transaction relating to UK real estate (whether in writing or not, and whether or not executed in the United Kingdom). Any sale by a partnership of any real estate will result in a SDLT charge for which the buyer will be liable.