PM163390 - Partnership expenses paid by partners - legal basis

The question of when an expense incurred by a partner is an expense of the partnership, and potentially an allowable deduction in arriving at the profits of the trade or property business carried on in partnership has been considered by the Court of Appeal.

Peter Vaines v HMRC [2018] EWCA Civ 45

The background is that Peter Vaines worked as a partner in the London offices of a German law firm. This firm ceased trading on 31st December 2005.

Following this he became a member of another law firm in London, a UK LLP.

However when it ceased trading, the German firm had owed a substantial sum of money to a number of banks, one of which sought to recover money from Peter Vaines.

Although Peter Vaines did not consider that he was personally liable to the Bank, he was aware of the risk that he could be made bankrupt if the case came to Court. If he was made bankrupt he would lose his position as a member of the UK LLP. He came to an agreement with the German Banks under which he was released from all claims in return for a payment of 300,000 euros.

The UK LLP made a loan to Peter Vaines to enable him to make the payment. Peter Vaines then repaid the loan over an agreed time period.

Peter Vaines claimed relief for the sterling equivalent of £215,455.

The Court of Appeal upheld the decision of the Upper Tribunal that it was not an allowable expense.

The first point is that to be allowable it had to be an expense of the trade carried on by the UK law firm. Henderson LJ said at paragraph 30:

30.As the Upper Tribunal pointed out at paragraph [37] of the UT Decision, “the trade” in this context is the trade of SSD conducted collectively by its members as partners. The payment in question was not borne by SSD, nor was there any suggestion that Mr Vaines’ decision to pay €300,000 to Bayerische Landesbank was a matter for discussion and agreement between him and the firm’s management committee, or the members of SSD as a body

In the same paragraph, Henderson LJ stated that the fact that Peter Vaines had made the payment to protect his own career was not relevant.

Nor could the FTT’s finding that Mr Vaines’ purpose in making the payment was “to preserve and protect his professional career or trade” be of any assistance to him. It merely indicates “that this was a personal expense, directed at resolving Mr Vaines’ situation, and not one that was related to the professional activities of [SSD] that he was carrying on in common with the other members of the firm” (ibid).

Henderson LJ approved the comments of the Upper Tribunal which distinguished between Peter Vaines position and one where the UK LLP had agreed to meet the liability

Henderson LJ made it clear at paragraph 32 that whilst Peter Vaines made the payment for entirely understandable reasons, the fact that it enabled him to pursue his career did not make it an expense of the business:

Mr Vaines made the payment, for entirely understandable reasons, in order to settle a claim which had the potential to render him bankrupt, if he lost, and thereby to lose his position as a partner in SSD. From his personal point of view, therefore, it was expenditure which bought him peace of mind and enabled him to continue in his chosen career. But that does not turn it into expenditure which was wholly and exclusively incurred for the purposes of SSD’s trade.

He went on to say that there needed to be evidence that the firm had decided, in accordance with the rules of that firm, that it would make the payment, or would reimburse Peter Vaines

Had that been the case, it would have been necessary to adduce evidence of a decision to that effect taken by the firm in accordance with its constitution, and one would then expect the firm to have made the payment itself, or at least to have reimbursed the payment if Mr Vaines made it personally. By contrast, the firm’s involvement was limited to lending the necessary money to Mr Vaines who then repaid it over an agreed period. The firm’s balance sheet was thus unaffected. How, then, could a deduction properly be allowed, for expenditure which the firm had deliberately decided not to incur, in computing the firm’s trading profits?

Henderson LJ then set out what needed to have occurred, the firm needed to have incurred the expense, which would need to be deducted in arriving at the commercial profits and satisfy the rules set out in the Taxes Acts

By virtue of section 25(1) of ITTOIA, the profits of a trade must be calculated in accordance with generally accepted accounting practice. The rules regarding deductions are strict, and are subject to the “wholly and exclusively” test. On the basis of the evidence before the FTT, and its single finding about Mr Vaines’ purpose, there is simply no way in which this test could have been satisfied.

In his decision Henderson LJ considered the HMRC’s practice, set out in a help-sheet, of allowing doctor’s expenses to be deducted in the computation of the profits of the partnership, rather than requiring them to be included in the partnership accounts. He said at paragraph 35 that the help-sheet:

correctly emphasises the general rule that the only legal basis for giving relief for expenditure by an individual partner is as a deduction in the calculation of the profits of the partnership business. Thus, for example, if a doctor incurs expenditure relating to his individual specialisation, but the expenditure nevertheless satisfies the “wholly and exclusively” test, it may properly be deducted in calculating the partnership profits. Secondly, however - and here there may be a small element of concessionary treatment - HMRC do not insist on the inclusion of all such expenditure in the partnership accounts. Provided that the expense in question “would be allowable if met from partnership funds”, HMRC will accept entries made in the relevant sections of the partnership tax return, by way of adjustment to the partnership accounts. Once the adjustments have been made, the expenditure will then be treated as if it had been included in the partnership accounts. There is no suggestion, however, that any expenditure by an individual doctor could be allowed as a deduction even if it failed to satisfy the “wholly and exclusively” test. Nor is there any indication that a doctor could make such adjustments in his personal tax return, which is what Mr Vaines purported to do. At most, therefore, the help sheet provides a limited measure of practical assistance for medical partnerships.

To be allowable the expense has to be accepted by the partnership as an expense of the partnership and it also has to satisfy the tests set out in the Taxes Acts.

C Connelly & Co v Wilbey (H M Inspector of Taxes) [1992] 65 TC 208

The case of C Connelly & Co v Wilbey (H M Inspector of Taxes) [1992] 65 TC 208 arose from the dissolution of an accountancy partnership.

One of the successor firms claimed relief for the legal costs but the General Commissioners held that these were incurred not for the purposes of the partnership, but to protect the interests of one of the partners in the partnership.

On appeal to the High Court Maddocks J made the point at page 218 that:

I cannot regard expenses incurred by Mr. Burton to protect his interests in the partnership as a trading expense of the practice.

Maddocks J emphasised the importance of taking what we would now call a realistic view of the facts.

At first sight some of the expenses seemed to relate to steps taken to protect assets of the partnership, but the reality was that all the expenses related to a dispute between the partners, and the subsequent dissolution of the partnership.