legal sector update - june 2016

Legal Sector UpdateAndrew Allen and Steve York June 2016

Overview

1. Benchmarking and financial outlook

2. Regulatory update and outlook

3. Taxation – risks and opportunities

4. Pensions and succession planning

pkf-francisclark.co.uk

Benchmarking and financial outlook

1. DASLS benchmarking results

2. Financial outlook 2015/16 and beyond




• Fee income



• Structure



• Productivity – Fees per EP



• Productivity – Fees per F/E

2014/15 DASLS SW LMSLower 91 102 103

Median 105 119 119

Upper 126 144 145



• Expenses• People costs (real gross profit margin)

• Marketing

• I.T investment

• Property

• PII



• Lock up

2014/15 DASLS LMSLower 120 100

Median 179 140

Upper 267 202



• Strategy

Regulatory update and outlook

1. Reporting Accountants Regime 2015 changes

2. SRA AR Consultation 2016

3. Separate Business Rule 2015 changes



Reporting Accountant Regime Changes

• Consultation history - 2014/15• Engagement with SRA -2015• SRA Guidance – September 2015• ICAEW Guidance –December 2015• Evolution of Audit Programmes• Evolution of approach in 2016 and 2017


Work impact – Out?

• Nominal ledger “ticking” at selected dates• Checking all outstanding items on office and client accounts

at 2 selected dates• Detailed testing of bills (outside main file review)• Separate testing of receipts• Paid cheque audits• Client to office transfers outside file review sample• Bank audit letters


Work impact - In

• Planning

• Engagement letter updates

• Planning memorandum

• Planning meetings

• Risk factors

• Evaluation of appropriate work to complete

• Impact on sample sizes


Work impact - In

• Planning

• Involve law firm in process

• Review internal breaches schedule

• Review of SRA correspondence

• Review of claims and complaints register

• Consideration of financials

• Notable changes in the business

• Linking risk and sample sizes


Work impact - In

• Controls assessment and testing

• Document key control system (law firm?)

• Testing of control operations

• Consideration of overall control environment – adequacy and operation

• Review of internal management of control system and regular review of operation


Work impact – On law firms

Impact on law firms

• Involvement in planning process

• Variability of “audit experience”

• Reporting / feedback process

• Qualifications - Examples in guidance

• Whistleblowing regime

• Cost implications


Professional judgement

Highlights from SRA guidance

Topic Section Objectives, control systems importance, professional judgement and whistleblowing

1

Serious and Moderate factors 2

Example qualifications 3


Professional judgement – Serious Factors

1. Significant and / or un-replaced shortfall2. Wilful disregard for safety of client funds3. Actual or suspected fraud or dishonesty4. Material breaches not reported to SRA5. Inadequate accounting records / not retained6. Failure to provide documents requested by RA7. Three way client fund reconciliation not completed8. Client account used as a banking facility


Professional judgement

Highlights from ICAEW guidance

Topic PARAGRAPHSReliance placed by SRA on reports 33 - 36

Reporting Accountant risk exposure 37 - 40

Key actions to mitigate risk of Reporting Accountant 41- 43

Whistleblowing 69 - 73


SRA AR Consultation 2016

• Consultation period 21/9/16

• Implementation expected 2017

• Challenges & opportunities?


Separate Business Rule

• Key changes

• Future requirements

• Opportunities

Taxation – Risks and opportunities

1. Income tax rates and planning points

2. Risks areas advising clients


Income Tax

Rates2016/17 2015/16

Basic rate 20% 20%

Higher rate (income £43k - £150k) 40% 40%

Additional rate (income > £150k) 45% 45%

Dividend tax rate (BR) 7.5% 0%

Dividend tax rate (HR) 32.5% 25%

Dividend tax rate (AR) 38.1% 30.6%

Income Tax

Very High Marginal Rates

• £50,000 - £60,000 if higher earner and child benefit claimed – 58% if two children for example

• £100,000 - £122,000 – clawback of personal allowances – 60%

• £150,000 (possibly lower) and exceed the annual pension contributions allowances – 45% on income + tax on pension contributions excess at 45%

• Highly geared residential lettings – could be very high rates (see later)

Dividends

Change in way that dividends are taxed from 6 April 2016

• No longer required to “gross up” dividends – what you get is what is taxed

• New dividend “allowance”

• 0% on first £5,000

• 7.5% basic rate

• 32.5% higher rate

• 38.1% additional rate

• Dividend “allowance” not available to trusts or estates

• Settlements legislation

Income Tax – Partner Personal Planning

• VCT / EIS investments (30% tax relief)

• Claim allowable expenses – mileage and travel, use of home as office

• Loan interest relief – partnership capital, business element of car loan

• Gift aid relief on charitable donations – which spouse to make donations?, keep a record!, carry back if appropriate

• Use the dividend and savings “allowances”

• Separation of business into a corporate entity?

Planning points for LLP risk mitigation and your clients

“An opportunity to avoid PII claims and identify future fee income stream”

• Clients with high interest costs on buy to lets

• SDLT – 3% premium issues

• SDLT – multiple dwellings / mixed use assets

• IHT – Residence Nil Rate Band

Residential property – interest relief

• Restriction on finance costs and loan interest relief for landlords

• Deduction for finance costs will be disallowed and replaced with a basic rate tax credit

• Phased in over 4 years from 2017/18

• Will result in an increase in taxable income

• Many basic rate taxpayers will be unaffected by will push some into higher rates

• Does not apply to furnished holiday lets or commercial lets

Residential Property – interest relief

• There are potential issues where residential property is held in trust

• Discretionary trusts have no basic rate credit for finance costs – there will he a tax loss as there will be insufficient income after tax to reclaim from the tax pool.

• Life interest trusts will not get the basic rate tax credit for finance costs leading to an increase in tax (cash flow issues?).

• The life tenant can claim the basic rate tax credit. Consider mandating income direct to life tenant?


Finance costs – Example

Mavis has a residential property portfolio which produces annual profits of £10,000, after deducting loan interest and other finance costs of £20,000 a year.

She has partnership profits of £90,000 and no other sources of income. She has no sources of tax relief (pensions etc).

In 2016/17 the tax on her rental profits is £10,000 x 40% = £4,000

Note that her total income tax year is £90,000 + £10,000


Example (Mavis) – Continued

In 2020/21 assuming that everything remains as for 2016/17 then Mavis will have property income of £10,000 + £20,000 = £30,000.

The tax on this would be £16,000 (as her income exceeds £100,000 then there is a marginal rate of 60% on £20,000 of the income due to the clawback of the personal allowance).

She would get a tax credit of £20,000 x 20% = £4,000 so the net tax on rental income would be £12,000.

This is an increase of £8,000 in tax from 2016/17, or 200%.

Residential property - SDLT

• 3% SDLT supplementary charge for second homes and buy-to-let properties purchased after 31 March 2016

• Payable if already owns property at the time

• Repayable if replacing main home within 36 months

• Wear & Tear allowance abolished from 6 April 2016 and replaced with relief for costs of furnishings and white goods

• Reporting & payment of CGT within 30 days from 6 April 2019

• CGT rates continue at the higher level of 18% and 28% (due to 8% surcharge) – other gains at 10% and 20%

Residential Property - SDLT

• From earlier slide: 3% SDLT supplementary charge for second homes and buy-to-let properties purchased after 31 March 2016

• Payable if already owns property at the time

• Repayable if replacing main home within 36 months

• Draft legislation – fairly complex and creates a headache for advisers

• There is a need to understand much more about a client’s affairs

• Where does the responsibility for the lawyer end?


• Joint owners (watch partners of a partnership) – one in, all in

• Married couples – look at together

• Property anywhere in the world

• Children < 18 – treat as owned by parents

• Life interest beneficiary or absolute beneficiary treated as the purchaser if looking at trustee purchases. A discretionary trust with no life interest beneficiary will be liable to the higher rate charge.

• Not for consideration < £40,000, non-residential or mixed use property (eg shop with flat above)

• Also for companies and trusts


No additional charge if replacing main residence

• Disposal in the last 36 months, and was main residence at some point in that time (or spouse)?

• No other main residence acquired before the purchase of the property we are concerned with?

• New property intended to be the new main residence?

• Sometimes difficulties over identifying a “main residence”. No election as for capital gains tax.

• Not if this is first home purchase (must be a previous disposal)


Main residence not sold?

• Must pay the higher rate SDLT

• Can reclaim if disposal within three years.

• Solicitor responsible to follow this up with purchaser? Dealt with at the time of sale (a different solicitor acting?)

• Reclaim within three months of sale, or 12 months from SDLT filing date (whichever is later)

Multiple Dwellings Relief

• Narrower definition of “dwellings” than for the 3% higher rate charge (see John Endacott’s blog “Something to dwell on” 19/5/2016)

• MDR – residential rates apply to the average price, not the entire transaction value

• 6 or more residential properties – choose to apply non-residential rates to entire transaction value or apply residential rates (higher rates) with MDR applied.


An investor acquires an existing portfolio of 5 residential properties for £1M

SDLT on £1M–

• 3% on £125k = £3,750

• 5% on £125k = £6,250

• 8% on £675k = £54,000

• 13% on £75k = £9,750

• TOTAL = £73,750

NOTE: Higher rates have to apply as the transaction consists of a major interest in more than one residential property (also ‘linked transaction’ as same purchaser and same vendor and acquired as a single bargain)


Example continued

If claiming MDR based on the average of £200k per dwelling –

3% on £125k = £3,750

5% on £75k = £3,750

Total - £7,500 x 5 = £37,500

A saving of £36,250.


• It must be claimed

• 1 month SDLT filing deadline plus 12 month amendment window

• Granny Flats?

• Historic use not that relevant – consider use at time of purchase.

• Former care home, sold as possible holiday letting units or sold as individual units?

Mixed Use Assets

• The residential SDLT rates only apply if it is a wholly residential property.

• A shop with a flat above = non-residential rates; and no higher rates can apply.

• It is worth lawyers considering exactly what is being acquired. A definition of residential can be found at s116 FA 2003. This is relevant to MDR and mixed uses.

Mixed Use and MDR

Examples

1. Doris and the beach

2. Doris’s sister and the holiday lets

Other SDLT Issues

1. Incorporating partnerships – there may not be an SDLT charge

2. Transfers where there is a mortgage? Per HMRC:

A husband decides to transfer a half share in a property he owns to his wife. He doesn’t take a cash payment for this share, but there’s an outstanding mortgage on the property. The amount outstanding is more than the current threshold, so SDLT is payable, even if the husband keeps the mortgage. He must tell HMRC about the transaction.

Residence Nil Rate Band

Legislation to apply from 6 April 2017

• “Enhancement” to existing Nil Rate Band

• £100,000 (2017/18)

• £125,000 (2018/19)

• £150,000 (2019/20)

• £175,000 (2020/21)

• Existing Nil Rate Band frozen at £325,000 until 5 April 2021

• Protection available on downsizing / selling

• Will be restricted where estate is worth > £2m


• Only available on gifts of residential property to children (including step-children and adopted children), descendants and their spouses

• Trusts?

• Life interest trusts for qualifying beneficiaries

• Discretionary trusts• Bereaved Minor Trusts (entitlement at 18)

• 18-25 Trusts (income at 18, capital at 25)

• Disabled Persons Trusts (qualifying conditions in trust deed)

• Statutory trusts on intestacy


• Whilst relief is calculated by reference to residential property on death, it is applied across all of the chargeable estate

• Must have been occupied as a residence at some point. Choose which property obtains relief by election

• Downsizing protected provided funds released on sale are left to qualifying beneficiaries (NB do not have to purchase replacement property, e.g. moving into long-term care)


• Traps?• Only applies to property passing on death, so lifetime gifts and donatio

mortis causa (gifts in anticipation of death) cannot qualify

• Property identification will be important

• Not available on gifts to relevant property trusts (review current Wills – many older ones will contain Nil Rate Band discretionary trusts, which will not qualify)

• Consider devolution of estate on first death – will this cause total estate to exceed £2m threshold at which RNRB is abated?

• Carefully monitor time limits for claiming

• Gifts with Reservation of Benefit will qualify, as the property is treated as remaining in the estate


• Planning?• Review current Wills – many existing Wills will not qualify

• Lifetime gifts of property are likely to become less popular. This could cause an increase in IHT on death (seven year clock does not apply to the RNRB)

• Gifts of other property during lifetime may become more popular. IHT exemption after seven years, and may reduce estate below £2m to enhance the value of the RNRB available – but remember CGT implications

Pensions & Succession

1. Practical impact for law firms

2. Pension changes

3. Opportunities



Practical impact for law firms

• Succession timing

• Cash-flow for income tax payments

• Capital funding

Pension changes

• Annual pension contributions limit 2016/17 remains £40,000

• Restricted for higher earners with “adjusted earnings” between £150,000 and £210,000

• Tapered at rate of £1 of £2 of income

• Minimum allowance of £10,000

• Don’t forget “carry forward” capacity

• May affect some taxpayers with income of £110,000 of more.

Pension contributions

Example

2016-17 tax year (ends 5 April 2017)

Billy is 58 and has partnership income of £145,000 for the year ended 30 April 2016, income from an annuity of £5,000 and net rental profits from a commercial lettings of £20,000. His total income is therefore £170,000.

Billy has £30,000 of “carry forward” pension capacity from the previous three tax years and makes regular contributions to an existing pension fund of £500 per month.

Pension Contributions

Example (Billy) – Continued

Billy has capacity to make a single premium pension contribution in the year ended 5 April 2017 of:

Maximum £40,000 less

(170,000 – 150,000) / 2 = (10,000)

To give an allowance of £30,000

Plus carry forward relief of £30,000 to give a total of £60,000.

Less regular premiums of £6,000 = £54,000.

Pension contributions

Example (Billy) – continued

Note that Billy makes his contributions net of basic rate tax. The tax relief scenario is as follows:

Tax relief at source - £12,000 (£48,000 net premiums)

Tax relief through tax return:

£20,000 x 25% + £40,000 x 20% + £12,000 x 20% = £15,400

Net cost - £60,000 - £12,000 - £15,400 = £32,600

Tax relief in this case – 45.7%


Practical impact for law firms

• Future profit retention – in business vs pension

• Opportunities available under SBR

• Incentives to control timing of personal taxation on profits

• Consideration of short term “close relative” planning

• Long term extraction of value from law firms


Contact

Andrew [email protected]

Steve [email protected]

mailto:[email protected]

mailto:[email protected]

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