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Lecture 1 - Partnerships

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LECTURE 1 – PARTNERSHIPS What is a Partnership?  A partnership is defined as: "an association of persons carrying on business as partners or in receipt of ordinary or statutory income jointly, but does not include a company." (Section 995-1 of the ITAA (1997))  A taxation partnership exists if the partners are carrying on a business and also where two people earn income jointly. o If two people derive interest from a joint bank account or derive rental income from a rental property owned in joint names, a taxation partnership exists (see FCT v McDonald 87 ATC 4541).  However, a partnership only needs to lodge a partnership tax return if they are carrying on business. o Where two or more persons are in receipt of joint income, the income is split between the two parties with each person declaring the income in their individual tax returns.  The amount of income each person will include depends on his or her ownership interest in the property. Does a Partnership Exist?  The Commissioner has issued Taxation Ruling TR 94/8 which outlines the factors he considers relevant to determine whether a partnership exists. o Whether or not there is a formal partnership agreement?; o The intention of the parties to the partnership; o Sharing of profits and losses; o Whether a partnership bank account exists?; o Whether or not partners have contributed capital, services and labor and/or expertise?; o Participation of partners in control and management ofthe business; o Whether business records are maintained?; o Whether a business name has been registered?; o Is there joint ownership of assets?; and o Authority to act on behalf of the partnership.  None of these factors in themselves are indicative of a partnership – conclusion is drawn from examining all of the factors.  Where a partnership exists, the Commissioner requires that a partnership tax return be lodged The Advantages and Disadvantages of Partnerships  Advantages of a partnership include: o Allows for the pooling of capital, talent and resources to carry on a business; o Easily understood and operated structure; o Relatively simple, straightforward and low cost to set up and operate; o Allows for the splitting of incomewith partners thus reducing taxable income; o Allows the partnership losses to offset other income, thus reducing the taxable income and tax paid; o Allows for the deduction ofsalaries to employees and deduction of business expenses; o Allows for partnership to pay superannuation contributions to the partners; and o Relatively easy to dissolvethe partnership.  Disadvantages of a partnership include:  Unlimited liability;  No flexibility in distributions to partners once the partnership agreement has been drawn up;  Conflict between partners due to distribution of profits, losses etc; and  Any change in the partners in the partnership dissolves the partnership and creates a new partnership eg. When a partner leaves or a new partner wishes to join the partnership must be dissolved and a new partnership created, thus impacting on capital gains tax. Partnership Net Income  A partnership is not a separate legal entity. It cannot have a taxable income and cannot pay income tax in its own right. o However, a partnership is considered a taxpayer for the purposes of the ITAA (1936) because it derives income.  Under Section 91 of the ITAA (1936), a partnership is required to lodge a partnership income tax return (P form).  In the partnership tax return, the partnership includes its assessable income and deducts its allowable deductions on the basis that it is a resident taxpayer. o A partnership tax return includes both Australian and foreign-sourced income and deductions.  However, a partnership cannot have a taxable income as it doesn’t pay tax o Instead, the difference between the partnership’s assessable income and its allowable deductions is called the “net income of the partnership”.  In determining the net income of the partnership, the following deductions are not able to be claimed in the name of the partnership:  Prior year losses under division 36 of the ITAA (1936);  Personal superannuation contributions made by the partners under section 82aat of the ITAA (1936); and  Capital gains and losses (section 106-5 of the ITAA (1997)) – the partnership does not own the asset (they are owned individually)). o Instead, these items are included in each partner's income tax return.  Once the net income of the partnership has been ascertained, this profit is distributed to each partner to be included in their respective income tax returns. o Regardless of whether there has been a cash distribution of the profit or not (section 92(1)). o Each partner includes their share of the partnership profit and pays tax on it at their marginal tax rates. A Partnership Loss  If the partnership derives a net loss, the loss is distributed in that income year to each of the partner’s to offset against other assessable income in the partner's individual tax return (section 92(2)). o When a partnership makesa loss it is distributed to the partners – it is not carried forward.  However,Division 35 ITAA 1997 contains the non-commercial loss provisions. o These provisions will quarantine the loss of a partnership in certain circumstances. Determining Each Partner’s share of the NIP  A partner is assessable on the net income of the partnership as income of the year in which it was derived by the partnership (Rowe v FCT, 71ATC 4157). o NOT in the year which the income is received by the partner.  Allocation of the net income of the partnership is based on each partner’s individual interest. o Where a partner is a resident, the partner includes their share of the net partnership income as assessable income in their tax return (Section 92(1)(a)). o Where a partner is a non-resident, the partner is only assessed on their share of the net partnership income attributable to Australia-sources, and is entitled to a deduction for their share of partnership losses attributable to Australian sources (Section 92(1)(b)). Partner’s Salaries  As a partnership is not a separate legal entity, a partner is not considered to be an employee of the partnership.  For taxation purposes a partner's salary is not deductible to the partnership under Section 8-1 of the ITAA (1997). o Even if the partnership pays a salary to a partner and calls it a salary in its management accounts. o Instead, a salary paid to a partner is regarded as a distribution of profit.  The partner's salary is shown as part of the partnership distribution in the partner's individual tax return and not part of salary and wages.  An agreement to pay a partner a salary must be documented in an agreement and signed by the partners before the end of the relevant income year. o The amount of the partner’s salary must also be reasonable and commensurate with the amount of work performed by the partner. o Where a partner is paid a salary in a year when the partnership makes a loss, TR 2005/7 provides that a partner’s salary cannot increase a partnership loss.  Salary paid to the partner is not deductible to the partnership and is not regarded as assessable income to the partner under Section 92(1)of the ITAA (1936).  Instead, it is regarded as drawings. Interest on Partner’s Capital  Partners are usually required to make an initial (and ongoing) capital contribution. o Given the large amounts of contributions that may be made, the partners may agree that the partnership will pay each partner interest on their capital contribution.  Interest paid to a partner on their capital contribution is not deductible to the partnership. (TR 2005/7) o Regarded as a distribution of partnership profit. Interest on Partnership Borrowings  Interest paid on monies advanced to the partnership by a partner is deductible provided the monies are used by the partnership for income-producing purposes o Where a partnership borrows money from a bank to repay loans to the partnership from partners (ie. partner’s funds in their capital account), the interest paid will be deductible under section 8-1 provided the borrowed monies are used for working capital purposes, which will subsequently allow the partnership to produce assessable income  The “purpose” for which the money was borrowed is of primary importance, rather than the ‘use’ to which the funds were put. o Funds borrowed from a bank simply to refinance earlier ‘borrowings’ (from the partners) and, in such a case, interest on these funds used to produce assessable income should also be deductible. This is known as the “refinancing principle”.  A deduction for interest on financing would be limited to the capital of the partnership including:  Capital contributed by the partners; and  Retained profits. Partner’s Drawings  Partner’s drawings are not taken into account in determining the net income of the partnership. o They are neither assessable to the individual partners nor deductible to the partnership for taxation purposes.  Drawings have no effect onthe profit of the partnership either for accounting or tax purposes EXAM TIP: CROSS OUT THEPARTNERS DRAWINGS AMOUNT Acquisition and Disposal of Partnership Assets and Interests  Usually a partnership may be dissolved either: o By agreement of the partners; o By the death or bankruptcy of a partner; or o By a court on application of a partner.  A partnership may be reconstituted where: o A partner dies and the remaining partners agree to continue the partnership; o A partner retires and the remaining partners continue the partnership; or o A new partner is admitted to the partnership.  If there is a change in composition of a partnership (a partner retires, dies or a new partner is admitted), the old partnership is dissolved and a new partnership is formed, unless the partnership agreement provides otherwise. There are three major taxation consequences of a partnership dissolution or reconstitution: Trading Stock  Where a taxpayer disposes of an item of trading stock outside the ordinary course of business, that taxpayer includes in his/her assessable income the market valueof that stockon the date ofdisposal. (Section 70-90) o The value of that trading stock is its market value on the day of disposal (Sections 70-90 and 70-95)  The partial change in the ownership of the trading stock is treated as a notional disposal of the trading stock at its market valueon the date ofdissolution of the old partnership. (Section 70-100) o The result could be that the net income of the old partnership is artificially inflated by the difference between the marketvalue of the trading stock on the date of the reconstitution of the partnership and the book valueof the trading stock.  This would be the case, even though those partners in the old partnership who continue to have a partnership interest in the new partnership have not derived any profit.  To overcome this situation, where the change of interest occurs in a partnership and at least 25% of the partner’s interests in the old partnership continue into the new partnership, an election in writing can be made to treat the trading stock at its book value and not its market value(sections 70-100(4) to (9)). Deprecation NO CGT ON Depreciating Assets  A change in the constitution of the partnership may result in a balancing adjustment (gain or loss on sale of depreciating assets) as if there was an actual disposal of the old partnership’s depreciating asset from the old partnership to the new. o Unless an election is made for rollover relief, the depreciating asset is taken to have been disposed of at its market value (Item 5 of Section 40-300).  The market value of the depreciating asset becomes its starting value for depreciation in the new partnership and a balancing adjustment is included in the tax return of the old partnership.  Where a joint election is made by both parties for rollover relief, no balancing adjustment is incurred by the transferor partnership, and depreciation in respect to the asset is transferred to the transferee (Section 40-345). Capital Gains Tax  For capital gains tax purposes, a partnership is not a separate legal entity. o The partners incur any capital gain or capital loss on the happening of a CGT event in relation to any partnership CGT asset because each partner is regarded as owning an interest in relation to each partnership asset, namely the partner’s interest in the asset (Sections 108-5(2) and 106-5).  Any capital gain is shown in the individual tax returns of each partner/  Any capital gain is not included in the net partnership income (Section 90 ITAA 1936).  To enable any capital gain or capital loss to be determined, each partner has a separate cost base and reduced cost base for their interest in each CGT asset of the partnership (Section 106-5(2)).  On admission of a new partner, the existing partners each dispose of a part of their interest in each of the assets of the partnership for their share of consideration paid by the incoming partner. o Where an existing partner’s share of the capital proceeds exceeds that partner’s cost base, an assessable capital gain will arise.  Similarly, if a partner retires, disposing of their interest in the partnership assets, an assessable capital gain will arise if the capital proceeds received by the retiring partner are greater than the cost base of the retiring partner’s interest in each partnership CGT asset. Assignment of a Partner’s Interest in a Partnership  A partner may assign his or her share (or part) in a partnership under a deed of assignment with the consequence that the net incomeof thepartnership attributed to the assigned share is derived beneficially by the assignee. o Such assignments are effective for taxation purposes.  Largely irrelevant since the introduction of CGT Alternation of Profit or Loss Entitlements  Attempts by partners towards the end of the ye
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