A rise in pre-profit tax

Now significant changes have been made to how the profitability of a conventional partnership is calculated, and therefore how such a partnership is taxed. All of this arises from changes to how accounts are prepared. The executive summary of the changes is that more turnover is going to be taxed sooner.

The changes are likely to have important implications, not only for consultants and advisers but perhaps also for clients – especially when it comes to fee retainers where accounts are not rendered quickly or on a regular basis.

A conventional partnership has until now been taxed only on profit from work once it was delivered to the client. Work in progress was assessed on the basis of the cost of doing the work, which meant only staff costs and some overheads. Significantly, both the time input and the profit to be made by the partner or sole trader was exempt from tax.

That all looks likely to change as a result of the Accounting Standards Board note published on 13 November concerning the application of FRS5 on turnover. The Accounting Standards Board are the people who say how accounts should be prepared and filed. As we all know, the more profit your accounts show, the more your tax bill is likely to be. Therefore the standards are applied to the preparation of an account is a pretty fundamental question.

The effect of these changes is dramatic: the bad news is that a partnership will be exposed to more taxable work-in-progress. This is because the accounting standard now requires a "fair value" to be placed on work in progress. That is defined as "the amount at which it could be exchanged in an arm's length transaction". Bluntly, this means what the work is really worth – and that will include partner input and potential partner profit. Quite a difference from an allowance against staff costs and expenses. The essence is that in carrying out work for a client, a partnership increases its asset value, ergo it is liable for tax on that increase.

In carrying out work for a client, a partnership increases its asset value, ergo it is liable for tax on that increase. And it gets worse

And it gets worse. Changes in accounting policy require a "prior period adjustment". Where a work-in-progress figure for a particular year has been calculated using the old method, this must be recalculated and the difference between the two figures is treated as additional profit arising in the year that is taxed (under schedule D, Case VI, if you want to know).

So, say you are a firm of surveyors, which as of 30 April 2003 had 2000 hours work-in-progress that is charged at £100 an hour. Under the old system, the work was valued at the staff salary expense/cost which might be £15 an hour, giving a figure of £30,000 and taxed accordingly. Under the revised system, the work in progress would be valued at £200,000 – the fair value likely to be charged for the work. The difference, £170,000, is treated as additional profit arising in the year to 30 April 2004. It is taxed under Schedule D Case VI and tax payable on 31 January 2006.

For those with accounting periods ending on 31 December 2003 or in January, February or March 2004, the change will be felt sooner, with the additional profit falling into the 2003/04 fiscal year with the additional tax liability due on 31 January 2005.

To minimise the obvious cash flow costs, many partnerships will be forced to reconsider fee arrangements in which they get paid when project reaches an advanced stage, potentially months or years in the future.

It will almost certainly become harder to find someone willing to do work on a deal today and charge later.