Legal Sector Update - June 2016

Legal Sector Update
Andrew 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 LMS
Lower 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 LMS
Lower 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 shortfall
2. Wilful disregard for safety of client funds
3. Actual or suspected fraud or dishonesty
4. Material breaches not reported to SRA
5. Inadequate accounting records / not retained
6. Failure to provide documents requested by RA
7. Three way client fund reconciliation not completed
8. Client account used as a banking facility

Professional judgement
Highlights from ICAEW guidance
Topic PARAGRAPHS
Reliance 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
Rates
2016/17 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 Allen
Andrew.Allen@pkf-francisclark.co.uk
Steve York
Steve.York@pkf-francisclark.co.uk

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