By Heron Goh, Associate Director, MustaphaRaj Chartered Accountants
Most legal firms in Malaysia will operate under a Partnership or Sole Proprietorship. They are not registered with the Registrar of Businesses and are governed via the professional body being “The Malaysian Bar Council”.
This article aims to address the follies of tax compliance-related matters within the ambit of a partnership and/or a sole proprietorship within the Legal Firms framework. There has been a reasonable amount of confusion from/due to the term “Partner” being used within a legal Firm.
Though registered under a professional body, the framework of the Legal Firm is based on the Laws of Partnership and The Laws of The Income Tax Act 1967 (IRB) and any other law that circumnavigates the running of a business in Malaysia. All laws will apply accordingly/correspondingly.
Definition of a partnership in general
This is a business entity owned by two (2) or more persons and must not exceed twenty (20) persons at any one time. The owners of the Firm may be Malaysian citizens or Permanent Residents (PR). Partnerships are deemed as a legal entity and are not considered a taxable body.
Assessment of Tax
All chargeable income generated by the Partnership will be assessed on the partners individually. This will be done based on their equitable interest in the business via their personal tax submissions (Form B). As mentioned above, the Partnership itself is not subject to any form of taxes and does not pay any income or corporate tax. As such, it may lead to a higher tax exposure on a partner’s personal income tax.
In certain situations, a lower tax exposure/position may occur as divisible current business loss are allowed to be utilised against all other sources of income for the year (e.g. employment income, interest income).
Liabilities in a Partnership
All partners in a partnership are held liable jointly and severally for the debts and liabilities of the practice/business.
In the event judgment is obtained against the partners of the Firm and/or the Firm as a whole, the creditor may commence bankruptcy proceedings against any one partner or all the partners (who were parties to the suit in which the judgment was entered) to claim the debt owned. This may have a direct impact on each partner’s personal wealth. Partnership laws vary from country to country with their own set of regulations – Malaysia is no exception.
Rights of a Partner
In general, a partnership is not allowed to expel any partners unless this has been specifically provided for in the partnership agreement at the point of its establishment.
When Does a Partnership cease to exist?
i) Cessation of business;
ii) Bankruptcy (by any of the partner or the business in general);
iii) Death of owner/ partner;
iv) Pursuant to court order; and
v) Partners leaving or being admitted into the business – (regardless of reasoning).
Pitfalls and the Follies of a Legal Firm
Many unwarranted complications have arisen within Legal Firms due to the lack of understanding on compliance matters by their accountants as well as the partners/lawyers within the Firm.
Situations in a partnership leading to non-compliance
Equity partners leaving or admitted into the Firm. When a partner leaves / is admitted into a Firm, the original partnership business ceases to exist. A common situation arises when most Legal partnerships will likely retain their existing name (which is accepted by the Bar Council) giving the impression that there is no necessity or rather the ignorance of “ Everything remains the Same”.
What is commonly overlooked is the accounting/tax treatment which has not taken into account the cessation of the business at the point when the equity partner(s) leave or are admitted.
Things that should be addressed
1. The Firm’s accounts must be closed at the point when an equity partner departs or when there is a new admission;
2. A complete disposal of Fixed Assets and a distribution of profits must be made at that point of time under the “Old” firm;
3. The IRB must be informed and a “New” Partnership Tax File (P file) has to be registered, as it is a new business entity regardless of the continuity of using the “Old” Firms name;
4. Tax clearance with/for the “Old” partnership must be made to ensure that tax liabilities from the past business is not brought into the “New” Business. This would also include attending to indirect tax matters (SST/GST);
5. Equity partner(s) arrangement towards profit share.
There must be a level of understanding between the partners towards this arrangement, as more often than not, equity partners tend to have either a fixed and rigid structure or one that is very flexible.
With both arrangements, the rules of engagement for the preparation of the tax computation are different and matters from capital allowance to other direct and indirect expenses will have to be addressed carefully. Please bear in mind that all liabilities are extended on a personal capacity.
What is a Form P
Upon informing and making the application to register a partnership with the IRB, a new P File will be put into place for the new business.
Therefore, it is not unusual that in/within a financial year, Two (2) or more Form P files could/might be submitted to the Inland Revenue depending on the occurrence of departure or admission of an equity partner. The Form P is a statutory declaration of/from the partnership dictating and advising the IRB towards the distributable profit/loss entitlement for each equity partner during the given period of time or financial year.
Each partner would be entitled to receive a Form CP30. This will stipulate the distributable profit to be put to tax or otherwise (similar to the EA- CP8d for employees but based on the profit/losses instead of a salary). In the event the CP30 is reports a loss, the adjusted (tax) business loss may be used to set-off against any other income reported in the individuals’ tax returns for the current year.
As mentioned above, the partnership is not taxable and the equity partners are individually taxed on/in their own personal capacity. Thus, it is for the benefit of all parties to ensure that the above actions are carried out at the point of departure or entry of an equitable partner.
A partnership could be in a loss position when one departs. However, after one’s departure it could be in a profit position (vice versa). The position of the business will be determined at the cut-off date and not the customary financial year-end.
Income is based on an accrual basis and not on a cash basis. Therefore, monies received may well have been taxed in past years (only collected currently).
The Common Follies by Partners
1. Under the impression that drawings are salary/remuneration when in actual fact Drawings do not affect the profit/loss of a Firm. It merely impacts the Firm’s cash flow; (You are not taxed on Drawings – You are taxed on your profits).
2. “I pay taxes on what I received” when in actual fact it could be a business loss position and there’s no tax to address. Monies taken i.e. drawings could well be monies that have already been subject to tax in the past years.
3. Accepting a simple letter dictating the so-called deemed income for the period/year based on a cash basis when it should be on an accrual basis. This practice is incorrect and may attract heavy penalties for the Firm/Partners.
Equity partners must receive a CP30 while a paid partner should receive a Form EA.
Paid/Salaried partners are partners in name but do not hold any equity in the Firm. The IRB’s standpoint is that they are employees and as such, their remuneration should be subject to Scheduler Tax Deduction (STD).
In the past, many Legal Firms have not adhered to Schedular Tax Deduction for their paid partners. The position taken is that paid partners are partners and equated to them having/being under the same rules as that of an equity partner.
This has resulted in forgetting/overlooking the fact that as they are not business owners (equity partners), they are subject to the Employers Remuneration Rules under the tax guidelines. Other statutory regulatory requirements (e.g. Socso & EPF) may also be compromised unintentionally.
Arguments for the above have always been on the basis that the defense of “Being a partner” which clearly is not the case for tax compliance purposes as they are not equity partners. This is again made complex by the fact that all partners “equitable or paid partners” are held equally responsible for the daily activities of the Firm within the Legal Framework/Rules of Bar Council. A distinctive line must therefore be drawn between equity partners and paid partners to enable a clear understanding of the Firm’s obligation towards STD compliance.
The arrangements made by legal Firms may be legally sound. However, at times due to an oversight of tax compliance requirement(s), these arrangements may cause an accounting nightmare and unnecessary exposure to tax and penalties that may accompany it. The common pitfall is the utilisation of a Chamber system adopted within a partnership. The Chamber system although proven and accepted in the United Kingdom may not be suitable for Malaysian application.
Let us have a basic understanding of a Chambering system.
What is A Chamber System?
“In law, a barrister’s chambers or barristers’ chambers are the rooms used by a barrister or a group of barristers. The singular refers to the use by a sole practitioner whereas the plural refers to a group of barristers who, while acting as sole practitioners, share costs and expenses for office overheads. The concept of barristers’ chambers is commonly thought of as a law firm.” – Source Wikipedia
Basically, the situation will/may arise when a Partnership is built/structured upon the chamber model. The model proposed may not necessarily accommodate tax compliance fit. More often than not, this is a result of everyone having their own idea of how it could be possible to organize the matters in a way satisfying their wants and needs.
Unfortunately, the foundation and framework for such a Chambering system have yet to be put into place, thus causing a mismatch of tax and regulatory compliance. The lack of understanding of tax administrative/technical procedures encompassing the matters above may lead to an unwanted situation. An example is when a group of lawyers within the same partnership wish to work within the same firm (for Branding purposes). However, the business is being compartmentalised (different divisions having its own P&L).
You cannot be a sole proprietor within a partnership as the Bar council rules prohibit this. It is either a sole proprietor or partnership. Should you take the approach of compartmentalising the legal divisions, all divisions must converge as one (1) Firm resulting in a partnership.
Structuring such a Firm will require due care, taking into consideration tax requirements and having an understanding within the equity and dynamics of the business towards its accounting requirements as well as a proper tax compliant plan to be put into place.
What is legally perfect by contract, may lead to unnecessary misunderstanding and disastrous tax exposure. The issues with a partnership are non-exhaustive and the above is merely a fragment of the problems encountered repeatedly.
For clarification and better understanding, do drop us a note and we shall be happy to assist.
Yours faithfully I remain always,
The Deadlines to Comply With
Form E (Employer remuneration Form) – 30th March
Form P (Partnership reporting) – 30th June
Form B (Individuals running a business) – 30th June
Form BE (individuals with Employment and no business source of income) – 30th April