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 under 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
A business entity is owned by two (2) persons and must not exceed twenty (20) persons at one time. The owners may be Malaysian or Permanent Resident (PR) who are allowed to register a Partnership to run their business. Partnerships are deemed a legal entity and thus are not a taxable body.
Assessment of Tax
All chargeable income generated by the Partnership will be charged to the partners individually.
This will be done based on their equitable interest in the business via their personal tax submission (Form B). As mentioned above, the Partnership is not subject to any form of taxes and does not pay corporate tax. As such, it is likely that it would 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 losses are allowed to be utilised against all other sources of income for the year (e.g. employment income, interest income).
Liabilities in a Partnership
As the business is not a separate legal entity. All partners are jointly and severally liable for the debts and liabilities of the practice/business.
Legally this would mean, should any bankruptcy action be enacted, towards any one partner, the creditors have the right to sue all the partners involved to claim the debt owed. This will have a direct impact on each partner’s personal wealth. When it comes to Partnership laws, every country has its 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 indicated 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 and being admitted to the business – (regardless of reasoning).
Pitfalls and the Follies of a Legal Firm
There are many situations that have put many Legal Firms into a situation 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 and admitted to the Firm. Basically, when a partner leaves / is admitted to a Firm, the business ceases to exist or comes to an end for the existing Firm. The situation arises as most Legal Business will likely retain the existing name (which is allowable by the Bar Council) giving the impression that there is no necessity or rather the ignorance of “ Everything is the Same” due to the lack of technical knowledge with tax compliance.
What has been 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/are admitted.
Things that should be addressed
1. The Firms 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 on paper;
3. The IRB must be informed and a “New” Partnership Tax File (P file) has to be registered, as it is a new business 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 are 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 than often, equity partners tend to have either a fixed and rigid structure or one that is flexible.
With both arrangements, the rules of engagement for the preparation of the tax computation are different and matters from capital allowance as well as other direct and indirect expenses will have to be addressed carefully. Please bear in mind that all liabilities are extended in 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 entitled to each equity partner during the given period of time or financial year.
Each partner would be entitled towards receiving a Form CP30. This will contain the distributable profit that is to be put to tax or otherwise (similar to an EA- CP8d for employees but based on profit/losses instead of a salary). In the event the CP30 is reporting a loss, the adjusted (tax) business loss may be used to set off against any other income reported in the individuals’ tax returns.
As mentioned above, the partnership is not taxable and the equity partners are individually taxed in their own personal capacity. Thus, it is for the benefit of all parties to ensure that the above actions are being 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 cutoff date and not the general financial year-end period.
Income is based on an accrual basis, not on a cash basis. Therefore, the money you 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 profitability/loss in a Firm, they merely impact the Firms 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. Money taken i.e. drawings could well be money for which has already been subject to past years tax as mentioned above;
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 to the Firm.
Equity partners must receive a CP30 while a paid partner are to receive a Form EA.
Paid partners are partners in name but do not hold any equity. 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 (STD) for the paid partner. The position taken is that paid partners are partners and equated to having/ being under the same rules of an equity partner.
This has resulted 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 with the defense of “Being a partner” which clearly is not the case for tax compliance as they are not equitable partner. This is again made complex with 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 be drawn between equity partners and paid partners to enable a clear understanding of the Firms 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 pit fall is the utilisation of a Chambers system adopted within a partnership. The chamber system though proven and accepted in the United Kingdom may not be suitable for the Malaysian application.
Let us have a basic understanding towards 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 for the tax compliance to fit in. 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 may lead to an unwanted situation. An example is when a group of lawyers within the same partnership wishes 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 are prohibitive towards this. It’s 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 of 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 issues encountered repeatedly.
For clarification and better understanding, do drop us a note and we shall be happy to assist.
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