Part A: Taxing businesses
Partnerships
Key takeaways
- When a partner joins or retires during the year, split the period at the exact date of the change and share each part's profit in the ratio in force during that part.
- A retiring partner shares only in the profit before retirement, and a new partner only in the profit after admission.
- Converting a partnership into a limited company is a cessation of the partnership's business and a commencement of the company's, with specific rules for the transfer of assets.
- Where a partnership's records are incomplete, taxable profit is reconstructed by indirect methods, such as the net worth or expenditure approaches, rather than computed directly.
- Kenyan and persuasive foreign case law shows how the Income Tax Act's partnership provisions apply to disputed facts.
Partnership tax rules
Apportioning profit around a mid-year partner retirement (not a decided case)
A three-partner firm, A, B and C sharing profit 2:2:1, has annual profit (accruing evenly through the year) of KES 3,600,000. Partner C retires at the end of the 8th month, after which A and B continue sharing equally (1:1).
Profit for the first 8 months = 3,600,000 x 8/12 = KES 2,400,000, shared 2:2:1: A = 960,000, B = 960,000, C = 480,000.
Profit for the remaining 4 months = 3,600,000 x 4/12 = KES 1,200,000, shared 1:1 between A and B only: A = 600,000, B = 600,000.
Total taxable share for the year: A = 960,000 + 600,000 = KES 1,560,000. B = 960,000 + 600,000 = KES 1,560,000. C = KES 480,000 (only the first sub-period, since C had retired before the second).
Exam tip
The mid-year partner change computation is the most numerically examined item in this chapter, always split the accounting period at the exact date of the change, apportion time-based profit for each sub-period, and apply the correct profit-sharing ratio to each sub-period separately.
Self-check
(a) A two-partner firm, X and Y sharing profit equally, admits a new partner Z at the end of the 9th month, after which the three share 2:2:1. Annual profit, accruing evenly, is KES 2,400,000. Compute each partner's taxable share for the year. (6 marks)
(b) Explain why a partnership converting into a limited company triggers a cessation of the partnership's business for tax purposes. (2 marks)
(c) State the indirect methods used to reconstruct taxable profit where a partnership's records are incomplete. (2 marks)
Show worked answer
(a) First 9 months = 2,400,000 x 9/12 = 1,800,000, shared equally: X = 900,000, Y = 900,000. Remaining 3 months = 2,400,000 x 3/12 = 600,000, shared 2:2:1: X = 240,000, Y = 240,000, Z = 120,000. Totals: X = 900,000 + 240,000 = KES 1,140,000; Y = 900,000 + 240,000 = KES 1,140,000; Z = KES 120,000 (6 marks).
(b) The partnership and the new company are separate taxable persons; the business carried on by the partnership legally ends and the company's own business begins, with specific rules then governing how assets transfer and any resulting tax consequences of that transfer (2 marks).
(c) Net worth and expenditure approaches, indirect methods that infer taxable profit from a taxpayer's unexplained increase in net worth or spending, rather than from a complete set of direct accounting records (2 marks).