Legal Business Blogs

HMRC review raises questions over law firm financing as banks tighten up lending terms

Law firms are facing a shake-up of their banking and taxation arrangements as both lenders and HM Revenue & Customs (HMRC) move to minimise their losses under the current system.

Following HMRC’s consultation on limited liability partnerships, draft legislation will be unveiled in its autumn statement, which is expected to substantially tighten the criteria for favourable tax treatment under partnership.

The legislation, which according to Norton Rose Fulbright partner Dominic Stuttaford may be tweaked but is unlikely to change tack, is expected to say that a partner is someone with a share of the equity – and of the risk – leaving the status of salaried partners in limbo.

Other factors, such as whether current partners have a say in management decisions, may also be considered and Macfarlanes tax partner Andrew Loan says: ‘There may be some firms with a layer of salaried partners who are in effect glorified employees that could be affected.’

The changes will mean many current partners becoming pay-as-you-earn employees and firms will have to pay higher national insurance. One way around this would be to give all partners a small equity stake, but Stuttaford points out that it is unlikely to be right for the firm or the employee to structure internal arrangements around taxation and that many salaried partners may choose to be classed as an employee rather than incorporate an element of risk into their pay packet.

HMRC is also understood to be considering an end to tax deductibility of interest rate payments for LLPs, which would have major implications for law firm funding.

The move comes as banks have, in the wake of recent high-profile law firm collapses, been revisiting some of the assumptions on which law firm lending is based and demanding more stringent arrangements to ensure they are protected if a limited liability partnership fails.

A litigation partner at one top 30 firm said: ‘The reality is that the nature of bank lending has changed. Once upon a time banks were giving money away. Now, with the fall of Halliwells and Cobbetts, they are far more risk-averse.’

Tom Wood (pictured), head of professional services industry at Barclays, commented: ‘Just because a firm is large and international doesn’t mean we should assume it’s successful. They are subject to new regulation, new entrants, a difficult economy and clients who want to see alternative service delivery models.

‘Barclays remains very keen on the legal sector and continues to actively lend, albeit with increasing levels of due diligence.

Wood adds: ‘We now want to know more about what a firm’s five-year plan looks like, so we can see strategically where our funding is being used, not just backdated profitability and historic profile.’

One consequence of this more risk-averse approach is that banks increasingly expect partners to have more ‘skin in the game’ by transferring firm borrowing to the partners.

This explains the increase in cash calls at City firms – often wrongly interpreted as meaning the firm has an inadequate financial cushion.

Firms borrow in partners’ names and pay them interest on the loan. One top 30 law firm partner added: ‘It’s not necessarily a big deal or about the partners putting their hands in their pockets, but about taking lending.’

‘Then, if the firm goes bust, the partners are still on the hook.’