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The Benefits of Incorporating Your Audit Practice
Since the recent implementation of the Statutory Audit Directive (S.I. No. 220/2010), which amends section 187 of the Companies Act 1990, auditors of companies can now incorporate. Now is an opportune time for statutory auditors to consider incorporation to avail of the benefits of separate legal personality and limited liability as well as certain tax advantages.
It is a well established principle of Irish company law that a company is an entirely distinct and separate legal person from its shareholders. Accordingly, it is the company (as a separate legal person) which is liable for its debts and obligations. A benefit for an auditor, who incorporates as a limited liability company, is that the liability of the shareholders in respect of the debts and obligations of that company is limited to the amount, if any, remaining unpaid on the shares held by them, save in exceptional circumstances.
The shares of a private limited company are (as a general rule) easily transferable by virtue of the shares being the shareholder’s personal property. The transfer of such shares (where they are fully paid up), generally speaking relieves the transferor of all his obligations to the company.
By contrast, Where a partner transfers his interest in a partnership, the transferring partner will continue to be liable for the pre-transfer obligations of the partnership unless the partnerships creditors agree to release him from, or the remaining partners agree to indemnify him in respect of, such obligations.
The transfer by a sole trader of his interest in an audit practice may also give rise to difficulties because the sole trader himself is required to discharge the obligations of the business and accordingly the transfer of those obligations may require the consent of the parties to whom those obligations are owed.
A company only ceases to exist where it is wound up or struck off the register of companies. This makes it easier to sell on the business by way of share sale, because the existing contracts continue in place with the company until a winding up or strike off.
Limiting Liability Contractually
Auditors in Ireland are effectively prevented under statute from contractually limiting their liability to the companies they audit. Section 200 of the Companies Act 1963
effectively prohibits a company from limiting the liability of an auditor in
respect of any negligence, default, breach of duty or breach of trust of which he may be guilty in relation to the company.
Section 200(1)(b) of the Companies Act 1963 provides that a company may indemnify an auditor of the company against any liability incurred by him in defending proceedings, whether civil or criminal, in which judgment is given in his favour or in which he is acquitted. Accordingly the indemnity will not apply if the auditor has been found guilty of negligence, for example.
In contrast with Irish law, Chapter 6 of Part 16 of the UK Companies Act 2006 permits auditors and companies to enter into liability limitation agreements in order to limit an auditor's liability to a company for negligence, default or breach of duty or trust in relation to the audit of that company’s accounts.
If an auditor chooses to incorporate as a private limited liability company, the provisions of section 200 will still apply, such that the audit company is prevented from contractually limiting its liability to the companies it audits. Thus, for example, should the audit be carried out negligently, it is the audit company, as opposed to the auditor individually (or as a firm) that will be liable to the company that it audits. The audit company will be liable, up to the extent of its assets, including in respect of insurance cover that the audit company has. Should the assets of the audit company be insufficient to pay the damages arising, then the audit company would be insolvent. However, the shareholders of the audit company should not have any liability for the debts and obligations of the audit company (beyond their paid up share capital) and accordingly, as noted in the example below, there should not be recourse to the shareholders’ personal assets, in the event that the assets of the audit company are insufficient to pay the damages arising.
Transfer of Undertaking
To benefit from this right of an auditor to incorporate, it will be necessary for firms who carry on statutory audit work to transfer this part of their business to a company. A business transfer agreement should be put in place in order to effectively transfer the relevant business and assets which in turn may require the novation or assignment of a number of existing contracts. Such a transfer of the business is also likely to trigger the European Communities (Protection of Employees on Transfer of Undertakings) Regulations 2003, which (broadly speaking) entitles the employees of that business to transfer to the company on the same terms.
Administrative & Filing Requirements
There are additional administrative and filing requirements which apply to a company but not to a partnership. These include the requirement to keep proper books of account which give a ‘true and fair' view of the state of affairs of that company, to present annually the accounts to shareholders at the annual general meeting and to file the accounts with the annual return in the Companies Registration Office. If there is concern in relation to the public availability of a company’s accounts, it is possible to implement a structure such that the company would not have to file its accounts, whilst maintaining the protection of
It would be prudent for the shareholders in the company to put in place a comprehensive shareholders agreement (to deal with matters which may previously have been managed in accordance with a partnership agreement), including for example: company structure, administrative issues, financing and shareholder rights and obligations.
The issue of limiting the liability of auditors is currently under review at a European Commission level and it appears likely that there may be further uniformity of rules introduced on this matter. More particularly, it has been examined whether there is
scope to introduce limits on liability in one of the following ways:
- a European-wide monetary cap on audit claims;
- a cap on the quantum of claims by reference to the size of the audit firm;
- a cap on the claims based on a multiple of the audit fees charged;
- the introduction of proportionate liability which would mean that an auditor is only responsible for the portion of the claim which corresponds to the auditor’s degree of responsibility.
Tax implications on Incorporation
The tax heads to be considered on incorporation include capital gains tax, income tax, stamp duty and VAT. Where possible, it will be necessary to structure the incorporation so as to avail of existing reliefs and exemptions in respect of these tax heads. With appropriate planning it is possible to minimise any potential tax costs arising.
Main tax implications following incorporation
- Corporation tax at the rates of 12.5% (on profits derived from the professional services provided by the company) and 25% (on passive income such as rental income and deposit interest) should apply.
- Additional tax only becomes payable when the shareholders wish to extract the income from the company.
- The new company will, in many cases, be regarded as a close company (ie a company that is controlled by five or fewer persons). Consequently, there are certain tax implications for close companies to consider.
- The PRSI position for shareholders of the new company will need to be carefully considered, particularly where there is to be a large number of shareholders in the new company.
Incorporating your practice may give rise to savings in insurance costs.
The ability to incorporate does not apply to a ‘public auditor’. For example, credit unions, friendly societies and industrial and provident societies must be audited by a public auditor.
- Various regulatory requirements will also need to be complied with in the incorporation process.
- Where firms have already incorporated part of their practices, the ability to incorporate the audit function should simplify operational arrangements and lead to cost savings.
- Depending on the existing structure of the firm, a valuation of the audit practice may be required.
Now is an appropriate time for audit firms to consider incorporation but it is important to consider the legal, regulatory and tax aspects.
This article is not intended to be comprehensive or definitive, but, instead, to give you a flavour of some of the legal and tax issues arising in determining whether or not to
incorporate. This article cannot be relied upon as professional advice and it is recommended that appropriate professional advice be obtained before proceeding.
This article first appeared on the Legalweek.com website (5 April 2011).