The ATO has released long-awaited draft guidance on its proposed compliance approach to the allocation of professional firm profits. The preliminary guidance is contained in the draft Practical Compliance Guideline PCG 2021/D2 (the draft Guideline). The ATO has also released a fact sheet ‘Assessing the risk: allocation of profits within professional firms’ (QC 42218) in relation to the draft Guideline.
When finalised, the Guideline will replace the professional firm guidelines that were suspended in December 2017 (the Suspended Guidelines).
Comments and submissions
Due Date: 26 March 2021
Contact Officer: Simon Webster
Email address: simon.webster2@ato.gov.au
Telephone: (03) 9275 5328
About the draft Guideline
Background
The ‘Assessing the Risk: Allocation of profits within professional firms guidelines’ and Everett Assignment web material published in 2015 stated that they would be reviewed in 2017. In reviewing the guidelines the ATO has become aware they are being misinterpreted in relation to arrangements that go beyond the scope of the guidelines.
The ATO has, for the years ended 30 June 2018 and 30 June 2019, stated that taxpayers who entered into arrangements prior to 14 December 2017 which comply with the guidelines and do not exhibit any of certain high risk factors can continue to rely on the suspended guidelines.
The draft Guideline explains how the ATO intends to apply compliance resources when considering the allocation of professional firm profit or income in the assessable income of an individual professional practitioner (IPP). The draft Guideline also assists an IPP to self-assess their risk.
The ATO is concerned about arrangements involving taxpayers who redirect their income to an associated entity from a business or activity which includes their professional services, where it has the effect of altering their tax liability.
The use of companies, trusts and other business structures do not of themselves give rise to avoidance concerns. However, the use of those structures can provide the controllers of a business with an opportunity to redirect income from them. When the business involves the provision of services, the ATO will be concerned with arrangements where the compensation received by the individual is artificially low while related entities benefit (or the individual ultimately benefits), and commercial reasons do not justify the arrangement.
The Commissioner’s preliminary view is that the profit or income of a professional firm may comprise different components — reflecting a mixture of income from the efforts, labour and application of skills of the firm’s IPPs (that is, personal exertion) and income generated by the business structure.
Warning — potential application of Part IVA
In some cases, professional firm income has been treated as being derived from a business structure, even though the source of that income remains, to a significant extent, the provision of professional services by one or more individuals. In that context, the ATO may apply Part IVA of the ITAA 1936 where income is redirected away from the individuals, despite the existence of a business structure.
Date of effect
Once finalised, the Guideline will apply prospectively from 1 July 2021. The application of the Guideline will be reviewed from 2022. Revisions will be made on an ‘as necessary’ basis.
Transitional arrangements
Taxpayers who entered into arrangements prior to 14 December 2017 are able to continue to rely on the Suspended Guidelines for the years ending 30 June 2018, 30 June 2019, 30 June 2020 and 30 June 2021, as long as their arrangement complies with those Suspended Guidelines, is commercially-driven, and does not exhibit any of the high-risk features outlined in the draft Guideline.
In recognition that certain arrangements considered low risk under the Suspended Guidelines may have a higher risk rating under the draft Guideline, the ATO is allowing a grace period for those IPPs to take the required steps to modify their arrangements to be lower risk, if they choose. Accordingly, those IPPs may continue to apply the Suspended Guidelines to their arrangements until 30 June 2023.
If a taxpayer identifies that they are no longer low risk, and they wish to transition their arrangements to a lower risk zone, they can inform the ATO of their intentions at any time. If the taxpayer engages with the ATO in good faith, this engagement will be on a ‘without prejudice’ basis.
A taxpayer should also contact the ATO if they are considering restructuring in a way that may not be assessed as low risk under the draft Guideline.
The ATO has a dedicated team for the oversight and management of profit allocation arrangement risks. Email: ProfessionalPdts@ato.gov.au
Protection available to taxpayers
It is important to note that the draft Guideline does not propose a ‘safe harbour’.
However, if a taxpayer’s circumstances align with the low-risk rating, the ATO will generally not allocate compliance resources to test the relevant tax outcomes.
The ATO is continuing work to identify taxpayers whose circumstances fall outside the draft Guideline or who wish to nominate themselves as a test case to obtain judicial guidance.
Key definitions
When the draft Guideline applies
The draft Guideline applies if all of the following criteria are met:
- an IPP provides professional services to clients of the firm, or is actively involved in the management of the firm and, in either case, the IPP and/or associated entities have a legal or beneficial interest in the firm;
- the income of the firm is not PSI;
- the firm operates by way of a legally effective structure, for example, partnership, trust or company;
- an IPP is an equity holder, that is, an IPP holds full rights to participate in the voting, management and income of the firm;
- the arrangement is commercially driven, that is, it satisfies Gateway 1 (see below);
- the firm and IPP do not demonstrate any high-risk features, that is, it satisfies Gateway 2 (see below).
The proposed risk-based compliance approach
The gateways
The ATO’s proposed risk-based compliance approach requires two qualifying ‘gateways’ to be passed before applying the risk assessment framework.
Gateway 1 — Commercial rationale
Gateway 1 considers whether the implemented arrangement and the way in which it operates are commercially driven.
There must be a genuine commercial rationale for the arrangement for all parties involved and the arrangement must achieve that end.
The arrangement must also be appropriately documented and there must be evidence that the stated commercial purpose was achieved as a result of the arrangement.
Indicators that an arrangement lacks a sound commercial rationale include the following:
- unnecessary complexity;
- a step, or a series of steps, that appear to serve no real purpose other than to gain a tax advantage;
- the tax result appears at odds with the commercial or economic result;
- little or no risk where significant risks would normally be expected;
- the parties are operating on non-commercial terms or in a non-arm’s length manner;
- a gap between the substance of what is being achieved and the legal form.
There must also be a genuine commercial basis for the way in which profits are distributed within the group, especially in the form of remuneration paid. Relevant considerations are whether:
- the IPP actually receives an amount of the profits or income which reflects a reward for their personal efforts or skill;
- the income has been distributed in substance;
- the IPP ultimately benefits from the distribution of income to associates, which is referrable to the personal efforts or skill of the IPP;
- the remuneration is less than a true commercial comparable and would not be perceived as an arm’s length payment;
- there are loan accounts relevant to the arrangement — whose name those accounts are in and whether they are aware of the loans;
- the payment recipients:
- have control in managing the entity’s cash flows and financials;
- actually receive the money and keep it, or whether it is distributed out to others. Where they do receive the money, whether it is available for their use and enjoyment, or is in fact predominantly for the IPP’s use and enjoyment.
Gateway 2 — High-risk features
High-risk features may include:
- arrangements covered by a Taxpayer Alert;
- financial arrangements relating to non-arm’s length transactions;
- exploitation of the difference between accounting standards and tax law;
- arrangements where a partner assigns a portion of a partnership interest that are materially different in principle from Everett and Galland;
- multiple classes of shares and units held by non-equity holders.
The list of high-risk features will be subject to amendment and addition as the ATO becomes aware of further high-risk arrangements.
The risk assessment framework
Step 1: Risk assessment scoring table
Where the taxpayer satisfies Gateways 1 and 2, they may self-assess their risk level against each of the risk assessment factors:
Step 2: Risk zones
The aggregate of the scores determines which risk zone applies:
* Note: The use of the third risk assessment factor is optional as the ATO recognises that it is difficult to determine accurately.
The first two risk assessment factors may be used, instead of all three, where it is impractical to accurately determine an appropriate commercial remuneration against which to benchmark.
Implications
Where an IPP returns 100 per cent of the profit entitlement from the firm in their personal tax return (i.e. risk assessment factor 1), the IPP is automatically within the green zone. There is no need to assess against the other factors.
Proposed ATO treatment
Green risk zone
The ATO will only apply compliance resources to review the taxpayer’s allocation of profit in exceptional circumstances, e.g. where:
- the ATO is not satisfied your self-assessment is correct, or is adequately supported with evidence;
- the ATO becomes concerned that higher-risk features are present in the arrangement;
- the ATO becomes concerned, from its data and analysis, that there is a change in the arrangement causing a shift towards the border of compliance;
- the ATO becomes concerned that the broader arrangements present a compliance risk (e.g. Div 7A);
- the arrangement relates to a broader set of circumstances being reviewed;
- changes to the arrangement may not have been appropriately treated or disclosed.
Amber risk zone
The ATO is likely to conduct further analysis on the arrangement. The ATO may contact the taxpayer to understand the arrangement and resolve any areas of difference.
Red risk zone
Reviews are likely to be commenced as a matter of priority. Cases may proceed directly to audit.
The ATO is likely to use formal powers for information gathering.
Note — Substantiation of assessment
If the taxpayer is unable to provide evidence to support their assessment, the ATO may undertake further compliance activity.
Examples
The draft Guideline includes five examples illustrating how to apply different aspects of the proposed compliance approach and seven case studies.
Case study 2 — IPP disposes of 40% of partnership interest and receives service trust income
Donald is an IPP in a partnership. The partnership has a service entity in its group that provides services to the partnership. Donald has disposed of 40 per cent of his interest in the partnership to a discretionary trust. The beneficiary of the discretionary trust is an associated company. An adult individual associated with Donald is a beneficiary of the service entity.
Donald’s income entitlement from the partnership is $800,000. There is also an entitlement to $80,000 profit from the service trust. Therefore, the aggregate of the total profit entitlement is $880,000.
Donald includes $480,000 of the partnership income in his tax return, the corporate beneficiary includes $320,000 in its tax return, and the service trust income of $80,000 is distributed to the adult individual beneficiary.
The risk assessment is as follows:
Risk assessment factor 1 — Proportion of profit entitlement from the whole of firm group returned in the hands of the IPP
$480,000, or 54.5 per cent of Donald’s entitlement of $880,000 is returned by Donald personally.
Score: 4
Risk assessment factor 2 — Total effective tax rate for income received from the firm by the IPP and associated entities
Using 2020–21 tax rates, the tax paid is:
The total effective tax rate is 32.53 per cent.
Score: 3
Risk assessment factor 3 — Remuneration returned in the hands of the IPP as a percentage of the commercial benchmark for the services provided to the firm
Not applicable. Donald has determined that in the circumstances it is impractical to accurately determine an appropriate commercial remuneration to benchmark against and therefore his aggregate score is determined against the first two factors only.
Score: 0
Total score: 7
The aggregate score of seven places Donald’s arrangement in the green zone.
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