Allocation of Professional Firm Profits

The ATO has released its Practical Compliance Guideline PCG 2021/4 (Guidelines) which sets out the ATO’s compliance approach to the allocation of profits or income from professional firms in the assessable income of the individual professional practitioner (IPP), replacing existing guidelines on the same topic that the ATO suspended in 2017.

Purpose

The purpose of the Guidelines is to mitigate the ATO’s concerns that taxpayers are directing their income to an associated entity from a business or activity which includes their professional services where it has the effect of significantly reducing their tax liability.

Importantly, these Guidelines (or any of the ATO Practical Compliance Guidelines) do not operate as law nor do they affect the operation of law in effect. They are intended to guide Australian taxpayers as to how the ATO will allocate their compliance resources to examine the tax outcomes. In these Guidelines, those resources will be allocated based on the ‘traffic light’ assessment rating. It is through the release of the Guidelines that IPP’s can self-assess their risk of being reviewed and/or audited by the ATO.

Application

The Guidelines will apply from 1 July 2022 subject to the transitional arrangements.

An IPP is defined in the Guidelines to be individual who provides services to clients of the firm, or to the firm itself, in circumstances where the IPP and/or associated entities have a legal or beneficial interest in the firm. In addition, ‘professional firms’ are those which offer customised, knowledge-based services to clients in a variety of professions including but not limited to, accounting, architecture, engineering, financial services, law, medicine and management consulting.

Whilst the Guidelines do provide some examples of what ‘professions’ apply, the examples are not comprehensive and the term ‘profession’ is not defined in any tax legislation. Despite a set of indicators being provided within the Guidelines, professionals may consider seeking accounting and legal advice to determine whether the Guidelines apply to them.

The Guidelines will apply to you 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 subject to the Professional Services Income rules.
The firm operates by way of a legally-effective structure, for example companies, trusts and/or partnerships.
An IPP is an equity holder, directly or through an associated entity.
The arrangement is commercially driven (satisfies Gateway 1, discussed below).
The firm and IPP do not demonstrate any high-risk features (satisfies Gateway 2, discussed below).

Assessment of Risk

Gateway 1 – Commercial rationale

This gateway is a consideration of whether the arrangement in place has a genuine commercial basis including for the way in which profits are distributed, including profit distribution between the IPP and related entities. Importantly, the genuine commercial basis must be able to be evidenced. The Guidelines state that legal documentation must be consistent with the operations of the professional firm which are legitimately implemented.

A range of illegitimate commercial rationales have been included in the Guidelines to assists professions to avoid these arrangements and in turn, have the appropriate legal documentation in place.

Gateway 2 – High-risk features

This gateway is a consideration of whether the arrangement in place contains any high risk features. The Guidelines specify that high-risk arrangements include those covered by Taxpayer Alert, but have also set out the additional high-risk features:

(a) Financing arrangements relating to non-arm’s length transactions;

(b) Exploitation of the difference between accounting standards and tax law;

(c) Arrangements where a partner assigns a portion of a partnership interest that is materially different in principle from Everett and Galland, including but not limited to arrangements:

(i) purporting to admit an individual as a partner, where the individual is not an owner or equity holder in the partnership; and

(ii) where the IPP’s relationship has characteristics indicating their relationship with the partnership is akin to a contractor or employee; and

(d) Multiple classes of shares and units held by non-equity holders.

If an IPP does not satisfy Gateways 1 or 2 the Guidelines cannot be relied upon and there is a higher risk that ATO will allocate their compliance resources to that arrangement. In particular in relation to Part IVA of the Income Tax Assessment Act (1936).

Risk Assessment Framework

Where an IPP satisfies Gateways 1 and 2, they can then self-assess using the ‘traffic light’ risk assessment tool contained in the Guidelines. Whilst the third is optional, there are three assessment factors an IPP can use:

Proportion of profit entitlement from the whole of the firm group returned in the hands of the IPP.

Total effective tax rate for income received from the firm by the IPP and associated entities.

Remuneration returned in the hands of the IPP as a percentage of the commercial benchmark for the services provided to the firm.

Depending on the percentage range selected for each factor, you will receive a corresponding score. Your total score for the factors can then be used to determine whether the risk is low (green), medium (amber) or high (red).

No Safe Harbour

Despite having the ability to self-assess risk, it should be reiterated that the Guidelines do not operate as law. As such, an IPP should be aware that even where their assessment of risk is low (green), this does not provide safe harbour against a trigger of anti-avoidance measures known as Part IVA of the Income Tax Assessment Act (1936). Legislation will always take precedence.

Importance of advice

These guidelines highlight the importance of taxpayers and professional firms being proactive and obtaining advice from qualified accountants and lawyers to minimise the risk of the ATO taking action against taxpayers as a result of their approach to the allocation of profits or income. Coulter Legal, in conjunction with your accountant, can assist to ensure that you are appropriately advised and have the correct the business structure and legal documentation in place.