The ATO issues updated guidance on the allocation of profits of professional firms

Tax

21 December 2021

The allocation of profits within professional firms is very complicated. On 16 December 2021, the ATO issued a final Practical Compliance Guideline PCG 2021/4 that applies from 1 July 2022 as part of its continuing efforts over the last six years to help ensure income earned by individual professional practitioners (IPPs) from delivering professional services in professional accounting, architecture, engineering, financial services, law, medicine and management consulting firms, is appropriately taxed to the IPP and not redirected to lower taxed associated entities.

Generally, profit distribution arrangements (arrangements) designed to ensure that the IPP is not directly rewarded for the services they provide to the business, or arrangements where the IPP receives a reward which is substantially less than the value of those services, are considered high risk by the ATO.

Such activity raises red flags for the ATO, because it will significantly reduce the IPP’s tax liability on income from personal exertion (i.e. income from the efforts, labour and application of skills of the IPP). Conversely, income arising from the business structure (rather than from the IPP’s personal exertion) can generally be redirected or assigned to lower taxed entities without raising concerns about tax avoidance.

How the ATO is addressing issues relating to the allocation of profits from professional firms

To address such issues relating to the allocation of profits from professional firms, the ATO has:

  • Released ATO website guidelines in June 2015. Pursuant to these guidelines, an arrangement would be low risk (and unlikely to attract ATO attention) if:

    • The IPP received appropriate remuneration equal to the upper quartile of the highest band of employees;

    • At least 50% of the income was assessed to the IPP; and

    • The total effective tax rate (TETR) was at least 30% (i.e. the total tax on the income of the IPP and the associates was at least 30%).

  • Suspended this guidance in December 2017 because the June 2015 guidelines were being misinterpreted;

  • Issued a draft Practical Compliance Guideline (PCG 2021/D2) in March 2021; and

  • Issued a final PCG 2021/4 on 16 December 2021 that applies from 1 July 2022.

These guidelines focus on different approaches to determine whether the risk posed by such arrangements would warrant further ATO investigation about the allocation of profits from professional firms (i.e. what the ATO’s compliance approach will be).

These guidelines are not law and they do not rule on what the ATO considers acceptable or unacceptable in relation to tax avoidance and they do not give safe harbours. The general anti-avoidance provisions in the tax law (Part IVA), and the ATO’s existing taxation rulings on the allocation of profits from professional firms, continue to apply.

The significance of the ATO’s guidelines is that they indicate the types of professional firms the ATO will focus its compliance attention on, in relation to the allocation of profits.

Assessing the ATO risk of income earned by individual professional practitioners

The ATO wants IPPs to self-assess their risk each year by passing two gateways. IPPs who pass the two gateways can then apply the risk assessment factors in the guidelines to determine if they fall into the low-risk green zone (or the moderate-risk amber zone, or high-risk red zone).

Gateway 1 is there must be a genuine commercial basis for the arrangement and profit distribution, and Gateway 2 is there must be no high-risk features.

Gateway 1 will be satisfied if the professional firm’s operating structure is designed on a genuine commercial basis. The way the profits are distributed must be done on genuine commercial terms and there must be a commercial rationale for the arrangement. Some factors that may indicate that an arrangement is commercial is when the arrangement:

  • Is not more complex than necessary to achieve the relevant commercial objective;

  • Does not include steps that appear to serve no other purpose than to obtain a tax advantage (e.g. interposing entities, having intra-group or related party dealings or arrangements involving a circularity of funds only to gain a tax advantage);

  • Does not deliver a tax result at odds with its commercial or economic result (e.g. claiming a tax loss when the business is profitable);

  • Is not operated on non-commercial terms or in a non-arm’s length manner (e.g. financial arrangements on unusual terms such as non-market related interest rates, insufficient security or long loan repayment periods); and

  • Steps are not taken to control the risk of the arrangement (e.g. use of non-recourse loans or use of put options).

Gateway 2 (i.e. no high risk features) will be satisfied if the type of arrangement:

  • Is not specifically mentioned in a Taxpayer Alert;

  • Does not relate to non-arm’s length financing arrangements that converts non-deductible debt into deductible debt (e.g. a discretionary trust borrows money that is guaranteed by the IPP to buy some of the interest of the IPP in the professional firm resulting in the trust claiming a deduction for the interest paid on the borrowing and the IPP using the sale proceeds to pay off mortgage debt on the IPP’s main residence);

  • Does not create artificial differences between taxable income and accounting income whereby income is assessed to individuals or businesses that pay little or no tax while allowing taxpayers on higher marginal tax rates to enjoy the economic benefits;

  • Does not admit an individual as a partner where the individual is not an owner or equity holder of the partnership, does not make the IPP’s relationship with the partnership akin to a contractor or employee, does not indemnify non-owner/non-equity holders against any professional liability, does not allow a fixed draw or salary if there is a risk to the business and allows all partners to fully participate in the management and benefits of the partnership; and

  • Does not consist of multiple classes of shares and units that do not have voting rights, being held by non-equity holders (e.g. dividend access shares that pays dividends to associated entities or non-equity holders).

If these two gateways are not passed (i.e. if the arrangement does not have a commercial basis and/or contains high risk features), the guidelines cannot be used. In these circumstances the ATO may consider whether to apply Part IVA to the arrangement. In considering whether to apply the Part IVA anti-avoidance provisions, the ATO has stated it will rely on the legislation, its existing rulings and publications, and its processes.

If these two gateways are passed (i.e. if the arrangement has a commercial basis and does not contain high risk features), the IPP and the ATO can conduct a ‘traffic light’ risk assessment to determine the likelihood of further ATO investigation and whether the professional firm’s risk zone is red, amber or green. Professional firms are placed into different risk zones depending on the amount of points they score based on the following sliding scales:

1. The proportion of profit entitlement in the hands of the IPP.

25% or less of profits of the firm returned to the hands of the IPP attracts more points and the most risk (and more than 90% would attract the least amount of risk).

2. The total effective tax rate (TETR) for income received by the IPP and their associated entities.

A total effective tax rate for income received from the firm by the IPP and their associates of 20% or lower attracts more points and the most risk (and more than 40% would attract the least amount of risk).

3. The remuneration returned to the IPP as a percentage of the commercial benchmark for the services provided to the firm.

Total remuneration (includes cash, superannuation, fringe benefits and any other non-cash benefits) received from the firm by the IPP of 70% or lower than the benchmark attracts more points and the most risk (and more than 200% would attract the least amount of risk).

A professional firm that scores in the amber zone will likely be subject to ATO review whereas firms in the red zone will be subject to ATO review. Professional firms in the green zone should be relatively safe from further ATO scrutiny, although they may be reviewed if the IPP’s profit allocation displays high risk features (as was set out above) or the arrangement relates to a broader set of circumstances that are reviewed by the ATO.

Although these guidelines are not legally binding, if a taxpayer has relied on these guidelines in good faith to determine they fall in the green zone, the ATO will generally not take action in relation to prior years and will not impose general interest charges.

The application of guidelines to IPPs

The guidelines will apply from 1 July 2022, however, there are various transitional rules in place.

The guidelines to determine the risk of further ATO investigation of the allocation of the profits of professional firms are as follows:

  1. For professional firm allocations made from 1 July 2022, PCG 2021/4 will apply (provided transitional rules do not apply).

  2. For professional firm allocations made from 1 July 2017 to 30 June 2022 the suspended guidelines will apply and you will be considered low risk if your arrangement is commercially driven and does not display high risk features as set out in PCG 2021/4.

  3. For professional firm allocations made from 1 July 2017 to 30 June 2024, the suspended guidelines will apply where the arrangement was low risk under the suspended guidelines but higher risk under PCG 2021/4. From 1 July 2024 (or income years ending from 30 June 2025), provided no further structural change is necessary to the professional firm, suitable resolutions in relation to the distributions of income can be made to ensure compliance with PCG 2021/4.

This means that PCG 2021/4 will not automatically apply from 1 July 2022. For example, if the arrangement was low risk under the suspended guidelines but higher risk under PCG 2021/4, PCG 2021/4 will only apply form 1 July 2024.

Next steps for IPPs delivering professional services

The ATO recommends that IPPs annually assess their eligibility to apply PCG 2021/4. Your Findex adviser can assist you to document this assessment and review your eligibility as a business or as the arrangement changes.

It is also noted that if other compliance issues that do not relate to the allocation of profits from a professional firm are present (e.g. non-recognition of capital gains, transfer mispricing, misuse of the superannuation system, promotion of schemes, failure to lodge tax returns on time, income injection to entities with carried-forward losses, Division 7A private company loan issues, Section 100A reimbursement agreement issues, inappropriate access to low-income tax offsets or other benefits or non-tax advantages which are dependent on taxable income), the ATO may also investigate these issues further.

If you run a business in professional services, please contact the Tax Advisory team so that we can do a financial health check on your firm. We can review your existing arrangements and, if necessary, assist you to explore whether it would be possible to modify your arrangements to a lower risk zone (which can be done on a “without prejudice basis” with the ATO).

Author: Roelof van der Merwe

Roelof is the National Tax Director of Findex and has more than 15 years' experience in Australia delivering practical tax and consulting services. Roelof joined Findex after gaining experience in Big 4 and mid-tier firms. Roelof helps to ensure that Findex stays up-to-date with the latest developments by interpreting technical tax information in a practical and relevant manner. He has experience on a wide variety of complex tax related topics and has the ability to identify, understand and clearly communicate how the tax law may impact business transactions and taxpayers.