Following several years of deliberation, the ATO has finally released draft Practical Compliance Guideline- PCG 2021/D2 that sets out the ATO's proposed compliance approach to the allocation of profits by professional firms.
The guideline explains how the ATO intends to apply compliance resources when considering the allocation of professional firm profits or income in the assessable income of the individual professional practitioner (‘IPP’). It also assists the IPP to self-assess against the risk assessment factors set out.
WHAT IS THE ISSUE?
The ATO is specifically concerned with arrangements involving the provision of services where the individual taxpayer redirects income to an associated entity, where it has the effect of altering their tax liability. Whilst there may be commercial reasons for doing this, the ATO’s concern is that the compensation received by the professional is artificially low and the commercial reasons do not justify the arrangement.
WHO IS IMPACTED?
Professional firms including, but not limited to, those providing services in the accounting, architectural, engineering, financial services, legal and medical professions. Furthermore, the guidelines apply if all the following conditions 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 personal services income (PSI);
- The firm operates by way of a legally effective structure, for example, partnership, trust or company; and
- An IPP is an equity holder, that is, an IPP holds full rights to participate in the voting, management and income of the firm.
WHAT IS THE ATO’S COMPLIANCE APPROACH?
In general, the ATO has set out two qualifying ‘gateways’ to be passed before applying the risk assessment framework they have set out. Where the ‘gateways’ are not passed, the risk assessment framework is not available to the taxpayer.
- Gateway 1 - there must be a genuine commercial basis for the arrangement which achieves the intended purpose
- Gateway 2 - the arrangement must not contain any high-risk features
Gateway 1 - Commercially driven arrangements
As a starting point, there must be:
- A commercial rationale behind the overall structures in place and the arrangement should reflect the overall needs of the business. Simply stating the arrangement was entered into for asset protection purposes is not in itself sufficient if the arrangement does not actually provide improved asset protection.
- A commercial basis by which income is distributed within the group. In particular, the remuneration paid to the IPP should be commercially comparable and at arm’s length.
Gateway 2 - High risk features
The next step is to determine whether the arrangement contains high risk features. The ATO considers the following as potentially high-risk features:
- Financing arrangements relating to non-arm’s length transactions.
- Exploiting the difference between accounting standards and tax law.
- Arrangements where a partner assigned a portion of a partnership interest that are materially different from an Everett assignment (e.g. certain non-equity partner arrangements).
- Multiple classes of shares and units held by non-equity holders.
RISK ASSESSMENT
Where an IPP passes the gateways, they may then self-assess against the risk assessment framework to determine the type of compliance attention that may be given to their arrangement.
|
Risk assessment factor
|
Score
|
|
1
|
2
|
3
|
4
|
5
|
6
|
|
1
|
Proportion of profit assessable to IPP
|
>90%
|
>75% to ≤90%
|
>60% to ≤75%
|
>50% to ≤60%
|
>25% to ≤50%
|
≤25%
|
|
2
|
Total effective tax rate (IPP and associated entities)
|
>40%
|
>35% to ≤40%
|
>30% to ≤35%
|
>25% to ≤30%
|
>20% to ≤25%
|
≤20%
|
|
3
|
Remuneration returned in the hands of the IPP as a percentage of the commercial benchmark for the services provided to the firm
|
>200%
|
>150% to ≤200%
|
>100% to ≤150%
|
>90% to ≤100%
|
>70% to ≤90%
|
≤70%
|
If it is impractical to accurately determine a commercial benchmark (factor 3 above), only the first two factors are to be used in assessing the score and the risk rating.
Once a score is established per the above, the arrangement will fall into one of the following risk zones:
| Risk zone |
Risk level |
Aggregate score against first two factors |
Aggregate of all three factors |
| Green |
Low risk |
≤7 |
≤10 |
| Amber |
Moderate risk |
8 |
11 & 12 |
| Red |
High risk |
≥9 |
≥13 |
Broadly, if the arrangement fails into the:
- Green zone - the ATO will not apply compliance resources unless there are exceptional circumstances.
- Amber zone - the ATO may contact the taxpayer and undertake a review of the overall arrangement.
- Red zone -it is likely the arrangement will be reviewed or proceed directly to audit.
Example
William is an IPP in a professional services firm with multiple partners. Each partner of the partnership is a discretionary trust controlled by an IPP and all partners receive an annual distribution from the partnership into their own discretionary trusts. William’s trust received $600,000 as a profit share during the 2021-22 income year. The discretionary trust distributes the income as follows:
- $200,000 to William
- $300,000 to a related company
- $100,000 to William’s spouse
Assessment of risk factors
- Proportion of profit – William received 33.33% ($200,000/$600,000 x 100) of the profit and based on the table above, the score is 5.
- Effective tax rate will be calculated as follows:
|
|
Income
|
Tax
|
|
William
|
$200,000
|
$60,667
|
|
Related company (tax rate @ 26%)
|
$300,000
|
$78,000
|
|
William's spouse
|
$100,000
|
$22,967
|
|
Total
|
$600,000
|
$161,634
|
The effective tax rate on the income is 26.94% ($161,634/$600,000 x 100) and based on the table above, the score for this factor is 4.
-
William does not believe it is practical to accurately benchmark commercial remuneration and therefore, this score for this factor is 0 and the assessment is based on the first two factors only.
As the arrangements overall score is 9, it falls within the red zone and William should expect the arrangement to be reviewed or audited by the ATO.
Example – alternative fact
For illustrative purposes, using the same facts above, if William could practically benchmark their remuneration against other professionals within the same industry and determined it to be $400,000, he would have received 50% as compared to the benchmark, giving a score of 6 for factor 3.
This would take the overall risk rating to 15 and would again be within the red zone and William should expect the arrangement to be reviewed or audited by the ATO.
|
WHEN DOES THE GUIDELINE APPLY?
The guideline is drafted to apply prospectively from 1 July 2021.
Transitional rules allow taxpayers that entered into arrangements prior to 14 December 2017 to rely on the ATO’s now-suspended guidelines for the years ended 30 June 2018, 30 June 2019, 30 June 2020 and the year ending 30 June 2021 provided the arrangement is compliant with the suspended guidelines, is commercially driven and does not exbibit any of the high-risk features outlined in the current guideline.
Further, in recognition that certain arrangements considered low risk under the suspended guidelines may have a higher risk rating under the new 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.
WHAT’S NEXT?
The guideline is in draft however, we recommend that if you believe this may affect the arrangements you have in place you contact your Moore Australia advisor for further advice and assistance.