Updated guidelines on allocation of professional firm profits PCG 2021/D2
The Australian Taxation Office (ATO) has historically expressed their concerns with professional firms making use of corporate structures which have the potential to provide Individual Professional Practitioner’s (IPP) with certain tax benefits.
The ATO has flagged that they are aware of arrangements where the taxpayer has redirected their income from professional firm profits (in which that income is derived from the individuals’ professional services) to an associated entity, thereby altering their tax liability.
In doing so, a taxpayer has the potential to trigger anti-avoidance measures known as Part IVA of the Income Tax Assessment Act (1936).
Due to these concerns, the ATO had previously released a series of guidelines in which they outline areas of consideration when determining if a taxpayer has breached part IVA of the Income Tax Assessment Act (1936).
It is important to note that the use of varying business structures do not of themselves give rise to these avoidance concerns. Rather, the use of such structures can provide taxpayers with the opportunity to redirect income.
Therefore, the ATO guidelines aim to differentiate between a legitimate business structure and one that was designed to avoid tax liabilities.
To do so, the ATO has outlined taxpayers that are either at low, medium or high risk of breaching the anti-avoidance measures.
Previous guidelines (now superseded with PCG 2021/D2)
In 2017, an IPP was considered to be low risk if it could meet any of the following benchmarks:
- Appropriate remuneration: The IPP’s remuneration is at least the remuneration of the lowest paid member of a similar level within the firm
- 50 per cent entitlement: At least 50 per cent of the income from the professional firm is going to the IPP and assessable in the hands of the IPP.
- 30 per cent effective tax rate: The effective tax rate on firm income of the IPP is at least 30 per cent.
If any of the benchmarks above were met, then the ATO had advised the taxpayer would be at low risk of breaching anti-avoidance measures.
However, these guidelines were suspended in 2017 and could no longer be used to help determine a taxpayer’s risk level.
Since that time, the profession has been awaiting updated direction.
The ATO has now drafted and released a new set of guidelines (to take into effect prospectively from July 1, 2021 once finalised).
As previously, this PCG aims to outline the ATO’s risk-based approach to IPPs and how professional firms allocate profits.
Unlike the previous rules, this PCG now refers to the taxpayer having to pass two ‘gateways’.
Gateway 1: commercial rationale
The first gateway considers whether the implemented arrangements in a professional firm are commercially driven (e.g. that there is a genuine commercial rationale for the arrangement and the way in which profits are distributed to IPPs).
When determining whether a structure has commercial rationale, the ATO will look to things such as:
- Whether the structure has actual commercial benefits to the business (such as the arrangement being likely to enhance or improve the ability of the business to make a profit);
- Whether there is appropriate documentation in place that highlights the commercial viability of the structure, as well as the decision making on why that structure was chosen;
- Whether the structure is more complex than necessary to achieve the commercial objective;
- Whether the arrangement includes steps that serve no real purpose other than to gain a tax advantage;
- Whether the parties involved in the arrangement are operating on commercial terms;
- Whether the structure has economic substance.
Further to reviewing the commercial rationale of the structure, the ATO also outlines that there must be a genuine commercial basis for the way in which profits are distributed. For example, the IPP receives (and is assessed) on the amount of profits that are reflective of their personal efforts in the firm.
A full list of considerations can be found in the PCG.
The ATO expects professional firms to evaluate themselves against this gateway to determine whether the arrangement is commercially driven. If not, then this may trigger Part IVA implications.
Gateway 2: high-risk features
If after considering Gateway 1 it is concluded that the arrangement is commercially driven, the professional firm must then also assess whether the arrangement has any high-risk features.
In this case, high-risk features include:
- Any arrangement that has been covered by a taxpayer alert;
- Financing arrangements relating to a non-arm’s length transaction. Particularly, financing arrangements involving related entities in which the arrangement gives rise to a tax benefit is considered high risk;
- Exploitation of the difference between accounting standards and tax law. Instances where the arrangement has created an artificial difference between taxable and accounting income are considered high risk;
- Arrangements where a partner assigns a portion of a partnership interest that are materially different in principle form;
- Multiple classes of shares and units held by non-equity holders.
As a part of the guideline, the ATO has also released a risk assessment scoring table where a professional firm or IPP can determine if they are low, moderate, or high risk.
This assessment is based on determining your score against three criteria, in which a higher score means higher risk of breaching anti-avoidance measures.
|Risk assessment factor||1||2||3||4||5||6|
|(1) Proportion of profit entitlement from the whole of firm group returned in the hands of the IPP||> 90%||> 75% to ≤ 90%||> 60 % to ≤ 75%||> 50% to ≤ 60%||> 25% to ≤ 50%||≤ 25%|
|(2) Total effective tax rate for income received from the firm by the 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%|
|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 and 12|
|Red||High risk||≤ 9||≤ 13|
Therefore, professional firms now have the ability to measure their own structures against this risk assessment table to determine their own level of risk – keeping in mind that the two gateways must still be passed.
Depending on the zone, the ATO has also outlined what level of action they may take. For example, if an entity falls into the green zone, the ATO has expressed they will only review allocation of profit in exceptional circumstances. If an entity falls into the red zone, the ATO has advised that reviews are likely to occur as a matter of priority (and then potentially proceeding into an audit).
Speak with the tax experts at LDB Group
The discussions are still ongoing on the above matters and there have been a series of changes requested before the guidelines are finalised.
Should you have any questions about how the guidelines on the allocation of professional profits may affect your business, please contact LDB Group’s taxation and advisory specialists by calling (03) 9875 2900 or filling out the contact form below.