For many years, the Australian Taxation Office (ATO) has been concerned that an insufficient portion of professional firms’ profits had been taxed in the hands of the firm’s partners. Instead, those profits have been distributed to related individuals and/or entities of the partner who are on lower tax rates, thus reducing the overall tax burden for the partner’s family group.
The ATO’s most recent guidance on which features of profit allocations it would regard as creating tax risk and which will lead to an increased likelihood of ATO review or audit of those partners and their businesses, can be found in Practical Compliance Guidance 2021/4 (PCG). This guidance goes through the allocation of professional firm profits and the– ATO’s compliance approach.
Importantly, the ‘transitional arrangements’ in the PCG allowed existing arrangements to continue relying on the previous guidance, which was more concessional, and came to an end on 30 June 2024. Therefore, from 1 July 2024, all allocation of professional firm profits are subject to the guidance in the PCG regardless of when the arrangements commenced.
Who does the PCG apply to?
The PCG applies to ‘individual professional practitioners’ (IPPs) in a wide range of professional firms including, but not limited to, engineers, architects, medical practitioners, consultants, accountants and lawyers.
The ATO broadly considers an IPP to be a ‘partner level’ person who holds equity in the practice either personally or via a related party such as a family trust or spouse. The actual title of the person, such as partner, principal or director, is not the relevant factor.
The ATO’s core concern is that IPPs work in professional firms but do not show taxable income commensurate with the value of the services that they provide individually. Instead, profit distributions are being made to an associated entity and a tax benefit is being obtained.
It’s clear from the Practical Compliance Guidance that the ATO has encountered IPPs and professional firms that are pursuing aggressive tax planning strategies. These professional firms can expect ATO review or audit activity in the near future.
However, the PCG can apply to all IPPs in professional firms, the majority of whom are likely complying with their tax obligations. As such, even compliant IPPs and the firms that they work in will have a tax risk management issue to contend with. They will need to reconsider their tax arrangements to ensure they fall within the ATO guidelines, or otherwise face the likelihood of an ATO review or audit.
How do the guidelines work?
The ATO applies some initial ‘gateway factors’ followed by a risk calculation to assess the appropriateness of the profit allocation arrangements of IPPs. If these factors are not satisfied, the arrangement may automatically be considered ‘high risk’ and an ATO review or audit is much more likely.
If the arrangements pass the initial gateways pertaining to ‘sound commercial rationale’, and no ‘high risk’ features’, a risk rating is then calculated.
The calculation looks at a combination of factors relating to the proportion of profit entitlement the IPP receives, the overall tax rate paid on profits and market value remuneration for the IPP.
The three risk profiles that could then arise are as follows:
- Green ‘low risk’ – should not attract the ATO’s attention
- Amber zone ‘moderate risk’ – likely to be further analysed by the ATO, and
- Red zone ‘high risk’ – likely to be subject to an ATO review or audit
What arrangements will increase your risk?
Salaried partners and non-equity holders
The ATO is of the view that all of the profits allocated to non-equity holders like salaried partners or their associates should be taxable income of the IPP.
Having a different class of shares or units with discretionary income entitlements, held by non-equity holders, is automatically considered a high-risk feature, as are ‘Everett assignments’ by non-equity partners. ‘Everett assignments’ generally are subject to ATO scrutiny.
All firms with ‘non-equity’ partners, principals, directors, etc. will need to review their arrangements from 1 July 2024.
Equity holders
Even for equity holders, the use of shares or units with discretionary income entitlements can be problematic. Where the income distributions are determined using metrics based on individual performance, the ATO will generally question whether this should be considered personal income of the IPP.
Related-party financing and refinancing arrangements are also considered high-risk features. This is particularly true where the IPP utilises financing arrangements involving associated entities to acquire some or all of their existing equity interest in a professional firm.
‘Exotic’ and non-standard structures
‘Exotic’ and non-standard structures in any business sector always tend to attract the attention of the ATO, and it’s no different for professional practices, where the ATO is looking for evidence of a genuine commercial rationale for the arrangements.
Some other areas of concern
The guidance also highlights other areas of concern that may bring IPPs’ profit-sharing arrangements into the ATO’s focus, including Division 7A loans and Section 100A (reimbursement arrangements) distributions. Further, service trust arrangements and the valuation of goodwill on entry/exit of IPPs are always focus areas for the ATO.
William Buck’s assessment of the guidance
One of the biggest criticisms of the Practical Compliance Guidance was that the ATO did not provide any real legal justification for its views. The ATO acknowledged that the PCG is a risk assessment tool and not a statement of the law. Importantly, that does not make the ATO’s view wrong as it may well be upheld by a court in the future. However, it does highlight a practical problem facing taxpayers who fall within the scope of the PCG.
The low-risk strategy is for an IPP to arrange their affairs to achieve a ‘Green’ risk rating. The trade-off is that this may require the IPP to pay more tax than would otherwise be the case.
An alternative strategy is for an IPP to follow the law as it currently stands, even if this results in an ‘Amber’ or ‘Red’ risk rating. The challenge with this approach is that the additional compliance costs to deal with an ATO review may exceed the tax savings that are achieved.
Ultimately, where an IPP sits on the risk scale is a commercial decision for each IPP – what risk are you prepared to accept and what price would you be prepared to pay to mitigate that risk?
If you are prepared to adopt a risk rating other than ‘Green’, but still wish to mitigate some level of risk, it is important to go back to the core of the ATO concerns – the level of personal taxable income for the IPP – is it lower than ‘market rate’? This includes all forms of remuneration such as salary, superannuation, benefits, profit distributions, etc. To mitigate this aspect, IPPs should have personal remuneration that makes commercial sense. Comparability with the remuneration of senior employees would be one factor. Changes in personal remuneration, as the IPP takes on additional responsibilities, would be another.
IPPs, and the firm overall, should structure profit allocation arrangements to achieve a level of personal remuneration that makes the IPP an unattractive target for ATO compliance resources by:
- structuring remuneration arrangements in a way that can be commercially justified, and does not look artificial or contrived, and
- ensuring that the level of personal income reported by the IPP compares to senior employees in the organisation or industry.
Even if a ‘Green’ rating can’t be achieved under the practical compliance guidance’s risk assessment framework, following these principles should help minimise the risk of attracting the ATO’s attention. or any ATO audit or review resulting in adverse findings.
For assistance in assessing and managing your tax position, contact your local William Buck Tax Advisor.
