For many years the Australian Taxation Office (ATO) has been concerned that an insufficient portion of the profits of professional firms have been taxed in the hands of the firm’s partners. Instead, those profits have been distributed to related entities of the partner who are on lower tax rates, thus reducing the overall tax burden for the partner’s family group.
The ATO has tackled this concern by issuing guidance setting out 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 (Practical Compliance Guidance 2021/4 – Allocation of professional firm profits – ATO compliance approach – ‘PCG’).
Who does the PCG apply to?
The PCG will apply 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 are working in professional firms but not showing taxable income commensurate with the value of the services that they provide. Instead, profit distributions are being made to an associated entity and a tax benefit is being obtained.
It’s clear from the PCG 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 these IPPs (and the firms that they work in) will have a tax risk management issue. 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 proposes to apply some initial gateway factors and then a risk calculation to assess the appropriateness of the profit allocation arrangements of IPPs. If the gateway factors are not satisfied, the arrangement may automatically be considered high risk of an ATO review or audit.
If the arrangements pass the initial gateways pertaining to ‘sound commercial rationale’, and no ‘high risk features’, then a risk rating is calculated. The calculation looks at a combination of factors relating to proportion of profit entitlement the IPP receives, the 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
- 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 (such as salaried partners) or their associates should be taxable income for the practitioner.
Having a different class of shares, or units with discretionary income entitlements, held by non-equity holders is a high-risk feature, as are Everett assignments by non-equity holders. Everett assignments generally are subject to ATO scrutiny.
All firms with ‘non-equity’ partners, principals, directors etc will need to review their current arrangements.
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 is questioning whether this is actually considered personal income for the IPP.
Related party financing and refinancing arrangements are also considered a high-risk feature. 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 which on their own account will bring IPPs profit sharing arrangements into ATO focus, including Division 7A loans and section 100A (reimbursement arrangements). For firms, service trust arrangements and the valuation of goodwill on entry/exit of IPPs are also focus areas.
William Buck assessment of the guidance
One of the biggest criticisms of the PCG is that the ATO does not provide any real legal justification for its views. The ATO acknowledges 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, it may well be upheld by a court in the future, but 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 PCG risk assessment framework, following these principles should assist in minimising the risk of attracting the ATO’s attention.
The ATO has announced that transitional arrangements will be in place for certain IPPs through until 2024. This will give most professional firms and IPPs time to restructure their affairs to better manage their tax risk.
For assistance on assessing and managing your tax position, contact your local William Buck Tax Advisor.
