The ATO last week released Draft Practical Compliance Guideline PCG 2021/D2 in relation to the allocation of profits for professional firms and medical practitioners, to apply from 1 July 2021. And it says more about the use of power than it does about taxation laws.
Allocation of your business’s profits
PCGs are essentially statements the ATO makes on how they will go about doing their job of administering taxation laws. In this case, the issue is whether the ATO will have a problem with the allocation of your professional firm’s profits for assessing income tax.
The PCG is relevant only for professional firms where the profits are not “personal exertion” income. That is, it won’t apply to, for example, a sole trader (even where operating through an entity), as the profits must be allocated to that individual in any case. So, we’re generally concerning ourselves with professional firms that have professional staff in addition to the owners. The ATO’s concern is over the owners of a professional firm being taxed on an “artificially low” share of the business’s profits.
To be clear, there are no new laws here, and taxation laws fundamentally apply equally to all industries. Yet, it seems some industries are more equal than others. The PCG effectively amounts to the ATO singling out professionals and medical practitioners for a different approach to the administration of equal-applying taxation laws. Such discrimination is a rather unusual thing to see in 2021 at an institutional level.
The PCG sets out a series of measurements relating to the allocation of your business’s profits between the owners and related parties. Applying those measurements results in a score for your business which places you in one of three “risk zones”: Green, Amber or Red. This determines whether the ATO pays further attention to your business in relation to its allocation of profits. A greater proportion of the business’s profits being allocated to the owners shifts you towards the Green zone. As less and less is allocated to the owners, and more to related parties, this sends you to the Amber zone, and then the Red zone.
The zones determine whether the ATO will further investigate your arrangements in relation to the allocation of your business’s profits. If you’re in the Green zone, absent exceptional circumstances, the ATO will pretty much leave you alone. If you’re in the Amber or Red zones, expect further analysis of your arrangements. Priority focus will be given to those in the Red zone, perhaps even proceeding directly to an audit.
However, in order to qualify to apply the above zone scoring to your business, it must firstly pass two “Gateway” tests, relating to the commercial substance of the business’ structure and absence of high-risk features. It’s unclear where a professional business stands if it doesn’t pass both Gateway tests, and thus doesn’t qualify to apply the above Green/Amber/Red zone scoring system in the first place.
And then… what?
If you are in the Amber or Red zones, and the ATO investigates further, it’s unclear what the possible outcomes might be. To reiterate: Provided your business’s profits are not personal exertion income, and are allocated as permitted by your business structure (company, trust etc), your professional firm’s profits are no different to those earned in any other industry (such as retail selling of goods). Further, no anti-avoidance laws will have been offended in relation to the mere profit allocation itself. However, the ATO is pretending otherwise while offering no legal support for this.
One can only speculate that the ATO’s underlying goal is to intimidate professional and medical business owners into engineering unnecessarily conservative tax outcomes. There is a significant power differential at play here, as the vast majority of affected businesses are in no position to take up the legal fight with the ATO.
It’s also unclear how the ATO will review your zone self-assessment, as this is not readily ascertainable from the information disclosed in your business’s tax returns. Perhaps, they will select a random sample of professional firms, ask for your self-assessed zone score with support, and go from there.
Following a period for receiving comments, the draft PCG is expected to be finalised in the coming months, and the ATO will apply it to the 2021–22 year onwards. We will be keeping abreast of this, and for affected clients, we’re going to have to have a discussion.
Based on your existing profit-allocation practices, we’ll have to assess which zone you’ll likely land in for 2021–22. If it’s looking like you’ll land in the Amber or Red zones, and you’re uncomfortable with the position that puts you in as discussed above, we’ll need to plan for a different profit allocation that will shift you towards the Green zone.
Looking over the profit-allocation measurements, it seems many professional businesses’ current profit-allocation practices would likely place them in the Green or Amber zones in any case.
David Montani, national tax director, Nexia Australia