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Allocation of professional firm profits: Understanding the new rules

The ATO’s recent guidance on the allocation of professional firm profits has caused an expected stir. It is important that firms understand the likelihood of the ATO examining their arrangements.

Insights Robyn Jacobson, The Tax Institute 26 March 2021
— 5 minute read

Background

The tax and accounting profession has shown a keen interest in the latest ATO guidance on the allocation of professional firm profits, issued in the form of draft Practical Compliance Guideline PCG 2021/D2 (draft PCG) on 1 March 2021. This follows the withdrawal of the previous ATO guidelines on 14 December 2017.

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The guidance has been developed in consultation with peak professional bodies and concerns arrangements involving taxpayers who redirect their income to an associated entity from a business or activity which includes their professional services. Such a taxpayer is referred to as the individual professional practitioner (IPP).

The guidance does not apply to income of the firm that that is personal services income (and subject to the PSI regime).

The draft PCG explains how the ATO intends to apply compliance resources when considering the allocation of professional firm profit or income in the assessable income of the IPP, and provides a risk diagnostic tool that allows taxpayers to self-assess against the risk assessment framework to determine the type of compliance attention that will be given to their arrangement. When finalised, the PCG is proposed to apply from 1 July 2021.

If the PCG is finalised in its present form, the ATO has clarified that the suspended guidelines will continue to have effect until 30 June 2021 for arrangements entered into prior to 14 December 2017. However, there is a further transitional ‘grace’ period until 30 June 2023. This has the effect of deferring the commencement date until 1 July 2023 (i.e. the 2023–24 income year) for those arrangements entered into prior to 14 December 2017 and having a higher risk rating under the new PCG.

Bear in mind that a PCG is not a legal interpretative document. PCGs are not public rulings, and they do not have the legally binding effect of a ruling. A PCG is simply a statement of the ATO’s risk approach. It is a guidance product that is intended to provide taxpayers with a clear understanding of where they reside, in the ATO’s view, on a risk assessment framework.

The draft PCG is designed to give you confidence that, if you determine your circumstances are ‘low-risk’, the ATO will generally not allocate compliance resources to test the relevant tax outcomes of your arrangement.

Preconditions for applying the guidance

A taxpayer cannot apply the risk assessment framework to the allocation of their professional firm profit unless their circumstances pass two ‘gateways’. Where an IPP’s circumstances pass Gateways 1 and 2, the risk assessment framework may be used by the practitioner and the ATO to understand what compliance attention will generally be given to the arrangement.

The first gateway requires there to be sound commercial rationale for entering into, and operating, the arrangement or structure. The way in which the operating structure is designed, and profits are distributed, should be based on commercial terms. The draft PCG sets out the various conditions which should be considered in reviewing the commercial substance of professional firm structures.

Under the second gateway, the arrangement must not contain any of the stated ‘high-risk’ features, including the following:

  • those covered by a Taxpayer Alert;
  • financing arrangements relating to non‑arm’s length transactions;
  • exploitation of the difference between accounting standards and tax law;
  • arrangements where a partner assigns a portion of a partnership interest that are materially different in principle from Everett and Galland; and
  • multiple classes of shares and units held by non‑equity holders.

Once you are through the ‘gateways’ you can move to the risk assessment framework.

Understanding the risk assessment matrix

The risk assessment framework is a ‘point scoring’ system and effectively brings the three criteria contained within the suspended professional firm guidance material and combines them into a single risk assessment framework. The higher the score, the riskier the arrangement and the greater the likelihood of the arrangement attracting the ATO’s attention.

Where you satisfy Gateways 1 and 2, you may self-assess your risk level against each of the following three risk assessment factors:

  1. Proportion of profit entitlement from the whole of firm group returned in the hands of the IPP.
  2. Total effective tax rate for income received from the firm by the IPP and associated entities (excludes any levy based on taxable income, such as the Medicare levy and the Medicare levy surcharge).
  3. Remuneration returned in the hands of the IPP as a percentage of the commercial benchmark for the services provided to the firm.

The circumstances are measured against each of these risk assessment factors to determine a corresponding score. The scores are then aggregated to determine which risk zone the arrangement falls within.

If the arrangement scores 10 or less, using all three risk assessment factors, it is considered low risk (green zone). If it is impractical to accurately determine an appropriate commercial remuneration against which to benchmark, then the first two risk assessment factors may be used (instead of all three), in which case a score of 7 or less would be needed to be considered low risk. The ATO will only apply compliance resources to review the allocation of profit under a green zone arrangement in exceptional circumstances.

If the score is 11 or 12, using all three risk assessment factors, (or 8 on the basis of the first two risk assessment factors), the arrangement is considered moderate risk (amber zone). The ATO is likely to conduct further analysis on amber zone arrangements.

If the score is 13 or higher, using all three risk assessment factors, (or 9 or higher on the basis of the first two risk assessment factors), the arrangement is considered high risk (red zone). The ATO is likely to commence reviews on red zone arrangements as a matter of priority. Cases may even proceed directly to audit.

Observations

There are a number of difficulties with the draft guidance. Of particular interest are the following concerns:

  1. Effective rate of tax: Benchmarking against the effective rate of tax is increasingly problematic due to the lower corporate tax rate that applies to base rate entities. When the original guidance was released by the ATO, the corporate tax rate was universally 30%. The reduction in the rate to 25% from 1 July 2021 will result in a score of 5 using risk assessment factor 2, making it much easier to fall in the amber or red zone. This is compounded by the recent increases in the personal income tax thresholds which now means that for an individual to have an average tax rate of 30%, they need to have earnings of just over $195,000.
  2. Amounts not known during the income year: The trustee of a discretionary trust can resolve to distribute — on the basis of a percentage approach rather than a dollar approach — 50.1% to the IPP on 30 June without knowing the actual amount of profit. This will result in a score of 4 using risk assessment factor 1. This may be problematic for a company that must distribute profit based on shareholdings and would likely not know the final profit at year end to ensure more than 50% is allocated to the IPP.
  3. Too easy to transition between zones: Slight changes in the allocation of profit can easily result in the arrangement moving from the amber zone to the green zone, or indeed from the green zone to the red zone. The risk zones could be recalibrated to widen the aggregate scores so that subtle changes do not result in arrangements being unduly characterised as moderate or high risk.

The draft PCG states that: ‘The ATO is continuing work to identify taxpayers whose circumstances fall outside this Guideline or who wish to nominate themselves as a test case to obtain further judicial guidance’. It will be interesting to see whether a taxpayer is bold enough to so nominate themselves.

The Tax Institute has formed a subcommittee which is working with members to determine the impact of the draft PCG. Public submissions are due by 16 April 2021.

Robyn Jacobson, senior advocate, The Tax Institute

Allocation of professional firm profits: Understanding the new rules
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