New ATO release: compliance approach for professional firm profits

On 16 December 2021, the ATO published Practical Compliance Guideline PCG 2021/4 (PCG 2021/4) on its revised compliance approach to the allocation of profits or income from professional firms in the assessable income of the individual professional practitioner (IPP).

The PCG sets out a risk assessment framework to allow practitioners to understand how the Commissioner of Taxation assesses risk in relation to the allocation of profit arrangements and allows practitioners to assess their compliance risk, including a risk assessment scoring table and a 'traffic light' risk assessment rating of green (low risk), amber (moderate risk), or red (high risk).

What is PCG 2021/4 about?

IPPs, such as a law firm or accounting firm partner, have been known to enter arrangements involving the redirection of profits from a business to an associated entity where it has the effect of significantly reducing their tax liability. Several integrity measures exist in the tax legislation to ensure any tax benefit obtained through such an arrangement is nullified, most notably Part IVA of the Income Tax Assessment Act 1936 (Cth).

The ATO has now issued PCG 2021/4 which outlines the two 'gateways' and a risk assessment framework to rate IPP arrangements as low (green), moderate (amber) or high (red) risk.

What sort of arrangements are the ATO concerned about?

The ATO has identified arrangements that create artificial differences between taxable income and accounting income which are exploited to have the income assessed to individuals or businesses that pay little or no tax, while providing the economic benefits to other entities.

Not all profit allocation arrangements are in the Commissioner's crosshairs. The ATO acknowledges that:

• The use of companies, trusts and other business structures do not of themselves give rise to avoidance concerns. Further, the profit generated by the business may not be wholly generated by the individual and there may also be good non-tax reasons as to why the IPP receives significantly less of the business' profits than would otherwise be the case.

However where there is no sound commercial reason for such an arrangement, and it includes some "high risk" factors, the Commissioner will apply the anti-avoidance provisions or other integrity rules.

What does PCG 2021/4 mean practically?

PCG 2021/4 adopts a risk assessment methodology made up of three risk zones (low, moderate and high) to assess your profit allocation arrangement.

If an arrangement does not have a low (green zone) risk rating, the ATO considers it at risk of giving rise to an inappropriate tax outcome. Therefore, the ATO will likely conduct an audit to understand the facts and circumstances of your arrangement and the resulting tax outcome.

When is this PCG 2021/4 applicable?

The PCG 2021/4 applies if all of the following criteria are met:

1. an IPP provides professional services to clients of the firm or has a legal or beneficial interest in the firm;
2. the income of the firm is not personal services income (PSI) (PSI is income earned mainly as a result of personal efforts, rather than being generated by assets or employees of the firm and is dealt with under a different set of rules);
3. the firm operates by way of a legally-effective structure (such as a partnership);
4. an IPP is an equity holder, directly or through an associated entity;
5. the arrangement is commercially driven; that is, it satisfies Gateway 1, and
6. the firm and IPP do not demonstrate any high-risk features; that is, Gateway 2 is satisfied.

Where a taxpayer satisfies Gateways 1 and 2, they may self-assess your risk level against each of the risk assessment factors which has a corresponding score. The aggregate of the score against each risk assessment factor determines which risk zone the taxpayer falls within.

So, what are the 'Gateways' of this PCG 2021/4?

The PCG 2021/4 only applies if the two gateways are passed:

7. The ATO expect there to be a sound commercial rationale for entering into and operating the arrangement or structure; and
8. There must not be certain 'high-risk features'.

Gateway 1 - commercial rationale

Gateway 1 considers whether there is a genuine commercial basis for the arrangement and also for the way in which profits are distributed, with it being reflective of the commercial needs of the business. Furthermore, taxpayers must be able to substantiate that the stated commercial purpose was achieved as a result of the arrangement. It is not enough to simply state that 'asset protection' was the commercial driver behind the arrangement, if no asset protection can actually be proved as a result.

The presence of discrepancies between internal management documents, procedures and practices as well as the firm's constituent documents may indicate artifice or contrivance in the manner in which the arrangement is carried out. Furthermore, where an arrangement is overly complex compared to its objective, arrangements involving no real shift in value or circularity of money, or where the taxpayer's risk is very limited are all stated factors pointing towards an arrangement with no commercial basis.

Finally, the ATO state at paragraph 44 of PCG 2021/4, that "any change in tax performance, absent any other non-tax related practical changes, is a strong indicator of a lack of commercial rationale for the arrangement."

Gateway 2 - high-risk features

Once a taxpayer has successful passed through Gateway 1 by showing that the arrangement is commercially driven, the analysis then turns to whether the arrangement contains any "high-risk features".

The ATO considers potentially high-risk features as including:

• financing arrangements relating to non-arm's length transactions;
• exploitation of the difference between accounting standards and tax law; and
• multiple classes of shares and units held by non-equity holders.

The Commissioner considers arrangements with related parties generally involve a greater level of potential tax compliance risk.

Therefore, financing arrangements involving associated entities (such as an associated discretionary trust) that give rise to a tax benefit are considered high risk and extra compliance resources will be deployed to audit the scheme/arrangement.

More information from Maddocks

For more information, contact Maddocks on (03) 9258 3555 and ask to speak to a member of the Commercial team.

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