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ATO now targeting: professional firm profit allocations

Professional firms (include legal, accounting and financial services practices) have historically been structured as partnerships of natural persons. Today many professional firms more alternative structures which often involve distribution of business profits to entities associated with individual professional practitioners (IPPs), including trusts and companies.

In response to concerns about legitimacy of business profit allocations, the Australian Tax Office (ATO) released Practical Compliance Guidelines 2021/4 (Guidelines) . The Guidelines flag a major change in the compliance approach to professional firm’s profit allocation arrangements to IPPs. Last month, the ATO confirmed that they were contracting individual IPPS to find our more about their profit allocation arrangements and assist them with using the Guidelines.

This article provides some clarity around how the Guidelines apply to IPPs and will highlight the key risk features under the Guidelines that IPPs should carefully consider.

Nick Worth, Maddocks

What is the purpose of the Guidelines?

The Guidelines first came into effect on 1 July 2022 and aim to address concerns around whether income earned by an IPP is appropriately taxed, in particular where professional firm profits are redirected to an associated entity of an IPP.

IPPs are encouraged to use the Guidelines to self-assess the level of risk their particular income allocation arrangement faces with reference to the Guideline’s ‘traffic light’ risk framework. If an IPP’s circumstances align with the low-risk rating, the ATO would be unlikely to conduct compliance activities to test the tax outcomes of that arrangement.

The Guidelines provide general examples of arrangements that may be of concern to the ATO, such as where:

  • an IPP’s compensation from a services business is artificially low while the associated entities benefit disproportionately, and commercial reasons do not justify the relevant proportions;
  • actual direct compensation to the IPP does not reflect the individual performance of the IPP during the year in question; and
  • overall remuneration arrangements reflect an arrangement more closely resembling that of a highly-paid employee rather than a ‘partner’ of a firm (which is flagged as the most concerning arrangement by the ATO).

From a practical perspective, the Guidelines provide a basis for IPPs to potentially restructure from high-risk to low-risk arrangements.

Do the Guidelines apply to you?

The Guidelines capture all professional services business structures which may generate unintended tax consequences and compliance risks. For the Guidelines to apply, IPPs in professional services firms cannot be subject to the ‘personal services income’ tax rules. IPPs are referred to as individuals who provide services to clients of the firms in which they also have a legal or beneficial interest.

If you are an IPP who is allocated 100% of the firm’s profit entitlement and includes this in your personal tax return, this would automatically align that arrangement with the low-risk green zone and the other factors do not need to be considered.

Pass the gateways before applying the risk framework

Before applying the risk framework, the Guidelines explain two ‘gateway’ starting points that an IPP must first consider. The ATO suggests a potential consequence of not passing those gateways is the application of anti-avoidance provisions of the tax law. IPPs may also engage with the ATO if there is any doubt as to how the factors apply at professionalPdts@ato.gov.au.

Gateway 1: Determining the commercial rationale behind the profit allocation arrangement

There must be a sound commercial rationale that justifies operating the arrangement or structure in place. The Guidelines also ask that there is documentation or ‘evidence’ that the arrangement achieves a particular commercial purpose. Justifying the arrangement as a means of ‘asset protection’ for example is not on its own sufficient without evidence. An indication of a lack of commercial rationale includes if the arrangement seems more complex than is necessary to achieve the commercial objective.

Gateway 2: No ‘high-risk’ features 

The arrangement cannot have certain high-risk features. There are a number of examples the Guidelines describe and notably include the following in relation to the arrangement:

  • it has financing arrangements relating to non-arm’s length transactions;
  • it involves multiple assignments or disposals of an equity interest;
  • there is a misuse the superannuation system, including assignments or disposals of an interest to associated self-managed super funds (SMSFs); or
  • it distributes income to entities, other than the IPP, with losses.

Risk framework and assessment scores

After passing the gateways, IPPs may self-assess the level of risk associated with their arrangement using the scoring tables below. The overall risk level reflects the likelihood that the ATO would further analyse the facts and circumstances or initiate a compliance activity.

The Guidelines explain that ‘total effective tax rate’ under Factor 2 means the average rate of tax for the entire income received from the IPP by the firm. It is calculated as follows and excludes levies such as Medicare levy and surcharge: (total tax paid by the IPP, and associated entities of the IPP, on professional firm income) ÷ (Total firm income collectively received) × 100. It is expressed as a percentage.

Risk assessment factor

Score 1

Score 2

Score 3

Score 4

Score 5

Score 6

Factor 1: Proportion of profit entitlement from the whole of firm group returned in the hands of the IPP

More than 90%

More than 75% to 90%, inclusive

More than 60% to 75%, inclusive

50% or more to 60%, inclusive

More than 25% to less than 50%

25% or less

Factor 2: Total effective tax rate for income received from the firm by the IPP and associated entities

More than 40%

More than 35% to 40%, inclusive

30% or more to 35%, inclusive

More than 25% to less than 30%

More than 20% to 25%, inclusive

20% or less

Factor 3: Remuneration returned in the hands of the IPP as a percentage of the commercial benchmark for the services provided to the firm

More than 200%

More than 150% to 200%, inclusive

More than 100% to 150%, inclusive

More than 90% to 100%, inclusive

More than 70% to 90%, inclusive

70% or less

 

Risk zone

Risk level

Aggregate score against
first 2 factors

Aggregate of all 3 factors

Green

Low risk

7 or less

10 or less

Amber

Moderate risk

8

11 and 12

Red

High risk

9 or more

13 or more

 

What was the ATO’s previous approach?

The ATO’s former compliance approach was captured in the ‘Assessing the Risk: Allocation of profits within professional firms guidelines’ (Suspended Guidelines) which were suspended at the end of 2017. This was following a review that concluded that the guidelines were being misinterpreted by professional firms.

Taxpayers with pre-existing arrangements had been able to continue relying on the Suspended Guidelines up to 30 June 2022, provided their arrangements complied with those guidelines and satisfied the two gateways. Low risk arrangements under the Suspended Guidelines that now have a higher risk rating under the Guidelines however can continue to apply the Suspended Guidelines until 30 June 2024.

More information from Maddocks

For more information, contact Maddocks on (03) 9258 3555 and ask to speak to a member of the Tax & Structuring Practice Group.

More Cleardocs information on related topics

You can read earlier ClearLaw articles on a range of topics, such as:

Order related document packages

 

Lawyer in Profile

Paul Ellis
Paul Ellis
Special Counsel
PH: 61 3 9258 3524

Paul is a Special Counsel in the Maddocks Commercial team with particular expertise in commercial agreements for the supply of goods and/or services, the Personal Property Securities Act 2009, the National Consumer Credit Protection Act 2009 and the National Credit Code and the Australian Consumer Law.

Paul's key areas of practice include:

  • Australian Consumer Law;
  • credit and securities law;
  • commercial law and contracting;
  • government contracts; and
  • trust and superannuation law.

Before joining Maddocks, Paul was employed for 13 years with the Victorian Department of Justice, principally as a Deputy Registrar in the Victorian Magistrate's Court, but also as a legislation, policy and project officer for the Department.