ATO Compliance Guidance issued for Allocation of Firm Profits
ATO Compliance Guidance issued for Allocation of Firm Profits
During December 2021, the Commissioner issued Practical Compliance Guideline PCG 2021/4 titled Allocation of professional firm profits — ATO compliance approach (the Guideline).
The Guideline sets out the Australian Taxation Office’s (ATO) compliance approach in relation to the allocation of profits or income from professional firms being recognised in the assessable income of the individual professional practitioner (IPP).
At a high level the ATO is concerned about arrangements which involve redirecting income or profits from a professional firm to related parties and where this has the effect of reducing the tax liability of the relevant IPP.
In particular, the ATO is concerned about arrangements where:
- taxpayers redirect their income to an associated entity from a business or activity which includes their professional services, with the effect of significantly reducing their tax liability;
- in the context of business structures involving company and trust entities, the compensation received by an individual is artificially lowered while associated entities or other the individuals benefit, and commercial reasons do not justify the arrangement.
Relevant taxpayers can use the risk assessment guidelines to assess whether they are rated as low, moderate or high risk using the parameters set out in the Guideline, as reproduced in the two tables below.
The risk rating determines the ATO’s allocation of compliance resources. If the client has a low risk rating, the ATO will generally not devote compliance resources to review the individual’s allocation of professional firm profits, except to ensure that the self-assessment is appropriately supported and evidenced.
If the arrangement falls within the moderate risk or high risk zones, the ATO is likely to undertake review activities and request further information. This will be treated as a matter of priority in the case of a high risk assessment.
What is the date of effect?
The Guideline applies from 1 July 2022. The ATO will review the use and application of the guideline from and during the 2022–23 income year.
What is the scope of the Guideline?
The Guideline applies to tax compliance risks associated with relevant arrangements within professional firms including (but not limited to) accounting, financial services, legal, medical, architectural, engineering and management consulting professions.
The Guideline sets out a proposed risk assessment framework to indicate the level of compliance attention that the ATO show in relation to profit allocation arrangements. Under a self-assessment system, an IPP may use the Guideline to:
- determine the level of risk applicable to their profit allocation arrangement, based on the risk assessment framework;
- determine what level of interaction with the ATO they can expect, based on their risk assessment level; and
- provide the opportunity for an application for binding advice with the ATO (if necessary).
When will the Guideline apply to an arrangement?
The Guideline applies if all of the following criteria are met:
- An IPP provides professional services to clients of the firm, or is actively involved in the management of the firm, and (in either case) the IPP or any associated entities have a legal or beneficial interest in the firm entity;
- The income of the firm is not subject to the personal services income (PSI) rules;
- The firm operates by using a legally effective structure (ie. partnerships, trusts or companies);
- The IPP is an equity holder in the structure (directly or indirectly);
- The arrangement is commercially driven (see Gateway Test 1 below);
- The firm and IPP do not demonstrate any high risk features (see Gateway Test 2 below).
An IPP will be expected to make a documented annual assessment of their eligibility to apply the Guideline, and also review eligibility in the event of business, structure or arrangement changes.
What are the two gateway tests that need to be satisfied to apply the Guidelines?
The Gateway Test 1 is the commercial rationale test, and it can be passed where there exists a commercial basis for the arrangement and the way profits are distributed to the IPP.
Factors that suggest a lack of commercial rationale, include where the arrangement:
- Seems more complex than is necessary to achieve the relevant commercial objective;
- Includes a step (or multiple steps) which appear to serve no real purpose other than to gain a tax advantage (ie. arrangements that involve a circular distribution of funds);
- Results in a tax result that appears to be at odds with its commercial or economic result;
- Results in little or no risk in circumstances where significant risks would normally be expected;
- Operates on non-commercial terms or in a non-arm's length manner (ie. using loans with interest rates above/below the market rate); or
- Present a gap between the substance of what is being achieved and the legal form it takes.
It is also necessary to consider whether there is a commercial basis in the way profits are distributed.
The Gateway Test 2 is the high risk factors test, and this test is failed if the arrangement is covered by an ATO Taxpayer Alert or it contains certain high risk features.
The ATO has flagged the following as being potentially high risk features (but not limited to):
- 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 their partnership interest to another individual or entity which is a related party or the IPP's relationship with the firm is more akin to a contractor or employee of the entity; or
- Multiple classes of shares or units are held by non-equity holders (ie. issuing shares which contain discretionary dividend rights to associated entities of the equity holder or individual professional).
If both Gateway Tests are satisfied, how is the IPP’s risk rating determined?
Where you satisfy Gateways 1 and 2, you may self-assess your risk level against each of the risk assessment factors (per the first table below).
If the IPP’s entire profit entitlement (ie. 100%) from the professional firm’s group is assessed to the IPP (ie. no income or profits are taxed in the hands of related parties or associated entities), then the arrangement should be treated as low risk and there is no need to assess against the risk factors (described in the first table below). A low risk rating will generally not attract the ATO’s compliance resources to test the relevant tax outcomes of the IPP’s arrangement.
On the other hand, where an IPP (and their tax advisers) perform a review (against the first risk assessment table below) and it identifies that a practitioner has either a moderate risk or high risk rating, the ATO is likely to implement some review activities and request further information. This will be treated as a matter of priority in the case of a high risk assessment.
How do the risk assessment tables determine the risk rating?
The following table sets out the score for each risk assessment factor:
| Risk assessment factor score |
|---|
| 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 |
| 3) Remuneration returned in the hands of the IPP as a percentage of the commercial benchmark for the services provided to the firm |
| 1 | 2 | 3 | 4 | 5 | 6 |
|---|---|---|---|---|---|
| > 90% | >75% to ≤90% | >60% to ≤75% | >50% to ≤60% | >25% to <50% | ≤25% |
| >40% | >35% to ≤40% | >30% to ≤35% | >25% to <30% | >20% to ≤25% | ≤20% |
| >200% | >150% to ≤200% | >100% to ≤150% | >90% to ≤100% | >70% to ≤90% | ≤70% |
An IPP can self-assess your profit allocation arrangement using:
- risk assessment factors 1 and 2 only, or
- all three risk assessment factors (nb. the use of the third risk assessment factor is optional as it is difficult to determine accurately).
The following table sets out the risk rating depending on whether you risk assess against two factors or all three factors (in the table above):
| Risk Zone | Risk Level | Aggregated score against first two factors | Aggregated score of all three factors |
|---|---|---|---|
| Green | Low Risk | ≤ 7 | ≤ 10 |
| Amber | Moderate Risk | 8 | 11 & 12 |
| Red | High Risk | ≥ 8 | ≥ 13 |
Conclusion
The overriding message of the Guideline is that an IPP needs to continue to maintain accurate records of their income distributions from professional firms and early engagement with the ATO is encouraged when it is required.
Where an IPP (and their tax advisers) perform a review and identifies that the practitioner has either a moderate risk or high risk rating, but they want to transition their arrangements to a lower risk zone, the IPP can inform the ATO of their intentions and this engagement will be treated on a ‘without prejudice’ basis (where the IPP is acting in good faith).
Please do not hesitate to contact your Lowe Lippmann Relationship Partner if you wish to discuss any of these matters further.
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