On 17 December 2021 the ATO released its finalised audit risk guidelines in relation to income splitting by professionals through practice entities: Practical Compliance Guideline - Allocation of professional firm profits: ATO compliance approach (PCG 2021/4). The final version effectively reproduces the draft issued for comment on 1 March 2021 (PCG 2021/D2).
Background
The author detailed the historical development of the income tax rules impacting the structuring of professional practices and the current state of play in this publication in “Professional practices – tax limbo continues,” Australian Tax Week Issue 35, 11 September 2020 at ¶694. The subsequent release of the March 2021 draft guidelines, together with draft PSI ruling TR 2021/D2, were discussed in “Professional Practices Update,” Australian Tax Week Issue 11, 1 April 2021 at ¶166.
The guidelines have had a gestation period of over four years since the previous audit risk guidelines were suspended in 2017. Members of professional practices have been operating in limbo during this period with the veritable sword of Damocles suspended over their heads.
Audit Risk and the Law/Lore
Audit risk guidelines are not a statement as to the ATO’s views as to the law but rather an indication of factors that might flag non-compliance with its rulings and lead to an audit. Audit risk guidelines issued in October 2014 (revised June 2015) identified three alternative low risk indicators, namely that a practitioner receives a typical market return for their services AND/OR that at least 50% of their income entitlement be assessable to them AND/OR that there be an effective tax rate of at least 30% on their income. It was these guidelines that were withdrawn on 14 December 2017 and have now been replaced by PCG 2021/4.
It is important to acknowledge at the outset that the ATO does state some questionable positions in its rulings dealing with income splitting by professionals (see IT 276, IT 2531, IT 25, IT 2330 and IT 2639). Notwithstanding the considerable caselaw and legislation (in particular, FCT v Everett [1980] HCA 6 and FCT v Galland [1986] HCA 83 on partnership assignments; FCT v Phillips (1978) 36 FLR 399 on services trusts; Gulland, Watson and Pincus 85 ATC 4765 on practice entities and income diversion; Part IVA and its jurisprudence) the rulings place little focus on these specifics but rather focus on a distinction between income from personal exertion (where, apart from superannuation contributions for the benefit of the principal(s), all practice income must be paid to them) and income from a business structure. Thus, while no practitioner would want to be audited a failure to comply with these rulings may not necessarily be contrary to the law.
Practical Compliance Guideline PCG 2021/4
The primary difference between the draft and final PCG is as to the start date that has now been deferred by 12 months to 1 July 2022 (for those arrangements in compliance with the suspended guidelines, commercially driven and not exhibiting certain high-risk features (identified in paragraph 47)). The two-year transitional period has similarly been extended to 1 July 2024 for arrangements entered into prior to 14 December 2017 and having a higher risk rating under the new PCG (again assuming commercially driven with no additional risk factors). Other changes from the draft are the inclusion of further explanation, detailed below, and additional examples as to how the ATO will apply the guidelines.
The final PCG restates that the risk framework that the ATO will adopt to determine if it will audit the structure of a professional firm is the application of two gateway tests followed by consideration of a risk rating score table (if the gateways are passed). The PCG specifies three tax compliance risk zones (green, amber and red) dictated by taxpayer behaviour and arrangements.
The Gateways
The requirement that an arrangement have a commercial rationale is the first gateway that must be first passed through. There must be both a genuine commercial basis for the arrangement and the way in which the profits are distributed. The structure should assist or improve the business’ ability to make profits and there should be clear compliance in practice with the constitutional requirements of the structure.
The various factors to consider are detailed in paragraphs 45 and 46 and include whether the arrangement includes steps that appear only to provide a tax advantage, whether the parties are operating on non-commercial terms or in a non-arm’s length manner, whether the individual practitioners receive an amount of income that reflects their personal efforts or skill and whether the income is distributed to them in substance and not just form.
The second gateway is that the arrangement must not contain any identified high-risk features such as those covered by a Taxpayer Alert, financing arrangements relating to non-arm’s length transactions (an associated entity of a practitioner should not borrow to acquire an existing portion of the practitioner’s interest in a professional firm), exploitation of differences between accounting standards and tax law (such as enabling income to be assessed to entities that pay little or no tax while allowing others to enjoy the economic benefits), assignments materially different from Everett and Galland, and multiple classes of shares and units held by non-equity holders (in particular without accompanying voting rights and where income entitlements are discretionary): paragraphs 50 to 59.
Paragraphs 55 and 56 detail when arrangements will be considered materially different in principle to Everett and Galland as arrangements purporting to admit an individual as a partner, where the individual is not an owner or equity holder in the partnership, and arrangements where the practitioner’s relationship has characteristics indicating their relationship with the partnership is akin to a contractor or employee. Furthermore, factors identified as indicating that there has been a departure from Everett and Galland are stated to include indemnification of the assignee against any professional liability in respect of actions against the partnership, a fixed draw or salary (particularly where there is limited or no exposure to the risks and benefits associated with the performance of the partnership) and a lack of rights to full participation in management and the benefits of the partnership.
These paragraphs are difficult to understand as the essence of an Everett and Galland assignment is that the assignee (from a partner) does not become a partner nor have any involvement in the management of the partnership and would be expected to be indemnified from partnership liabilities. It is unclear whether the paragraphs are simply poorly worded or there is a failure to comprehend the true nature of the assignment.
Risk rating score table
Once through the gateways the risk assessment framework is a point scoring system for each individual professional practitioner (IPP). The table at paragraph 76 sets out the score for each risk assessment factor:
Background
The author detailed the historical development of the income tax rules impacting the structuring of professional practices and the current state of play in this publication in “Professional practices – tax limbo continues,” Australian Tax Week Issue 35, 11 September 2020 at ¶694. The subsequent release of the March 2021 draft guidelines, together with draft PSI ruling TR 2021/D2, were discussed in “Professional Practices Update,” Australian Tax Week Issue 11, 1 April 2021 at ¶166.
The guidelines have had a gestation period of over four years since the previous audit risk guidelines were suspended in 2017. Members of professional practices have been operating in limbo during this period with the veritable sword of Damocles suspended over their heads.
Audit Risk and the Law/Lore
Audit risk guidelines are not a statement as to the ATO’s views as to the law but rather an indication of factors that might flag non-compliance with its rulings and lead to an audit. Audit risk guidelines issued in October 2014 (revised June 2015) identified three alternative low risk indicators, namely that a practitioner receives a typical market return for their services AND/OR that at least 50% of their income entitlement be assessable to them AND/OR that there be an effective tax rate of at least 30% on their income. It was these guidelines that were withdrawn on 14 December 2017 and have now been replaced by PCG 2021/4.
It is important to acknowledge at the outset that the ATO does state some questionable positions in its rulings dealing with income splitting by professionals (see IT 276, IT 2531, IT 25, IT 2330 and IT 2639). Notwithstanding the considerable caselaw and legislation (in particular, FCT v Everett [1980] HCA 6 and FCT v Galland [1986] HCA 83 on partnership assignments; FCT v Phillips (1978) 36 FLR 399 on services trusts; Gulland, Watson and Pincus 85 ATC 4765 on practice entities and income diversion; Part IVA and its jurisprudence) the rulings place little focus on these specifics but rather focus on a distinction between income from personal exertion (where, apart from superannuation contributions for the benefit of the principal(s), all practice income must be paid to them) and income from a business structure. Thus, while no practitioner would want to be audited a failure to comply with these rulings may not necessarily be contrary to the law.
Practical Compliance Guideline PCG 2021/4
The primary difference between the draft and final PCG is as to the start date that has now been deferred by 12 months to 1 July 2022 (for those arrangements in compliance with the suspended guidelines, commercially driven and not exhibiting certain high-risk features (identified in paragraph 47)). The two-year transitional period has similarly been extended to 1 July 2024 for arrangements entered into prior to 14 December 2017 and having a higher risk rating under the new PCG (again assuming commercially driven with no additional risk factors). Other changes from the draft are the inclusion of further explanation, detailed below, and additional examples as to how the ATO will apply the guidelines.
The final PCG restates that the risk framework that the ATO will adopt to determine if it will audit the structure of a professional firm is the application of two gateway tests followed by consideration of a risk rating score table (if the gateways are passed). The PCG specifies three tax compliance risk zones (green, amber and red) dictated by taxpayer behaviour and arrangements.
The Gateways
The requirement that an arrangement have a commercial rationale is the first gateway that must be first passed through. There must be both a genuine commercial basis for the arrangement and the way in which the profits are distributed. The structure should assist or improve the business’ ability to make profits and there should be clear compliance in practice with the constitutional requirements of the structure.
The various factors to consider are detailed in paragraphs 45 and 46 and include whether the arrangement includes steps that appear only to provide a tax advantage, whether the parties are operating on non-commercial terms or in a non-arm’s length manner, whether the individual practitioners receive an amount of income that reflects their personal efforts or skill and whether the income is distributed to them in substance and not just form.
The second gateway is that the arrangement must not contain any identified high-risk features such as those covered by a Taxpayer Alert, financing arrangements relating to non-arm’s length transactions (an associated entity of a practitioner should not borrow to acquire an existing portion of the practitioner’s interest in a professional firm), exploitation of differences between accounting standards and tax law (such as enabling income to be assessed to entities that pay little or no tax while allowing others to enjoy the economic benefits), assignments materially different from Everett and Galland, and multiple classes of shares and units held by non-equity holders (in particular without accompanying voting rights and where income entitlements are discretionary): paragraphs 50 to 59.
Paragraphs 55 and 56 detail when arrangements will be considered materially different in principle to Everett and Galland as arrangements purporting to admit an individual as a partner, where the individual is not an owner or equity holder in the partnership, and arrangements where the practitioner’s relationship has characteristics indicating their relationship with the partnership is akin to a contractor or employee. Furthermore, factors identified as indicating that there has been a departure from Everett and Galland are stated to include indemnification of the assignee against any professional liability in respect of actions against the partnership, a fixed draw or salary (particularly where there is limited or no exposure to the risks and benefits associated with the performance of the partnership) and a lack of rights to full participation in management and the benefits of the partnership.
These paragraphs are difficult to understand as the essence of an Everett and Galland assignment is that the assignee (from a partner) does not become a partner nor have any involvement in the management of the partnership and would be expected to be indemnified from partnership liabilities. It is unclear whether the paragraphs are simply poorly worded or there is a failure to comprehend the true nature of the assignment.
Risk rating score table
Once through the gateways the risk assessment framework is a point scoring system for each individual professional practitioner (IPP). The table at paragraph 76 sets out the score for each risk assessment factor:
