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Tax & AccountingJanuary 14, 2022

Long awaited professional practices income splitting guidelines finalised

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 It was these guidelines that were withdrawn on 14 December 2017 and have now been replaced by PCG 2021/4.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:

Score
 Risk assessment factor  1 2 3 4 5 6
1. Proportion of profit entitlement from the whole of firm group returned in the hands of the IPP >90% 

 >75%

to

≤90%

 >60%

to

≤75%

 ≥50%

to

≤60%

 >25%

to

<50%

 ≤25%
 2. Total effective tax rate for income received from the firm by the IPP and associated entities1  >40%

 >35%

to

≤40%

 

 ≥30%

to

≤35%

 >25%

to

<30%

 >20%

to

≤25%

 ≤20%
 3. Remuneration returned in the hands of the IPP as a percentage of the commercial benchmark for the services provided to the firm  >200%

 >150%

to

≤200%

 >100%

to

≤150%

 >90%

to

≤100%

 >70%

to

≤90%

 ≤70%

1 Levies based on taxable income are ignored.

Risk assessment factor 1 provides a score depending on the proportion of the profit entitlement that is returned personally to the practitioner compared to the total income to which they and their associated entities are entitled from the whole firm group including the income from any service or other associated entity. In the event that a practitioner returns all their profit entitlement from the firm in their personal tax return then they will automatically fall within the green zone and are not required to assess against the other two risk factors.

Risk assessment factor 2 provides a score depending on the total effective tax rate paid by the practitioner and their associated entities. ‘Effective tax rate’ refers to the average rate of tax paid across the entire income from the firm (a formula is provided that allows for other sources of income and deductions).

Note that a practitioner’s superannuation contributions are included, whether or not made by the firm, in the calculation of the effective tax rate given that the amount would otherwise have flowed to the practitioner as a profit distribution. However, where superannuation contributions are deductible to the practitioner or the firm then, as they will be subject to tax in the hands of the superannuation fund at a rate of 15%, this tax paid should be included in the calculations: see paragraphs 95 and 96.

Risk assessment factor 3 requires consideration of the remuneration returned in the hands of the practitioner as a percentage of the commercial benchmark for the services they provide to the firm. A list of appropriate benchmarks, and factors if no benchmarks are available, are contained in paragraphs 101 and 102. The benchmark must include all components of remuneration such as salary, superannuation and fringe benefits. Benchmarks are to be reviewed annually.

Paragraph 105 accepts that an acceptable benchmark may be established if the business approached an employment agency and negotiated remuneration based on the considerations outlined in paragraphs 101 and 102.

Additional guidance in the final PCG

The final PCG includes some additional guidance from the draft, namely:

• Part-time practitioners - the assessment under risk assessment factor 2 should be made on a pro-rata basis and profit allocation should be adjusted to a full-time equivalent in order to assess the level of risk.
• Remuneration - all components of remuneration are to be included in the risk assessment (including cash, superannuation, fringe benefits and any other non-cash benefits).
• Fringe benefits tax – where fringe benefits tax is paid by the firm the tax paid is to be included in determining risk assessment factor 2.
• Other relevant considerations – the PCG accepts that there may be a number of other relevant factors pertaining to individual arrangements which will affect a risk rating. These may include timing differences, retention of income within a firm in a particular year for commercial purposes, access to tax concessions and provisions including accelerated depreciation and instant asset write-off, and other extraordinary business factors. In such cases the ATO is open to engagement.

Risk assessment table
After tallying the risk assessment factor scores the total is assessed according to the following table from paragraph 78:

Risk zone  Risk level  Aggregate score against first two factors  Aggregate of all three factors*
 Green  Low risk
 
 ≤ 7  ≤ 10
 Amber  Moderate risk  8  11 & 12
 Red  High risk  ≥ 9  ≥ 13

*The ATO accepts that the use of the third factor is optional given the difficulty of determining benchmark remuneration.

If the arrangement falls within the amber or red 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 red assessment. If the arrangement falls within the green zone, then the ATO will generally only apply compliance resources to ensure that the self-assessment is appropriately supported and evidenced. However, reviews may still be conducted if other risks are present as the guidance solely focuses on the audit risk driven by the allocation of profits.

Evidentiary requirements
Practitioners must retain evidence to support that they have undertaken a risk assessment review, including evidence as to how they have satisfied the gateways, which the ATO may request to sight. This assessment and evidence must be reviewed annually or upon a change in the arrangement or business.

Conclusion
Retention of evidence of the annual assessment and early engagement with the ATO are the takeaway messages from this PCG. Paragraphs 115 to 119 state that if upon a review it is identified that a practitioner is no longer low risk but wishes to transition their arrangements to a lower risk zone they can inform the ATO of their intentions and, provided they engage in good faith, this engagement will be on a ‘without prejudice’ basis. The PCG recognises that there may be different requirements for transition depending on the current arrangements of the practitioner and their firm and that some arrangements will have flexibility and sufficient discretion in terms of distribution of firm income to enable compliance with the PCG for the year ending 30 June 2025 and subsequent years while other arrangements may require structural change.

Certainly, the new approach adopted in the PCG may well result in structures that previously enjoyed a low audit risk rating being moved to an amber risk setting (at least). Now such taxpayers should have an expectation that they will be called upon to justify their structure where previously this may not have been the case. Unfortunately, this may result in a greater degree of uncertainty in practice.

Even those operating in the green zone need to be wary as the PCG identifies that the ATO may make enquires of a green zone taxpayer should there be any “drift” towards the limit of the green zone arising from additional profit shifting following the release of this guidance. Any such drift will need to be justified on commercial grounds.

Finally, the PCG states, at paragraph 6, a motherhood statement to the effect that the ATO’s concern increases the more the actual return to a practitioner is linked to their individual performance during the year in question (as contrasted to a given share of the overall profit of the professional firm, a share which may increase over time as the partner’s contribution to the partnership accumulates) but is not reflected in the actual direct compensation to the individual. Although possibly appropriate from an audit risk methodology perspective it should be re-iterated that the underlying principles are clear that while income from personal exertion cannot be split, income from a business may be distributed however the structure allows with the only qualification that should a principal not receive an appropriate return this will trigger the need for a commercial justification.

Justin Dabner
Principal - Tax Resolutions
Justin has in excess of 35 years of experience in tax consulting and education. The author of many hundreds of publications and presentations, Justin is a regular contributor to CCH Australian Tax Week and an author for Thomson Reuters Tax Commentary.
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