Contributed by Dr Justin Dabner, Principal of Tax Re-solutions, Tax advisory and education services
Background
It is difficult to be too critical of the ATO presently, with the demands on it delivering the government stimuli, but this is little consolation for professionals seeking some clarity as to acceptable tax planning structures for their practices. The audit risk safe harbour guidelines were withdrawn at the end of 2017, on the promise of a revised set of guidelines within 6 months, yet almost 3 years on this undertaking has still not been met. This short article stocktakes where we are currently with tax planning structures for professionals.
First, a trip back in time
The late 70s and early 80s were the formation years for setting the principles for tax planning structures for professionals. In the late 70s FC of T v Phillips 78 ATC 4361; (1978) 36 FLR 399 had endorsed an opportunity for professionals to deflect some income through the establishment of a services trust as long as the fees paid were commercially justifiable and there was a business case for the arrangement. ATO blessing was forthcoming (IT 276). Then the cases of FC of T v Everett 80 ATC 4076; [1980] HCA 6 and FC of T v Galland 86 ATC 4885; [1986] HCA 83 established that partners could assign a right to income to their spouse or family trust, thereby setting partners apart from sole practitioners for whom the opportunities to deflect income for tax purposes were more limited. Sole practitioners were, typically, viewed as deriving income from their personal exertions rather than from some assignable right or contract.
During this period perverse distinctions existed in the tax deductibility of contributions to superannuation funds that prejudiced self-employed taxpayers. Initially administration entities were used as a common structure to mitigate this prejudice. Professionals, not permitted to operate via a corporate entity when providing professional services, split their time between their professional practice and working on administrative matters as an employee of an administrative entity that on-charged their time back to the practice. This structure allowed some access to the more generous tax deductions for employer superannuation contributions (IT 2531).
Eventually pressure was exerted on professional bodies (and government) to allow professionals to operate as employees of practice entities, justifiable by the superannuation and, to a lesser extent, asset protection advantages (IT 25). In the three doctors’ cases of Gulland, Watson and Pincus 85 ATC 4765 the High Court mandated that the use of these practice entities to split income to family members would breach the general anti-avoidance rule (GAAR). The ATO soon ruled that this precedent equally applied to its new GAAR in the form of Part IVA (IT 2330).
Thus, the standard structure became the practice company with an associated services trust and (self-managed) superannuation fund. All practice income after deducting service trust fees and superannuation contributions for the practitioner was paid to the practitioner in some form (including by way of fringe benefits once salary packaging became the fashion in the late 80s).
The growth in the advent of independent contractors led to the introduction of the personal services income (PSI) rules in 2000 on the recommendation of the 1999 Ralph review into business taxation. Professional practices were a potential casualty of these rules requiring advisers to identify whether one of the four personal services business (PSB) tests might alleviate the need to attribute the practice income to the professional and deny them business related deductions. Although the initial prospect was that satisfaction of the PSI rules would operate as a safe harbour from the GAAR applying the ATO soon ruled that these were additional rules and Part IVA could still apply even where a PSB existed (TR 2001/8).
The subsequent period might be characterised as one were practitioners sought to push the boundaries of the rules while the ATO demonstrated increasing annoyance with the income splitting opportunities available, particularly Everett assignments and services trusts. At the same time the ATO was developing a more nuanced position pivoting on a distinction between income derived from personal exertion (not able to be split) and that derived from a business utilising assets and/or employees (able to be split).
The scourge of the PSI rules
The PSI rules are contained in Part 2-42 of the ITAA 1997. For most professional practices they are just an annoyance requiring careful consideration of the four PSB tests to identify which would supply the “out”. As a reminder, the four tests are:
- the results test (s 87-18)
- the (two) unrelated clients test (s 87-20)
- the (principal) employment test (s 87-25)
- the business premises test (s 87-30).
There was even a possibility, depending on the nature of the practice, that the rules did not apply by dent of the absence of (enough) PSI. Section 84-5 activates the rules were income is “mainly” from personal services as distinct from the provision of goods, use of assets or engagement of employees. According to TR 2001/7 this is a crude 50% test.
Conveniently, the ATO issued detailed rulings on the PSI rules (TR 2001/7, TR 2001/8, TR 2003/6 and TR 2003/10) which have assisted in defining the circumstances that safeguard against their application. Worryingly, ATO work under development item [3767] is stated to be as to the meaning of PSBs. Hopefully this will simply involve an update for the cases over the last two decades and not a substantial reconsideration of the, sometimes concessionary, approach adopted in the rulings.
A conclusion that the practice is a PSB then leads to the broader question as to whether Part IVA may, nevertheless, apply to the structure.
Part IVA
All readers will know that the application of Part IVA is predicated on the existence of a scheme with a dominant purpose to obtain a tax benefit. The ATO’s rulings on its application to practice entities place little focus on these specifics. Rather the rulings draw from the earlier pre-Part IVA precedents distinguish 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. Thus, IT 2639 identifies the relevant considerations when drawing this distinction. One of the specified factors is the ratio of principal to non-principal practitioners, taken to establish a 50% safe harbour rule.
While satisfaction of the one or more of the PSB tests (or that the income is not mainly PSI) will not absolve a taxpayer from the need to consider Part IVA, where there is reliance on the employment or business premises tests (or that the income is not PSI) then these are also considerations towards whether the income is being derived from a business. In this sense the same considerations might count towards satisfying both the PSI and Part IVA rules. However, facts that allow reliance on the results or unrelated clients tests are unlikely to be of much value in the Part IVA analysis.
A further gloss on the business “concession” is the need to identify a commercial justification or business case for the structure. This gloss might pertain particularly to services trust arrangements. Fortunately, TR 2006/2, and the ATO guide to services trusts, not only contain safe harbour indicative margins that services type entities might charge but outline the business case that might be raised to justify the structure.
In October 2014 (revised June 2015) more generic audit risk safe harbour guidelines were issued by the ATO. Three alternative safe harbours were detailed:
- that the practitioner receives an appropriate return (based on salaries typically paid for the services they are providing)
- that at least 50% of the income entitlement of the practitioner (including any entitlement of a services trust) be assessable to them, and/or
- that there is an effective tax rate of at least 30% on the income attributed to the practitioner.
Withdrawn in December 2017, replacement guidelines remain listed as ATO work under development item [3991]. The rationale for their withdrawal was apparently evidence of abuse of the “concession”. The ATO has accepted that arrangements prior to 14 December 2017 that are both commercially driven and in compliance with the suspended guidelines will remain effective provided no risk factors are exhibited. The following risk factors are particularised:
- lack of any meaningful commercial purpose such as the disposal of an equity interest through multiple assignments, the creation of new discretionary entitlements (eg dividend access shares) and differences between tax and accounting income
- disregard for CGT consequences and inappropriate use of CGT concessions
- assignments where profit sharing is not proportionate to the equity interest
- the creation of artificial debt deductions
- undertaking an assignment to dispose of an equity interest to a self-managed superannuation fund
- assignments not on all fours with Everett and Galland.
As for practitioners intending to set up a new structure the ATO encourages early engagement.
Conclusion
The guides do not seek to address the legislation but merely provide some indication as to the audit risk that practitioners face. They are not rulings, nor in any sense binding on the ATO. Furthermore, a taxpayer who rates as high risk pursuant to the guides may, nevertheless, have a perfectly acceptable structure from a tax perspective. The income split may be quite appropriate given the employment of assets and employees. It is just that they may be called on to explain it.
While both the guides and rulings might assist a taxpayer in dealings with the ATO, neither the guides nor the rulings are the law. Ultimately, any application of Part IVA will come down to the perceived dominant purpose (of the scheme or sub-scheme). Does the structure have a business (non-tax) case as its motivating factor? Traditionally, reference is made to the asset protection, succession planning and superannuation benefits of the arrangement. With recent changes to the tax deductibility of superannuation contributions removing any distinction between employer and employee/self-employed contributions this justification now carries little weight. A professional may not always be able to find much justification in the asset protection and succession planning arguments as well.
It may be that for those professionals who cannot take advantage of a services trust to split income their advisers might more usefully focus on the professional’s non-practice assets and investments and how these might be tax effectively structured. Employing a practice entity to split income may simply be too problematic.
Finally, while one interpretation of the guides is that the ATO is seeking to carve out personal exertion income from business income by virtue of requiring an appropriate (or 50%) return to the practitioner. However, this is in no sense the law but simply the application of an audit risk methodology. The underlying principles are clear, if not blunt. 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.
