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ATO releases new draft guidelines on the allocation of profits by professional services firms
Technical article

ATO releases new draft guidelines on the allocation of profits by professional services firms

The Australian Taxation Office (ATO) has released Draft Practical Compliance Guideline PCG 2021/D2 (draft PCG) setting out how it proposes to apply compliance resources when examining the manner in which profits by professional services firms are allocated to individual professional practitioners (IPP). Once finalised, the revised guidelines will apply from 1 July 2021.

What is the Draft PCG about?

The draft PCG outlines a “traffic-light” risk assessment that will be used to tailor compliance resources and may be used by taxpayers to understand the level of scrutiny they may expect from the ATO.

The risk weighting of a particular professional firm’s profit allocation arrangements will be benchmarked against three factors set out in the table below. The third factor is optional reflecting the difficulty that its use may occasion.

  • Performance for each factor is assessed on a scale of 1 to 6.
  • An overall score of 10 or less (7 or less where only the first two factors are applied) would result in a low-risk (green zone) rating
  • A score of 13 or more (9 or more on a two factors basis) would result in a high risk (red zone) rating.

A rating in the red zone would result in an ATO review “as a matter of priority” while a rating in the green zone would likely only result in the ATO confirming the guidelines have been correctly applied (including that two gateway conditions noted below are satisfied).

What are the risk factors and scoring system?

The following table is taken from the draft PCG:

Risk assessment factor

Score 1

Score 2

Score 3

Score 4

Score 5

Score 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 entities

>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%

Concerns with the PCG

The PCG has not been based on analysis of the relevant law. Further, it only applies to professional services firms and not to businesses that rely to a large extent on the personal effort of senior management to generate income.

The guidelines suggest that they provide a risk weighting as to the application of Part IVA, the general anti-avoidance rule. However, in the absence of that fundamental legal analysis it is difficult to rationalise those weightings. To achieve a score of 3 or better on the first two factors, more than 60% of the profit entitlement for an income year must be assessed to the IPP personally and result in an effective tax rate of more than 30%. The reason a professional service business should be required to subject its profits to tax at a rate higher than the corporate tax rate is not adequately explained.

To achieve a score of 3 or better on the third factor would require that the IPP include in their personal return more than 100% of the commercial remuneration for the services they provide to the firm.

The score for each of the factors is calculated based on the IPP’s total profit entitlement from all the entities that comprise the firm’s business. This would, for example, include service entities that may provide employees and capital assets to the main operating entity.

The ATO has published separate guidelines on service entity arrangements that focus on whether the entity earns a commercial return on the services provided. As such, it seems inconsistent with the stated rationale for the possible application of Part IVA (i.e. the alienation of income from personal exertion) for the draft PCG to concern itself with the rate of tax on profits generated by a firm’s service entities.

What are the gateway tests to use of the draft PCG?

Two “gateway” criteria must be satisfied before the risk assessment framework will apply.

  • Gateway 1 considers whether the profit allocation arrangement and the way it operates are commercially driven. Factors indicating the arrangement fails this gateway include unnecessary complexity, differences between the economic and tax outcome and non-arm’s length dealings.
  • Gateway 2 requires an assessment of whether the arrangement contains features that the ATO considers high-risk. These include, but are not limited to:
    • financing of the related-party acquisition of interests in the professional firm,
    • exploitation of differences between accounting standards and tax law,
    • assignments of partnership interests involving non-equity partners, and
    • the use of companies or unit trusts with multiple classes of membership interests.

The draft PCG indicates that if either of these gateway criteria is not satisfied, the likelihood is that the Commissioner would subject the profit allocation arrangements to greater scrutiny. While that would not necessarily mean that Part IVA would apply, the risk that it is applied would be higher.

Who do the changes apply to?

The draft PCG identifies professional firms providing accounting, architectural, engineering, financial services, legal and medical professional services as the target of the guidelines.

More generally, the guidelines may apply to any entity where those providing the services are required to be accredited and adhere to ethical standards administered by a governing body, possess special knowledge and skills derived from a high level of education and training, and uphold a high standard of behaviour in their professional activities.

When do the changes apply from?

The ATO is looking to apply the guidelines from 1 July 2021 once finalised.

Taxpayers who entered into profit allocation arrangements before 14 December 2017 that complied with the previous guidelines (published in 2015 but suspended in 2017) will be able to continue to rely on those guidelines for the years ending 30 June 2018 to 2021 (inclusive). This is dependent on the arrangement continuing to comply with those guidelines, being commercially driven, and not exhibiting any of the high-risk features within Gateway 2.

In addition, arrangements rated as low risk under the previous guidelines that have a higher rating under the draft PCG may continue to rely on the guidelines until 30 June 2023. This will allow the arrangements to be modified to achieve a low-risk score under the new guidelines.

What is an example of how the changes will operate?

The following is based on one of the examples provided in the draft PCG.

Jacinta is an IPP in a partnership. Her total income entitlement from the partnership is $600,000. Jacinta assigns 40% of her partnership interest to a discretionary trust. Jacinta has a tax liability of $132,667 on the remaining 60% of her entitlement.

The discretionary trust’s beneficiaries are Jacinta’s spouse and a corporate beneficiary. Jacinta’s spouse receives $180,000 resulting in a tax liability of $51,667. The corporate beneficiary receives $60,000 and has a tax liability of $15,600.

  • Jacinta scores 4 on the first factor as she is personally taxed on 60% of her share of the total firm profit.
  • Taking account of the tax paid by her spouse and the corporate beneficiary, the effective tax rate on Jacinta’s share of partnership profits is 33.3% which gives a score of 3 on the second factor.
  • In considering the third factor, Jacinta determines that the commercial benchmark for the services she provided would be $450,000.
  • As her income is 80% of that benchmark ($360,000/$450,000), Jacinta scores 5 for the third factor and an overall score of 12 putting her in the moderate risk (amber zone).

What are the next steps?

Pitcher Partners both directly and in collaboration with the professional bodies will be raising concerns with the guidelines in a submission to the ATO. Recognising that the draft PCG is the result of three years of work by the ATO, firms that would be impacted by the guidelines should look to model the application of the draft PCG and whether changes need to be made to profit allocation arrangements.

Contact your Pitcher Partners representative to review your situation and determine what action is required before 30 June 2021.

This content is general commentary only and does not constitute advice. Before making any decision or taking any action in relation to the content, you should consult your professional advisor. To the maximum extent permitted by law, neither Pitcher Partners or its affiliated entities, nor any of our employees will be liable for any loss, damage, liability or claim whatsoever suffered or incurred arising directly or indirectly out of the use or reliance on the material contained in this content. Pitcher Partners is an association of independent firms. Pitcher Partners is a member of the global network of Baker Tilly International Limited, the members of which are separate and independent legal entities. Liability limited by a scheme approved under professional standards legislation.

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