Tax Files: Allocation of professional firm profits to individual practitioners By Andrew Shaw

Allocation of professional firm profits to individual practitioners

ANDREW SHAW, SHAW LAWYERS

“I like traffic lights. I like traffic lights. I like traffic lights. But only when they’re green.” – Monty Python, “Traffic Lights” (1980).

On 1 March 2021 the Australian Taxation Office (‘ATO’) released a draft Guideline setting out the ATO’s proposed compliance approach to allocation of profits by professional firms.1

The Guideline explains how the ATO intends to apply compliance resources when considering the allocation of professional firm profit or income in the assessable income of the individual professional practitioner (‘IPP’).

The Guideline is in draft for consultation. Once finalised, the Guideline is proposed to apply from 1 July 2021.2

Who comes within the Guideline?

The Guideline applies to professional firms including the legal profession, medical, accounting, architectural, engineering, financial services, and others.

The Guideline is directed at professional services income of IPPs (‘PSI’). An IPP is an individual who provides services to clients of the firm, or to the firm itself, in circumstances where the IPP and/or associated entities have a legal or beneficial interest in the firm. PSI is income earned mainly as a result of personal effort or skill of an IPP, rather than being generated by assets or employees of the firm.

What is the ATO worried about?

The ATO is concerned about arrangements where taxpayers alter their tax liability by redirecting, to an associated entity, their income from their professional services.

The ATO accepts that the profit or income of a professional firm may comprise different components - reflecting a mixture of income from the efforts, labour, and application of skills of the firm’s IPPs (personal exertion) and income generated from the business structure.3

The ATO also accepts that IPPs may use corporate structures and that “there may also be good non-tax reasons as to why the controller of a business receives significantly less of the business’ profits than would otherwise be the case”. However, where a business involves the provision of services, the ATO will be concerned with arrangements “where the compensation received by the individual is artificially low while related entities benefit (or the individual ultimately benefits), and commercial reasons do not justify the arrangement”.4

Guideline is not a safe harbour

The Guideline is not a “safe harbour” that makes a firm immune to ATO scrutiny. Nor is the Guideline a public ruling which is binding upon the ATO.

Instead, the Guideline provides a “traffic light” rating system to assess the risk of ATO compliance activity. If a firm’s circumstances align with a low-risk rating (green zone), the ATO will generally not allocate compliance resources to test the tax outcomes of the firm’s arrangements. If the firm has a moderate risk rating (amber zone) the ATO is likely to conduct further analysis and may seek further information. If the firm has a high-risk rating (red zone) the ATO is likely to commence reviews as a matter of priority and cases may proceed directly to audit.5

The Guideline applies only if the IPP’s circumstances pass two “Gateways”. There must be a genuine commercial basis for entering into and operating the arrangement or structure (Gateway 1). The arrangement must not have certain highrisk features (Gateway 2).

Some arrangements may come within the Guideline but are nonetheless regarded by the ATO as high-risk (red zone) because they are designed to ensure the IPP is not directly rewarded for services they provide to the business, or the IPP receives a reward which is substantially less than the value of those services. Failing a Gateway, or passing both Gateways but being in the red zone, does not necessarily mean that the general antiavoidance provisions will apply, but the ATO is likely to give closer scrutiny to profit allocation arrangements including a deeper consideration of whether the antiavoidance provisions apply.6

Ideal outcome

If you are an IPP, the ideal outcome is to pass both Gateways such that the Guideline applies to you, but to achieve a low-risk (green) rating. The ATO will apply compliance resources to review allocation of profits of an IPP in the green zone only in exceptional circumstances.7

The starting point – Gateway 1 – commercial rationale

The Guideline applies only if both Gateways are passed.

Gateway 1 requires that there must be a genuine commercial basis for the arrangement and also for the way profits are distributed. The arrangement must reflect the commercial needs of the business. The ATO also requires that the arrangement must be “appropriately documented” and there must be evidence that the stated commercial purpose was achieved as a result of the arrangement. A mere assertion of “asset protection” for an IPP is not sufficient if the arrangement does not actually provide improved asset protection. Legal form and documentation must be consistent with the economic substance of how the professional firm operates in practice. The ATO may look at internal management documents, procedures, and practices to determine whether a documented arrangement has, in fact, been correctly implemented.

Indicators that a profit allocation arrangement lacks a sound commercial rationale include unnecessary complexity, steps that serve no real purpose other than to gain tax advantages (e.g. interposed entities, related party dealings that merely produce a tax result, circularity of funds/no real money), negligible risk where risk would be expected (e.g. nonrecourse loans), and dealings on nonarm’s length terms.8

Gateway 2 – high-risk features

If Gateway 1 is passed, the IPP must assess whether the arrangement contains any high-risk features such as those covered by Tax Alerts issued by the ATO. High-risk features include financing

arrangements for an associated entity to acquire an existing portion of the IPP’s equity interest in the firm, arrangements to create artificial differences between taxable and accounting income (e.g. different rates of amortisation), assignments of nonequity interests in the firm, and certain types of dividend access shares linked to the personal performance of non-equity holders.

Next step – risk assessment framework

If both Gateways are passed, a risk assessment framework assists an IPP to assess its level of compliance risk.

The risk assessment is made up of the three risk zones: green, amber, and red. The applicable risk zone is determined by combining scores for each of three risk assessment factors (‘RAFs’).9 The

objective is to achieve a low score (least number of points) to fall within the green zone. Risk assessment factors (RAFs)

The scoring system for risk assessment factors is contained in tables with examples and case studies. It is too voluminous to reproduce in this article.10

In short, the three RAFs are: 1. (RAF 1) Proportion of firm profit taxed in the hands of the IPP;11 2. (RAF 2) Total effective tax rate on firm income received by the IPP and associates;12 3. (RAF 3) Remuneration taxed in the hands of the IPP as a percentage of the commercial benchmark.13

Scoring the risk zone

The risk zone is calculated as follows: • (Green) 7 points or less (if only RAF 1 and 2) or 10 points or less (if all 3

RAFs).14 • (Amber) 8 points or less (if only RAF 1 and 2) or 11 - 12 points (if all 3 RAFs). • (Red) 9 points or more (if only RAF 1 and 2) or 13 points or more (if all 3

RAFs).

What does the ATO really want to see?

Although the scoring tables provide various permutations, eligibility for the Green Zone probably requires an IPP to: (1) receive more than 60% of the profit entitlement from the firm, (2) have a total effective tax rate (including associated entities) of/above 30%, and (3) receive at least 90% of the commercial benchmark.

Paragraph 66 of the Guideline indicates that anything other than a lowrisk (green) rating will result in compliance activity: “If your arrangement does not have a low (green zone) risk rating (per paragraph 71 of this Guideline), we consider your arrangement, or your treatment of that arrangement, is at risk of giving rise to an inappropriate tax outcome. Therefore, we will generally conduct some form of compliance activity to further test the tax outcomes of your arrangement”. Take home messages: 4. The ATO expects IPPs to assess annually their eligibility to apply the

Guideline and to document their assessment of eligibility.15 Each IPP in the same firm will not necessarily have the same score. Each IPP should assess its own score annually. 5. Risk ratings are based on the most recently lodged tax return. An alternative approach may be justified in individual circumstances. 6. If the ATO reviews a profit allocation arrangement, its starting point will be the contemporaneous documentation substantiating the arrangement. The

ATO may also fact-check an IPP’s selfassessment of its risk zone. Absence of evidence to support a self-assessment may result in further compliance activity.16 7. There are some anomalies where the applicable risk zone may be altered by minor shifts in profit entitlement arrangements or the impact of total remuneration packages including superannuation contributions and nonsalary benefits. 8. It also seems harsh that an IPP who is remunerated at 100% or more of the commercial benchmark is not automatically in the green zone. 9. The ATO has extended the period for feedback on the draft Guideline until 16 April 2021. Several professional bodies are preparing submissions to the ATO. Law firms should monitor progress of the Guideline and carefully review the final version once published.

Tax Files is contributed by members of the Taxation Committee of the Business Law Section of the Law Council of Australia. B

Endnotes 1 Draft Practical Compliance Guideline PCG 2021/D2: “Allocation of professional firm profits –

ATO compliance approach” (‘Guideline’). 2 Transitional provisions allow professional firms to continue to rely on the ATO’s (previously suspended) 2015 guidelines for years of income ending on or before 30 June 2021 provided those arrangements comply with the suspended guidelines, are commercially driven, and do not exhibit high-risk features identified by the ATO. 3 Guideline, at [8]. 4 Guideline, at [5] – [7]. 5 Guideline, at [60] – [62], [99] – [100]. See the conclusions in [100] in particular. 6 Guideline, at [32] - [33]. The general antiavoidance provisions, known as Part IVA of the

Income Tax Assessment Act 1936 (C’th), allow the ATO to cancel a tax benefit if the ATO determines that a scheme was entered into with the sole or dominant purpose of obtaining a tax benefit. 7 Guideline, at [100]. 8 Guideline at [34] – [41]. 9 Guideline, at [65] – [69]. 10 The scoring tables are contained in paragraphs [70] – [93] of the Guideline. 11 Scored from 1 to 6 points, where more than 90% = 1 (best) and 25% or less = 6 (worst). If an

IPP returns 100% of the profit entitlement of the firm in their personal tax return, the IPP is automatically in the green zone. 12 Scored from 1 to 6 points, where more than 40% = 1 (best) and 20% or less = 6 (worst). 13 Scored from 1 to 6 points, where more than 200% = 1 (best) and 70% or less = 6 (worst).

Benchmarking should reflect the market comparability of remuneration for the role using a fact-based methodology that includes all components of remuneration to reflect the true cost to the business of employing a comparable individual: see [89] – [93]. 14 RAF1 and RAF 2 may be used, rather than all 3 RAFs, where it is impractical to accurately determine an accurate commercial remuneration against which to benchmark: see [73]. 15 Guideline, at [20]. 16 Guideline, at [62], [101].