The ATO has released Draft Practical Compliance Guideline PCG 2021/D2 (Draft PCG) which explains the compliance approach that the ATO intends to apply when considering the allocation of profits by professional firms, and the inclusion of income in the assessable income of individual professional practitioners (IPP). These guidelines apply to IPPs in professional practices including accountants, lawyers, engineers, doctors and architects etc. The ATO also intends for these guidelines to be applied by IPPs to self-assess their risk.
The draft PCG replaces the ATO’s Assessing the Risk: Allocation of profits within professional firms guidelines and Everett Assignment web materials which were suspended on 14 December 2017. The draft PCG has some similarities to the previous guidelines but there are also important differences in the details.
Comparison between Draft PCG and suspended guidelines
One of the similarities is that both the Draft PCG and the suspended guidelines have generally similar benchmark risk factors to pass, in order to be treated as low risk. These are generally:
- Proportion of available profit received by the IPP,
- Effective tax rate for the IPP and associate entities in relation to the firm’s profit distributions, and
- Amount received by the IPP from the firm in comparison to equivalent commercial remuneration paid for the types of services provided by the IPP to the firm.
One of the important differences is that under the suspended guidelines, an IPP was considered low risk if they passed any one of the three benchmark risk factors. However under the draft PCG, the IPP must pass both the first and second risk factors to be low risk. The third risk factor can also be used if it assists in the risk assessment as explained below.
The draft PCG has a number of inconsistencies and unexplained concepts as discussed below. The ATO has asked for submissions on the draft PCG and BDO will be identifying these issues in a BDO submission and/or in contributions to the tax and accounting professional bodies’ submissions.
The draft PCG represents a fundamental change from the former guidance that the ATO suspended in December 2017. However, there are transitional rules which allow the suspended rules to continue to apply for a limited time as discussed below.
Draft PCG - Application
The draft PCG guidelines apply where:
- The IPP provides professional services to clients of the firm or is actively involved in the management of the firm
- The IPP and/or associated entities have a legal or beneficial interest in the firm
- The firm operates via a legally effective structure such as a partnership, trust or company
- The IPP is an equity owner and holds full rights to voting, management and income of the firm
- The income of the firm is not personal services income.
Draft PCG - ATO's concerns
The draft PCG highlights the ATO's concerns about arrangements where an individual taxpayer (the IPP) may redirect their income from a business of providing professional services through a business structure in which the IPP has an equity interest, to an associated entity of the IPP, which has the effect of altering the tax liability of the IPP. The ATO accepts that not all profit generated by a professional services business is generated by the IPP but the ATO has concerns that in some situations the compensation received by the IPP is artificially low, and related entities of the IPP derive benefits that are not justified by commercial reasons.
ATO's 'risk-based' approach / risk assessment framework
The draft PCG explains the ATO's 'risk-based' approach to IPPs and how their firm allocates profits via two gateways. Both gateways must be passed for the risk assessment framework in the draft PCG to apply.
Gateway 1 - Commercial Rationale
Gateway 1 considers whether an arrangement and the way it operates are “commercially driven” for all parties involved. The ATO concern is that there must be a genuine commercial basis for the arrangement and the way in which profits are distributed. This includes if the arrangement is likely to enhance, assist or improve a business' ability to produce income, make profits or provide other commercial benefits. To aid achieving this, the arrangement should be appropriately documented with evidence that the stated commercial purpose was or will be achieved as a result of the arrangement, with the economic substance of the arrangement consistent with the legal form of the documentation. There must also be a genuine commercial basis for the way in which profits are distributed within the group, especially in the form of remuneration paid.
Gateway 2 - High-risk Features
The Draft PCG also requires an assessment of whether an arrangement contains any high-risk features, such as those covered by a Taxpayer Alert, or any of the following:
- Financing arrangements relating to non-arm's length transactions;
- Exploitation of the difference between accounting standards and tax law, (e.g. manipulation of impairment rules such as the amortisation of the portion of the IPP’s interest in the firm which should be tested annually for impairment allowing cash to be distributed to other entities); or
- Multiple classes of shares and units held by non-equity holders.
The Commissioner also includes in this list of high-risk features any arrangement where a partner assigns an interest in the partnership that is materially different from Everett and Galland assignments.
If an IPP has concerns that they do not pass through these gateways there is a higher risk that the ATO would take compliance action in relation to the arrangement and therefore it may be preferable for the IPP to engage with the ATO before ATO compliance action starts. The ATO invites discussion with the IPP in these circumstances.
Risk assessment framework
Where an IPP’s circumstances pass gateways 1 and 2, the risk assessment framework may be used by the practitioner and the ATO to understand what compliance attention will be given to the arrangement.
Risk assessment factors
There are three risk assessment factors which an IPP can use to self-assess their risk of attracting compliance attention from the ATO. Depending on the individual circumstances surrounding these factors, a score between 1 and 6 for each factor is given which is then aggregated and used to assess compliance risk.
The scores given for each factor are as follows:
|Risk assessment factor
|Proportion of profit entitlement of the IPP and associated entities from the whole of firm group returned in the hands of the IPP
||>75% to 90%
||>60% to 75%
||>50% to 60%
||>25% to 50%
||25% or less
|Total effective tax rate for income received from the firm by the IPP and associated entities
||>35% to 40%
||>30% to 35%
||>25% to 30%
||>20% to 25%
||20% or less
|Remuneration returned in the hands of the IPP as a percentage of the commercial benchmark for the services provided to the firm
||>150% to 200%
||>100% to 150%
||>90% to 100%
||>70% to 90%
||70% or less
The Draft PCG does however state that the third risk assessment factor is optional as the ATO recognises it is difficult to determine accurately. It is expected that the third risk factor would only be considered where the score for the first two puts the IPP in the amber or red zones as below.
Risk Zones and the ATO’s compliance approach
Depending on the score received, the draft PCG places an IPP in one of three risk zones - green, amber or red. The aggregate scores are as follows:
||Aggregate score against the first two factors
||Aggregate score of all three factors
||7 or less
||10 or less
||11 and 12
||9 or more
||13 or more
If an IPP is in the green zone, the ATO states it will only apply resources to review allocation of profit in exceptional circumstances or where there have been material changes to an arrangement. The ATO may possibly apply resources to check calculations in accordance with the Draft PCG, confirm the absence of exclusionary factors such as high risk factors, or to provide binding advice such as a private ruling, if requested.
Additionally, if an IPP’s proportion of profit entitlement from the whole of firm group returned in the hands of the IPP is equal to 100%, the ATO will deem them to be in the green zone without considering the other risk factors.
Where an IPP is in the amber zone, the ATO states they would be likely to conduct further analysis on the arrangement.
If an IPP is in the red zone, ATO reviews would be prioritized, likely proceed directly to an audit and formal powers would be utilised to gather information.
Example (extracted from the Draft PCG)
Nicolas is an IPP in a partnership. His total income entitlement from the partnership is $600,000. Nicolas has disposed of 45% of his partnership interest to an associated company.
Nicolas returns 55% of the partnership income ($330,000) in his personal tax return. Nicolas's tax liability on this amount is $119,167.
The company receives a total of $270,000 from the distribution. The corporate beneficiary's tax liability on this amount is $70,200 (26% of $270,000).
Together Nicolas and the company have a total effective tax rate of 31.56%.
|Risk Assessment Factor
||Application of criteria
|Proportion of profit entitlement from the whole of firm group returned in the hands of the IPP
|Total effective tax rate for income received from the firm by the IPP and associated entities (using tax rates applicable to for the 2021 income year)
|Remuneration returned in the hands of the IPP as a percentage of the commercial benchmark for the services provided to the firm
||n/a – Nicholas has determined it would be impractical to attempt to accurately calculate the percentage for this factor
|Outcome (Green zone)
The above example demonstrates that provided IPP’s maintain a proportion of profit entitlement of greater than 50% and a total effective tax rate of greater than 30%, they would be in the green zone.
However, one of the inconsistencies in the PCG is that if the facts are changed only slightly so that the IPP has a proportion of profit entitlement equal to 50% and an effective tax rate equal to 30%, they would have a risk rating of 9 for the first two risk factors and therefore fall in the red zone. This approach is a significant departure from the former guidelines, where an IPP needed only satisfy one of three benchmarks in order to be considered low risk.
Applying the guidelines
To be able to apply the guidelines, eligibility should be assessed annually and the assessment should be documented and reviewed as the business or arrangement changes.
Where gateways are not passed or in high risk zone
The ATO considers the Part IVA general anti-avoidance provisions in ITAA36 may apply to schemes that result in the IPP not being appropriately rewarded for their services provided. There is no technical analysis in the Draft PCG to backup this statement. However, the Draft PCG does say that just because an IPP’s circumstances do not pass gateways 1 and 2 or is in the higher risk zone (red zone) in the risk assessment framework does not mean the Part IVA general anti-avoidance provisions would automatically apply to them. What it does mean however, is the Commissioner is more likely to review the arrangement closely. The application of Part IVA will depend on a broad survey of the circumstances of each case.
Proposed application date and transitional arrangements
When finalised, the Draft PCG will apply prospectively from 1 July 2021. The ATO also states it will review the guidelines during 2022 and any revisions to improve its efficacy will be made on an 'as necessary basis'.
Arrangements entered into before 14 December 2017 that comply with the suspended guidelines, are commercially driven and which have no high-risk features can rely on the suspended guidelines for each income year until 30 June 2021. They will then be subject to these new guidelines.
However, the ATO also recognises there will be arrangements that would have previously been considered low risk under the suspended guidelines that would now be considered higher risk under this draft PCG. As a result, a grace period for these arrangements will be in place allowing IPP’s with a changing risk profile as a result of the Draft PCG, to continue relying on the suspended guidelines while they modify their arrangements. The grace period will end 30 June 2023. They will then be subject to these new guidelines.
IPP’s are also reminded that where they modify their arrangements, they should be mindful that this may trigger taxable capital gains and/or attract duties. The failure by IPPs to include taxable capital gains in their income tax returns as a result of restructures to their firm has previously been identified by the ATO as a compliance issue.
Other matters to consider
The draft PCG does not fully explain some of the concepts used and does not discuss certain arrangements which would be considered common as discussed below.
The draft PCG does not have examples of professional firms run through a corporate structures and does not deal with profit distribution made via dividends. In particular, it does not mention whether franking credits are taken into account in determining the remuneration received by the IPP for the first risk factor or the tax rate for the second risk factor. This also raises the issue of timing mismatches for the payment of dividends. If the firm profits for year one are paid as a dividend in year two, which year is the profit entitlement taken into account for the risk assessment, year one or year two? There may also be situations where the firm needs to accumulate some of the profits for business purposes, how are these profits dealt with in the risk assessment factors?
It would not be uncommon for IPP’s to direct a portion of their before-tax income to a super fund to boost their retirement savings. The draft PCG is silent on whether these should be taken into consideration as part of the IPP remuneration and/or effective tax rate calculation. Similarly, the draft PCG is silent on whether Division 293 tax would increase the effective tax rate.
Fringe benefits are also not considered in the PCG. IPP’s who receive fringe benefits in place of salary would have a lower effective tax rate than if the IPP receives cash remuneration instead of the fringe benefits.
We will be outlining these and other issues in our submission on the PCG. Hopefully they are dealt with appropriately in the finalisation of the PCG.