PCG on allocation of professional firm profits

The ATO’s recent finalisation and release of PCG 2021/4: Allocation of professional firm profits – ATO compliance approach (PCG) may raise questions about changes in the ATO’s approach to this area of the law. We discuss some of the key points raised in the PCG and provide an overview of the ATO’s new compliance approach and risk assessment framework.

Understanding the legal status of a PCG

Practical compliance guidelines are not legal interpretive documents and do not have the legally binding effect of a ruling. They set out how the ATO will apply its compliance resources to arrangements the ATO considers are high risk. They ‘convey the ATO’s assessment of relative levels of tax compliance risk across a spectrum of behaviours or arrangements.’¹

Practical compliance guidelines do not replace, alter or affect the operation of the law in any way. They provide taxpayers with a risk rating based on the various features of their arrangement. The shift toward ‘risk zones’ is intended to provide taxpayers with a clear understanding of where they reside, in the ATO’s view, on a risk assessment framework.

If a taxpayer has relied on a practical compliance guideline in good faith when determining their tax liabilities, should the ATO change their view, they will not take action in relation to the prior years and protection from interest charges is generally afforded.²

Key takeaways from PCG 2021/4

The PCG details the ATO’s compliance approach when considering the allocation of profits from professional firms in the assessable income of individual professional practitioners (IPPs). The compliance approach has been updated in light of the ATO’s concerns that business structures are being used to artificially lower the income of IPPs, or otherwise redirect their income.

The PCG highlights the Commissioner’s view of the features of business structures, and the amounts distributed to IPPs, that indicate the risk rating of the arrangement. It also contains a self-assessment framework for IPPs to use when determining the risk rating of their arrangements.

Date of effect and transitional periods

The compliance approach outlined in the PCG will be applied by the ATO from 1 July 2022. This is a welcome departure from the draft version of the PCG which was intended to retrospectively apply from 1 July 2021. The 12-month deferral will provide IPPs with a greater opportunity to consider the implications of the ATO’s approach and establish the appropriate record keeping procedures to evidence their self-assessed rating.

There are also transitional provisions for taxpayers who entered into arrangements prior to 14 December 2017 under the suspended Assessing the risk: allocation of profits within professional firms guidelines (Suspended Guidelines). Broadly, these taxpayers will continue to be able to rely on the Suspended Guidelines for the financial years ending 30 June 2018, 30 June 2019, 30 June 2020, 30 June 2021, and 30 June 2022 provided that the existing arrangement:

• complies with the Suspended Guidelines;
• has a sound commercial rationale; and
• does not exhibit the high-risk features highlighted in Gateway 2.

Further, the PCG acknowledges that some arrangements that were considered low risk under the Suspended Guidelines may now have a higher risk rating. Taxpayers who fall into this category will be provided with a grace period until 30 June 2024 to transition into a new structure that is considered low risk under the PCG.

Who does PCG 2021/4 apply to?

Broadly, the PCG will apply if:

• The IPP provides professional services to clients of the firm, or is actively involved in the management of the firm and, in either case, the IPP and/or associated entities have a legal or beneficial interest in the firm;
• Income of the firm is not subject to the personal services income rules in Part 2-42 of the Income Tax Assessment Act 1997;
• The firm operates by way of a legally effective structure (for example, a partnership, trust or company);
• The IPP is an equity holder (i.e. IPP holds rights to participate in the management, voting and income of the firm); and
• The arrangement satisfies Gateways 1 and 2.

It is also important to note that the PCG will apply to all professional firms. This will affect not only accountants and lawyers. It will also affect those providing services in the architectural, engineering, financial services, medical, management consulting and other similar professions.

What are Gateways 1 and 2?

The gateways described in the PCG are two extra sets of considerations that IPPs are required to satisfy before applying the ATO’s risk assessment framework. The gateways are intended to be applied in order. Not satisfying both gateways may mean the ATO considers the arrangement to be high risk, or a scheme to which the general anti-avoidance provisions may apply.

Gateway 1 — commercial rationale

Gateway 1 requires consideration of whether the arrangement is commercially driven. That is, whether there is a genuine commercial basis for both the arrangement and the way in which the profits are distributed.

The various factors to consider are detailed in paragraphs 45 and 46 of the PCG. They share some similarities with the considerations for Part IVA of the Income Tax Assessment Act 1936. Factors include, but are not limited to:

• 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.
• If the IPP actually receives an amount of profits or income that reflects their personal efforts or skill.
• If income is distributed to the IPP in substance and not just form.

Gateway 2 — high risk features

After the consideration of Gateway 1, if the arrangement is commercially driven, the PCG states that a further examination is required. Gateway 2 requires consideration of whether any high-risk features are prevalent in the arrangement. These include:

• If the arrangement is described in an existing Taxpayer Alert.
• If any financing arrangements are related to non-arm’s length transactions.
• If partnership interests are assigned in a manner that does not follow the principles laid out in Federal Commissioner of Taxation v Everett [1980] HCA 6 or Federal Commissioner of Taxation v Galland [1986] HCA 83.³

The PCG notes that this list is not exhaustive and will be subject to review and regular update by the ATO.

Overview of the risk assessment framework

If Gateways 1 and 2 are satisfied, the PCG prescribes a risk scoring table for taxpayers to use during their self-assessment. The table lists three factors and prescribes a score for each factor depending on the outcome. The aggregate score of the factors determines the relevant risk assessment.

The risk assessment table is set out at Table 1 below.

TABLE 1: Proportion of profit entitlement from the whole of firm group returned

Risk assessment factor 1

This factor provides a score depending on the proportion of the profit entitlement that is returned personally in the hands of the IPP, compared to the total amount of income to which the IPP and their associated entities are collectively entitled⁴ from the whole of firm group. Income from the whole of firm group includes the income from the service entity, and other associated businesses to the firm, to which the IPP or their associated entities are entitled.

It should be noted that if an IPP returns 100% of the profit entitlement from the firm in their personal tax return, then the IPP will automatically fall within the ‘green’ zone. In these instances, the PCG does not require an IPP to assess against the other two risk factors.

Risk assessment factor 2

Risk assessment factor 2 provides a score depending on the total effective tax rate paid by the IPP and their associated entities. It should be noted that ‘effective tax rate’ is not the marginal tax rate. Instead, it refers to the average rate of tax paid across the entire income from the firm.

The total effective tax rate is calculated using the following formula:

In this formula, ‘total tax paid by the IPP and associated entities of the IPP on professional firm income’ refers to the larger of:

• the tax that would be payable on firm-related amounts (including income and associated deductions) assuming it was the only income with no other sources of income or deductions; or
• the amount of income tax paid for the year, less the amount which would be payable if firm-related amounts (including income and associated deductions) were disregarded.

Risk assessment factor 3

Risk assessment factor 3 requires consideration of the remuneration returned in the hands of the IPP as a percentage of the commercial benchmark for the services provided to the firm. The PCG broadly requires that an IPP receive an amount of remuneration that is appropriate and comparable for the services they provide. A list of appropriate benchmarks, and factors if no benchmarks are available, are provided in paragraphs 101 and 102.

The PCG states that the benchmark must include all components of remuneration such as salary, superannuation and fringe benefits. Further, it requires the benchmarks to be reviewed annually.

It should be noted that use of risk assessment factor 3 is optional. The PCG notes that finding a commercial remuneration against which to benchmark can be difficult or impractical to accurately determine.

Thresholds for the risk zones

After the relevant scores for each factor are determined, they are aggregated and compared to the table below to determine the appropriate risk rating. The thresholds are indicated in Table 2 below.

TABLE 2: Risk zones

As noted above, risk assessment factor 3 may be optional. As a result, there are two thresholds that depend on whether the third risk factor is used.

If the arrangement falls within the amber or red risk zones, the ATO is likely to undertake review activities and request further information. 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.

Evidentiary requirements

The PCG states that the ATO may request evidence to fact check a taxpayer’s calculations, even if the self-assessment is in the green zone. This includes evidence regarding both the assessment under the risk framework, as well as evidence demonstrating that the arrangement has satisfied both gateways.

It is important for IPPs to ensure that they implement the appropriate evidence keeping protocols and ensure that they are able to demonstrate these evidentiary requirements. Where relevant, this also includes updating the evidence to ensure it is current.

How can The Tax Institute help you?

The Tax Institute will be providing our members with a range of tools and assistance that will allow you to better understand and apply the PCG. These include:

• Fact sheets to break down the requirements of the PCG.
• Webinars and other guides covering the detail of the PCG.
• Tools to help you calculate the risk rating based on the ATO’s risk framework.

Further guidance and information

If you have any specific concerns that have not been outlined above, please email us at taxpolicy@taxinstitute.com.au.

Footnotes

¹ For further information, see paragraph 5 PCG 2016/1: Practical Compliance Guidelines: purpose, nature and role in ATO's public advice and guidance (PCG 2016/1).

² PCG 2016/1, paragraph 26.

³ For further information regarding the ATO’s views on these types of assignments, see Taxation Ruling IT 2501: income tax: assignment of partnership interests and the ATO’s updated guidance on Everett Assignments.

⁴ This entitlement could be either direct or indirect.