Effective from 1 July 2021, the Draft Practical Compliance Guideline PCG 2021/D2 (PCG 2021/D2) issued by the ATO outlines their proposed compliance approach to the allocation of profits by professional firms. This PCG is critical for professional firms in allocating their profits in a way that does not draw ATO scrutiny.
These guidelines apply to ‘professionals’ such as lawyers, medical practitioners, engineers, architects, financial services and accountants. It should be noted that these guidelines can apply to any kind of professional, which includes any person who must be accredited by a body.
The previous guidelines were contained on an ATO webpage, titled ‘Assessing the risk: allocation of profits in professional firms’. These guidelines were suspended by the ATO suddenly in December 2017 due to suspected abuse by some professional firms.
Since December 2017, there has been no ATO guidance on any safe harbour for allocating profits in professional firms.
The new PCG uses a two-step approach to assess the tax risk, called ‘Gateways’, that must both be passed to be considered low risk.
Also included is a risk framework, with levels of risk of green, amber and red.
Gateway 1 – Genuine Commercial Rationale
The first gateway considers whether the implemented arrangement has a genuine commercial rational for all parties involved. This considers both, the overall commercial structure of the professional firm and
If the arrangement enhances, assists or improves the business’ ability to produce income or make profits, the commercial rationale is clear and this gateway will be passed. The arrangement must be appropriately documented, with evidence stating the commercial purpose was achieved as a result of the arrangement.
The commonly used explanation of asset protection will not be sufficient if the arrangement does not actually provide improved asset protection. The ATO has stated that when considering a structure or flow of profits, any change in tax performance with no change to the underlying business changing is a strong indication of a lack of commercial rational for the arrangement.
If there is a genuine commercial basis for the way in which profits are distributed within the group, then it will likely pass-through Gateway 1. Practically showing this will be difficult however.
Gateway 2 – Lack of High Risk Features
If you conclude that your arrangement will pass through the first gateway, you must then assess whether the arrangement contains any high-risk features. The ATO considers the following as potentially high-risk features:
- Financing arrangements relating to non-arms length transactions;
- Exploitation of the difference between accounting standards and tax law;
- Arrangements that are not ‘on all fours’ with the Everett case; and
- Multiple classes of shares and units held by non-equity holders.
This is particularly unhelpful as passing this gateway it depends on determining whether an arrangement is arms-length in almost all cases. These features are more difficult to identify in a practical sense.
The ATO has three zones your arrangement may fall into after passing through both gateways. Whether you fall within the low, medium or high-risk (Green, Amber or Red) category depends on your application of the following risk assessment factors and the aggregate scores for the following (extracted from PCG 2021/D2 paragraph 70 and 71.
|Risk assessment factor||Score|
|(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%|
The actual scoring applies to the below risk framework:
|Risk zone||Risk level||Aggregate score against first two factors||Aggregate of all three factors*|
|Amber||Moderate risk||8||11 & 12|
The result of each process is broadly:
Green – Compliance resources dedicated only to confirming calculations and position and ATO may provide binding advice
Amber – Likely to be reviewed and moderate analysis conducted to ensure arrangement is acceptable
Red – Reviews will be conducted as a priority, may proceed directly to audit, likely use of formal powers to gather information.
Of course, professional firms should seek to be in the green zone where possible but many will likely be pushed into the Amber if following the previous ATO guidelines.
The draft guidelines unfortunately do not clarify the ATO’s position on professional firm profits as it intended. It has made the process more systematic of determining risk, but clients should be aware that ATO guidelines are not law and should seek independent legal advice before ATO compliance activities start from the coming financial year.
Just because a client is in the green zone does not protect them from ATO audit activity or give any surety in their tax position. The general anti-avoidance rules in Part IVA are always a risk that every firm should consider in remunerating professionals and their families.
Chamberlains law firm are tax experts and are well equipped to assess the tax risk for your firm and professionals, navigate ATO guidelines, and find the optimal structure for your professional services firm.
Interested in learning more about Tax Planning?
Click on our recent articles to find out more: