The ATO has finalised their approach for determining when they will likely review the tax arrangements of professionals, and possibly progress to an audit. The ATO recently released Practical Compliance Guideline PCG 2021/4: Allocation of professional firm profits, which sets out the ATO’s approach to overseeing tax compliance amongst owners of professional firms (referred to as equity holders).
The issue in the ATO’s sights is whether an equity holder in a professional firm is taxed on a sufficient amount of their profit share from their firm, or is too much allocated to related parties on a lower tax rate.
Affected professionals
Equity holders in professional firms are the subject of the PCG. Named examples of relevant professional firms are those in the fields of accounting, architecture, engineering, financial services, law, medicine and management consulting. However, one would expect this would also include dentistry, veterinary, psychology, physiotherapy and other professional fields.
The draft PCG released earlier last year generated considerable controversy, and although the final has smoothed some of the harsher sentiments, it continues to raise the ire of professionals. It applies from the 2022-23 financial year.
Following is a summary of the ATO’s compliance approach, which will certainly require our attention into next financial year and beyond.
Income from personal services
Broadly, income derived from an individual’s personal services (including through a company or trust) must be assessed to that individual. Otherwise, the individual will offend anti-avoidance laws. However, where a professional firm has many professional employees, its profit is more likely derived from its income-yielding structure, rather than from any particular equity holder’s personal services. Despite this, the ATO’s position is that even where a firm has many professional employees, some of its profit might nonetheless be attributable to the equity holders’ personal contribution of services.
The ATO distinguishes professional firms from other kinds of businesses, such as retail or construction. The reason is that professional firms’ output is essentially services provided by people. In contrast, the value of people’s contributions in a retail or construction business manifests in providing a physical product, not a direct service by those people.
Professionals’ share of firm profit
Modern business structures for professional firms typically feature discretionary trusts, and companies and unit trusts with different classes of shares or units. Equity-holding professionals often hold their interest in the firm indirectly through an associated entity, such as a discretionary trust.
These structures enable some or all of an equity holder’s share of their firm’s profit to be assessed to associated parties, such as family members and companies, who may well be subject to a lower tax rate than the individual equity-holding professional.
The ATO’s key concern is whether a sufficient amount of an equity-holding professional’s share of firm profit is taxed to the individual professional, reflecting the value of their personal services contribution. It follows that if an excessive amount is being “alienated”, and taxed to those associated parties, the result is an inappropriately lowered tax impost on the professional’s overall share of profit.
Targeting system for reviews
The PCG sets out a scoring system under which equity holders in professional firms can self-assess the likelihood that the ATO will conduct a review of their tax arrangements. Essentially, the PCG is a targeting system for determining which professionals the ATO will review, and which they won’t. However, a number of qualifying criteria must be satisfied in order to rely on the scoring system. Two are of particular note.
The first, known as “Gateway 1”, requires the professional’s tax arrangements to be commercially driven, and there is a list of indicators that suggest when this is not so. The second, known as “Gateway 2”, requires there be to an absence of “high-risk” features, with some examples noted. Gateway 1 could be described as “doing the right things”, and Gateway 2 as “not doing the wrong things”.
Risk of being reviewed – zone scoring system
Where an equity-holding professional qualifies to rely on the PCG’s scoring system, they can self-assess their score based on three factors:
- Proportion of the professional’s overall profit share and remuneration assessed to the professional
- Collective effective tax rate amongst the professional and associated entities on the overall share of firm profit
- The total firm profits/remuneration assessed to the professional compared to a commercial benchmark.
There is a choice of determining your score from just the first two factors, or all three. The reason for granting the choice is that it can be difficult to establish a commercial benchmark for the third factor.
On a year-by-year basis, the professional’s tax arrangements will produce a score that falls within one of the following categories:
|
Risk zone |
Risk level |
|
Green |
Low |
|
Amber |
Moderate |
|
Red |
High |
As most professionals’ tax arrangements incorporate discretionary trusts, there is usually a discretionary power to allocate their share of firm profit amongst themselves and associated parties. Accordingly, they have some level of control over the taxation outcomes.
Essentially, the greater the proportion of firm profit assessed to the professional (and thus a lesser proportion to associated parties), and the higher the overall effective tax rate, the greater likelihood of falling into the green zone.
Risk of ATO reviewing tax arrangements
Absent exceptional circumstances, the ATO will generally not review professionals who fall into the green zone. Where they fall into the amber zone, the ATO is likely to conduct further analysis. Where they fall into the red zone, the ATO firmly states that they will further analyse the professional’s tax arrangements.
What if you don’t qualify, or are in the amber or red zone?
Failing to qualify to apply the PCG, or qualifying but being in the amber or red zones, does not necessarily mean a professional will offend the abovementioned anti-avoidance laws. At first instance, it means the ATO would like to take a closer look at your tax arrangements.
No goalposts
For equity holders in a professional firm with many professional staff, the fundamental difficulty with the PCG is that there is no benchmark metric for determining exactly how much, if any, of their share of profit ought to be taxed to them personally. Should it be at least 20 per cent? 40 per cent? 60 per cent? Or is none required to be taxed to them?
The tax laws do not address this specific question, and it has never been before the courts. Accordingly, no goalposts have been established. Thus, it is difficult to conceive, insofar as relates to profit allocation, what the ATO could look for under a review in the first place. The PCG refers to other kinds of tax mischief, but allocation of professional firm profits is not an indicator for most of these mischiefs.
The ATO appears to be searching for a suitable taxpayer to run a test case.
Tax cost of moving to the green zone
When considering who to appoint a year’s profit share to, the optimum allocation might place a professional in the amber or red zones for that year. In such a case, it is worth considering how much extra tax will arise from deciding on a different allocation that will place the professional in the green zone.
The question is how much extra tax you are prepared to pay for the peace-of-mind of a highly likely free pass, should the ATO tap you on the shoulder and ask for your self-assessed year-by-year zone outcomes. Only when that extra tax cost is quantified can you then make an informed decision.
Well in advance of 30 June next year, your trusted Nexia advisor will be talking to affected clients about what this development means for you, and how we can help you make these decisions.
