Note: Update to the allocation of professional firm profits can be read here.
The ATO has released draft Practical Compliance Guidance (PCG) 2021/D2, which details the ATO compliance approach when applying resources to consider the allocation of professional firm profits and their inclusion in the assessable income of individual professional practitioners (IPP). These guidelines are relevant to professional firms including, but not limited to, accountants, architects, engineers, lawyers, and doctors.
The ATO focuses on arrangements facilitating IPP to redirect their income to an associated entity from a business or activity that includes their professional services, where it has the effect of altering their tax liability. The ATO acknowledges that profits generated by a professional firm can be made up of different components such as the skills of the IPP and income generated by the business structure. The objective of the PCG is to ensure that amounts received by the IPP for their services are not substantially less than the value of those services and discontinue arrangements where the amounts received by the IPP are artificially low while related entities benefit (or the individual ultimately benefits), and commercial reasons do not justify the arrangement.
The PCG applies when all the following are met:
- an IPP provides professional services to clients of the firm or is actively involved in the management of the firm
- the income of the firm is not PSI
- the firm operates by way of a legally effective structure, for example, partnership, trust or company
- an IPP is an equity holder; that is, an IPP holds full rights to participate in the voting, management and income of the firm
- the arrangement is commercially driven; that is, it satisfies Gateway 1, and
- the firm and IPP do not demonstrate any high-risk features; that is, it satisfies Gateway 2.
The PCG’S guidance on the ATO risk assessment framework uses a gateway approach and risk zones. The three zones provide taxpayers with an understanding of where they reside in the ATO’s compliance risk rating. The three zones are:
- Green (Low),
- Amber (Moderate), and
- Red (High).
In order to utilise the PCG, taxpayers must first pass through the two gateways prior to assessing their risk under the risk assessment framework.
Gateway 1 – Commercial Rationale
Gateway 1 considers whether the implemented arrangement and how it operates are commercially driven for all parties involved. This means that there must be a genuine commercial basis for the arrangement and for the way in which profits are distributed. The arrangement should reflect the commercial needs of the business. For example, the arrangement is likely to enhance, assist or improve the business's ability to produce income or make profits, or the commercial benefits asserted to be achieved by the arrangement are justified.
The arrangement must also be appropriately documented, and there must be evidence that the stated commercial purpose was achieved as a result of the arrangement.
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
In order to pass through gateway 2, the arrangement must not contain any high-risk features, including the following:
- financing arrangements relating to non-arm's length transactions
- exploitation of the difference between accounting standards and tax law
- arrangements where a partner assigns a portion of a partnership interest that are materially different in principle from Everett and Galland
- multiple classes of shares and units held by non-equity holder
Once the taxpayer has passed through the gateways, they can apply the risk assessment framework.
Risk assessment framework
The risk associated with a professional firm’s profit allocation arrangement will be scored against the three factors set out in the below table. A score between 1 and 6 for each factor is given, which is then aggregated and used to determine which risk zone you fall within.
| Risk Assessment Factor |
Score |
| |
1 |
2 |
3 |
4 |
5 |
6 |
| (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% or less |
When an IPP potion of the profit entitlement is returned 100% in their personal income tax return, they will automatically be in the green zone. There is no need to assess against the other risk assessment factors.
The aggregated scores from the above table will place an IPP in one of the three risk zones below:
| Risk Zone |
Risk Level |
Aggregate Score Against First Two Factors |
Aggregate Of All Three Factors |
| Green |
Low Risk |
7 or less |
10 or less |
| Amber |
Moderate Risk |
8 |
11 & 12 |
| Red |
High Risk |
9 or more |
13 or more |
The ATO compliance approach for each zone is as follows:
- Green Zone – will only apply resources to review allocation of profits in exceptional circumstances or where there have been material changes to an arrangement.
- Amber Zone - would be likely to conduct further analysis on the arrangement.
- Red Zone - would be prioritised; the case may proceed directly to an audit and formal powers used to gather information.
Example from PCG 2021/D2
Bernie is an IPP in a partnership. Bernie has assigned 35% of his interest in the partnership to a discretionary trust. The beneficiaries of the discretionary trust include Bernie's spouse, Jane.
Bernie's income entitlement from the partnership is $500,000.
Bernie and Jane jointly (in equal shares) own a negatively geared rental property, which generated a net rental loss of $40,450.
Bernie includes $325,000 (65% of the partnership income) in his tax return, and the discretionary trust includes $175,000 (35% of the partnership income) in its tax return, which is then distributed entirely to Jane, who returns the same $175,000 in her tax return.
Bernie and Jane claim the rental loss equally, which is $20,225 each. For the purposes of calculating the total effective tax rate, deductions not related to the professional income are disregarded.
The risk assessment is as follows:
| Risk Assessment Factor |
Application of Criteria |
Score |
| (1) Proportion of profit entitlement from the whole of firm group returned in the hands of the IPP |
$325,000, or 65%, of Bernie's entitlement of $500,000 is returned by Bernie personally. |
3 |
| (2) Total effective tax rate for income received from the firm by the IPP and associated entities (using tax rates applicable to the 2020-21 income year) |
Bernie pays tax of $116,916 on the $325,000 returned by him.
Jane pays tax of $49,817 on the $175,000 received by her (her rental loss of $20,225 is disregarded).
The calculation of total effective tax rate is as follows:
The total effective tax rate is 33.35%.
($116,916 + $49,817) / ($325,000 + $175,000) × 100 = 33.35% |
3 |
| (3) Remuneration returned in the hands of the IPP as a percentage of the commercial benchmark for the services provided to the firm |
Not applicable. Bernie has determined that in the circumstances, it is impractical to accurately determine an appropriate commercial remuneration to benchmark against. Therefore, his aggregate score is determined against the first two factors only. |
0 |
| Total |
6 |
The aggregate score of 6 places Bernie's arrangement in the green zone.
It is important to note that the arrangements of professional firms profit allocations need to be assessed on an ongoing basis.
While this PCG is only in draft form, we hope that the final version will provide further guidance on other common business structures. Such as those run through corporate entities and the profit distributions made by way of dividends neglected by the guidelines.
Please contact us to review your current arrangements to determine whether any action is required.
Source: The Australian Taxation Office (ATO), Draft Practical Compliance Guideline https://www.ato.gov.au/law/view/document?docid=DPC/PCG2021D2/NAT/ATO/00001
%20(1).svg "Frame (18) (1)")
.svg "Close (1)")
2 min read
6 min read
