On 1 March 2021, the ATO released long awaited Draft Practical Compliance Guideline PCG 2021/D2 Allocation of Professional Firm Profits. Once finalised, the new Guideline will replaced the “old” guidelines that were suspended in December 2017 (suspended guidelines).
The ATO has always had concerns about arrangements involving redirecting of income that includes income from professional services received by individual professional practitioners (IPP) to associated entities to reduce the amount of tax liability.
The purpose of the new Guideline is to explain how the ATO intends to apply compliance resources when considering the profit allocation of professional firms and to assist the practitioners to self-assess their risk against risk assessment factors.
Proposed date of effect: 1 July 2021
Who needs to apply PCG 2021/D2 Allocation of Professional Firm Profits Guideline?
The Guideline applies to professional firms, including but not limited to those providing services in the accounting, architectural, engineering, financial services, legal and medical professions.
The proposed Guideline applies if the following preconditions are met:
- an 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;
- the income of the firm is not Personal Services Income (PSI) within the meaning of Part 2-42 of the Income Tax Assessment Act 1997 (ITAA 1997);
- 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.
Gateway 1 — Commercial rationale
This gateway is designed to ensure there is a genuine commercial reason for the way the arrangements are structured and profits are distributed. For example, the arrangement is likely to enhance, assist or improve the business’ ability to produce income or make profits, or the commercial benefits asserted to be achieved by the arrangement are justified.
The draft Guideline sets out various criteria which should be considered in reviewing the commercial substance of professional firm structures.
Gateway 2 — High-risk features
The arrangement must not contain any of the stated ‘high-risk’ features, including the following:
- those covered by Taxpayer Alerts;
- 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; and
- multiple classes of shares and units held by non-equity holders.
If the preconditions and the gateways are passed, you can apply the following risk assessment framework to evaluate your risk score.
Risk assessment scoring table
|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 third factor is optional as it may be impractical to determine accurately.
The first factor requires you to calculate the proportion of the profit entitlement returned personally in the hands of the IPP to the total amount of income to which the IPP and his or her associated entities are collectively entitled (whether directly or indirectly) from the whole of firm group, including service entities and other associated businesses.
Where an IPP returns 100% of the profit entitlement from the firm in their personal tax return (risk assessment factor 1), the IPP is automatically within the green zone. There is no need to assess against the other risk assessment factors.
The second factor requires you to calculate the total effective tax rate of the IPP and their associated entities. It should be noted that it is calculated using a specific formulas rather than by simply taken the actual amount of tax payable on the assessment. The formula is designed to remove the effect of unrelated deductions and losses from other activities such as negatively geared investments. PCG 2021/D2 provides practical examples of calculation of effective tax rates.
|Risk zone||Risk level||Aggregate score against first two factors||Aggregate of all three factors|
|Amber||Moderate risk||8||11 & 12|
Status of the Guideline
- The Guideline is still in draft stage at the time of writing and is open for comments and submissions until 26 March 2021. Once finalised, the Guideline is expected to apply prospectively from 1 July 2021.
- The Guideline is not a public ruling and do not have legally binding effect. However, once it is finalised, if you follow the Guideline in good faith, the Commissioner will administer the law in accordance with the approach set out in the Guideline.
- The Guideline does not provide “safe harbour” protection. However, if your circumstances align with the low-risk rating, the ATO will generally not allocate compliance resources to test the tax outcomes of your arrangements.
- This Guideline does not replace, alter or affect the operation of the law or ATO’s vies expressed in public rulings.
Taxpayers who entered into arrangements before 14 December 2017 can continue to rely on the suspended Guidelines for the years ending 30 June 2018, 2019, 2020 and 2021.
In addition, the ATO is allowing a grace period till 1 July 2023 for those practices that were considered low risk under the suspended guidelines but may have a higher risk rating under the new Guideline to modify their arrangements.
What do you need to do to minimise profit allocation compliance risks for your practice?
- Ensure your business arrangements are properly documented. You must be able to provide evidence of commercial rationale of the arrangement.
- Ensure the legal form is consistent with the economic substance of how the arrangements operate in practice.
- If you intend to rely on the Guidelines to test the level of risk of your arrangements, you need to keep appropriate records to document your assessment.
- You are expected to assess your eligibility to apply the profit allocation Guideline on annual basis. You also need to review your eligibility if your business arrangement change.
- Ensure you keep evidence of the facts used to conduct self-assessment of your risk level. The ATO may fact-check your assessment of your profit allocation and may undertake further compliance activity if you are unable to provide evidence.
- If you are uncertain of your eligibility to use the Guideline or unsure how to calculate your risk level accurately, seek advice from an appropriately qualified accountant who is up-to-date with the changes affecting professional services industries.
Prism Accounting specialises in providing taxation and accounting services to medical and dental professionals and clients in professional services industries. Contact us today to make an appointment with our specialist tax adviser.