Professional practices – accountants, engineers, lawyers and more – need to self-assess their risk profile under revised tax guidelines.
As the dust settles on the release of final ATO guidance on the allocation of professional practice profits, this article examines what firms need to do from 1 July this year.
Following around four years of consultation, the ATO issued Practical Compliance Guideline PCG 2021/4 on 16 December 2021. The PCG sets out the ATO’s compliance approach from 1 July 2022 to the allocation of profits or income from professional firms in the assessable income of the individual professional practitioner (IPP). The compliance approach comprises two gateways, both of which must be satisfied for the IPP to apply the self-assessment risk framework.
The PCG replaces the former guidelines that were suspended on 14 December 2017 after the ATO identified they were being misinterpreted.
The PCG applies only where the firm’s income is generated by a business structure and does not constitute personal services income (PSI). Broadly, PSI is income earned mainly as a result of personal efforts or skills, rather than being generated by assets or employees of the firm. The PSI rules are precluded from applying to professional practices that generate income from a business structure, but the ATO is concerned some arrangements may be an attempt by the IPP to alienate income flowing from their personal exertion to an associated entity. Despite there being a business structure, the ATO considers that Part IVA of the Income Tax Assessment Act 1936 may apply to these arrangements where income is redirected away from the IPP.
The ATO has flagged the PCG is relevant to professional practices that provide accounting, architectural, engineering, financial, legal, medical and management consulting services, however this list is non-exhaustive. The PCG does not apply to IPPs who provide their services directly; it applies only to those who provide their services through an entity.
Before we delve into the technical analysis of the PCG, it is important to remember that a PCG is not a taxation ruling. It does not set out the ATO’s interpretation or understanding of the law. It does not replace, alter or affect the operation of the law in any way. It does not set out whether Part IVA applies, or does not apply, to a particular type of arrangement. It is not legally binding on the Commissioner. A PCG does, however, provide protection from interest on any tax shortfall and from penalties for making a false or misleading statement where a taxpayer has relied on it in good faith when determining their tax liabilities.
The PCG explains how the Commissioner will apply the ATO’s compliance resources when considering the allocation of profits of income from professional practices in the assessable income of the IPP, based on their risk profile. By differentiating the risk of taxpayers’ arrangements, the ATO can tailor their engagement with taxpayers.
Notably, the failure to satisfy both gateways (which precludes the IPP from venturing into the risk assessment framework) or that an arrangement is determined to be high-risk using that framework does not automatically mean that Part IVA applies. It means the ATO is more likely to pay closer attention to the arrangement. Further, there are safeguards to ensure Part IVA is applied consistently, including a review by the General Anti-Avoidance Rules Panel and regard should be had to Law Administration Practice Statement PS LA 2005/24.
The ATO will generally not allocate compliance resources to arrangements that are determined to be low risk.
What does the ATO’s final guidance say?
Two gateways must be satisfied for the IPP to self-assess using the risk framework:
Gateway 1 — There should be a sound commercial rationale for entering into and operating the arrangement or structure, including an absence of the following indicators:
- The arrangement seems more complex than is necessary to achieve the relevant commercial objective.
- The arrangement includes steps that appear only to provide a tax advantage with no other apparent purpose.
- The tax result of the arrangement appears at odds with its commercial or economic result.
- The arrangement results in little or no risk in circumstances where significant risks would normally be expected.
- The parties to the arrangement are operating on non-commercial terms or in a non-arm’s length manner.
- There is a gap between the substance of the arrangement and its legal form.
Gateway 2 — The arrangement should not exhibit certain “high-risk features”, including:
- The arrangement is described in an existing Taxpayer Alert.
- Financing arrangements are related to non-arm’s length transactions.
- Differences between accounting standards and tax law are exploited.
- Partnership interests are assigned in a manner that does not follow the principles laid out in FCT v Everett  HCA 6 and FCT v Galland  HCA 83 (about the assignment of partnership interests).
- Multiple classes of shares and units are held by non-equity holders.
- Multiple assignments or disposals of an equity interest occur.
- Misuse of the superannuation system occurs, including assignments or disposals of an interest to associated self-managed superannuation funds.
- Distributions of income are made to entities, other than the IPP, with losses.
If you cannot satisfy both gateways your arrangement is considered high risk and you cannot apply the self-assessment risk framework.
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 ascribes a score for each factor depending on the outcome. The aggregate score of the factors determines the relevant risk assessment.
The risk profile of an arrangement is determined by combining the scores for each of three risk assessment factors:
- Proportion of profit entitlement from the whole of practice group returned in the hands of the IPP. If an IPP returns 100 per cent of the profit entitlement from the firm in their personal tax return, the IPP automatically falls within the green zone. In these instances, the PCG does not require an IPP to assess against the other two risk factors.
- Total effective tax rate for income received from the practice by the IPP and associated entities. This is the “effective tax rate” not the marginal tax rate and refers to the average rate of tax paid across the entire income from the firm.
- Remuneration returned in the hands of the IPP as a percentage of the commercial benchmark for the services provided to the practice. The benchmark must include all components of remuneration such as salary, superannuation and fringe benefits. The PCG notes that the use of risk assessment factor 3 is optional as finding a commercial remuneration against which to benchmark can be difficult or impractical to accurately determine.
An aggregated risk score in the:
- Green zone means your arrangement is considered low risk and the ATO will apply compliance resources to review your allocation of profit only in exceptional circumstances.
- Amber zone means your arrangement is considered to be moderate risk and the ATO is likely to conduct further analysis on the facts and circumstances of your arrangement.
- Red zone is considered high risk and the ATO will conduct further analysis on the facts and circumstances of your arrangement as a matter of priority. If further analysis confirms the arrangement remain high risk, the compliance activities may proceed to audit.
Under the risk assessment framework, if the arrangement does not fall within the green zone the ATO considers that the arrangement may be at risk of giving rise to an inappropriate tax outcome. Therefore, the ATO will generally conduct some form of compliance activity to understand the facts and circumstances of your arrangement and the resulting tax outcome.
The compliance approach outlined in the PCG will be applied by the ATO from 1 July 2022.
The ATO has advised the following transitional arrangements apply:
- If your arrangement complies with the suspended guidelines, is commercially driven and does not exhibit any of the high-risk features listed above under gateway 2, you can continue to rely on the suspended guidelines for the years ending 30 June 2018 to 30 June 2022.
- If your arrangement was considered low-risk under the suspended guidelines and has a higher risk rating under the PCG, you can continue to rely on the suspended guidelines until 30 June 2024.
What should practitioners do?
- Practitioners are expected to assess their eligibility to apply the PCG annually, so a review of your arrangements against the PCG should form part of your annual compliance checklist.
- Determine whether any of the transitional arrangements apply to your arrangement.
- Determine whether your arrangement satisfies both gateways and whether you can self-assess using the risk assessment framework.
- If your arrangement satisfies both gateways and falls within the green zone, continue to maintain appropriate documentation (as the ATO can still check your calculations) and ensure it remains low-risk.
- If your arrangement satisfies both gateways and falls within the amber zone, be prepared to explain the arrangement to the ATO so they understand it better, resolve any areas of difference and consider what may be necessary to modify the arrangement so it can prospectively come within the green zone.
- If your arrangement satisfies both gateways and falls within the red zone, engage with the ATO or be prepared for the ATO to undertake further analysis to determine whether here is a risk of Part applying to your arrangement.
- Consider engaging with the ATO where your arrangement lacks a sound commercial rationale under gateway 1 or exhibits any of the high-risk features in gateway 2.
Many practitioners have been confused and expressed concerns about the calibration of the risk zones. Some are finding that they are too easily falling outside the green zone. To reiterate, falling within an amber or red zone does not mean that the ATO will apply Part IVA to your arrangement. It means you are at greater risk of the ATO reviewing your arrangement. Taking the initiative and reviewing your own arrangements, and engaging with the ATO if necessary, may result in you modifying your arrangement to prospectively come within the green zone.
Practitioners have also noted several outstanding concerns with the ATO’s approach in the PCG. These include the need for:
- Further guidance on how certain amounts such as superannuation, franking credits and FBT amounts are treated in the calculation of the second factor in the risk assessment framework.
- Practical advice on how taxpayers can determine the appropriate commercial benchmark.
- Clarification of the use of certain ambiguous terms and concepts such as “profit entitlement” and “firm deductions” in the risk assessment factors.
The ATO advises that if you are contemplating entering into new arrangements, or have concerns about potential high-risk factors within your existing arrangements, you can contact them at [email protected].
Robyn Jacobson is the senior advocate at the Tax Institute.
Shared from Accountants Daily