ATO’s compliance approach - allocation of profits

Tax Insights

On 1 March 2021, the ATO released Draft Practical Compliance Guideline PCG 2021/D2 (‘the Draft PCG’) in respect of the ATO’s ‘swim between the flags’ compliance approach to the allocation of profits from professional service firms, including accounting and legal service providers and medical practices.

ATO’s compliance approachThe Draft PCG has been issued following a three-year-long wait after the suspension of the ATO’s former guidelines on this matter (‘the Suspended Guidelines’).

The Draft PCG sets out how the ATO intends on applying compliance resources when considering the allocation of professional firm profits or income in the assessable income of the individual professional practitioner (‘the IPP’) and their family members or associated entities.

In other words, the ATO threatens to review an IPP’s arrangements under the spectre of the general anti-avoidance provisions in Part IVA of the Income Tax Assessment Act 1936 in instances where the IPP’s profit allocation between itself and its associated entities (e.g., spouse, related companies, etc.) does not fall within certain limits.

The Draft PCG will be used by the ATO to tailor their engagement with IPPs based on three risk assessment factors.

The Draft PCG can therefore also be used by an IPP to self-assess and proactively manage their tax risk to avoid ATO scrutiny.​

When does it apply from?

The Draft PCG is proposed to apply from 1 July 2021 once finalised – although transitional rules allow for the continued reliance on the Suspended Guidelines for the 2018-income year through to the 2023-income year.

What is a PCG?

It is perhaps first useful to understand the legal status of a Practical Compliance Guideline (‘PCG’). A PCG is not law, nor is it a Public Ruling (such as a ‘Taxation Ruling’) and is therefore not binding on the Commissioner of Taxation (‘the Commissioner’).

ATO’s compliance approachRather, a PCG is a tool used by the ATO whereby they publish their views of the relative levels of tax compliance risk across a specific area of the tax law, with the purported intention of guiding the behavior of taxpayers who wish to operate in a low-risk environment.

In doing so, taxpayers can obtain some form of comfort that if they conduct their tax affairs ‘within the flags’ as set out in the PCG, then the Commissioner will administer the law in accordance with the approach set out within the document.

Accordingly, the Draft PCG does not replace, alter or affect the operation of the law in any way. It does not relieve the taxpayer of their legal obligations to comply with all relevant tax laws and it does not provide any safe harbor administrative concessions. Since it is not law, taxpayers are under no obligation to abide by it. However, not doing so can put a taxpayer at risk of ATO scrutiny, and therefore, choosing whether to adhere to it will ultimately depend on the taxpayer’s relative risk appetite.

In any case, the Draft PCG is still only a draft and, whilst many expect it to be published with only minor (if any) revisions, it may be prudent to wait for the final document before deciding on a course of action (e.g. restructure).

Who does it apply to?

The Draft PCG applies to an IPP.

An IPP is individual who is a ‘professional’ that provides services to clients of a ‘professional firm’, or to the firm itself, and who, either alone or together with associated entities (e.g. spouse, family trust, etc.), has a legal or beneficial interest in the firm.

A ‘professional’ is a member of a recognised profession (e.g. a lawyer). ‘Professional firms’ includes, but is not limited to, those providing services in the following industries:

  • accounting
  • architectural
  • engineering
  • financial services
  • legal
  • medical professions

Given that the Draft PCG only applies to the tax compliance risks that arise from professional firm arrangements, the Draft PCG provides some guidance in determining whether an individual is a ‘professional’. Due consideration of the guidance in the Draft PCG should be given in determining whether it is appropriate to apply the Draft PCG in instances where the individual operates in a profession in a type of firm or practice other than those listed above.

ATO’s compliance approachWhat are the pre-conditions?

Before an IPP can rely on the Draft PCG, they must first meet the following pre-conditions:

  1. the IPP must provide professional services to clients of the firm, or must be actively involved in the management of the firm;
  2. the IPP and/or their associated entities must have a legal or beneficial interest in the firm;
  3. the income of the firm must not be ‘personal services income’;
  4. the firm must operate by way of a legally effective structure (e.g. a partnership, trust or company);
  5. the IPP must have full rights to participate in the voting, managing and income of the firm;
  6. the arrangement must be commercially driven – i.e. Gateway 1 must be satisfied; and
  7. the arrangement and the IPP must not demonstrate any ‘high-risk’ features – i.e. Gateway 2 must be satisfied.

The Draft PCG sets out detailed guidance in the application of Gateways 1 and 2 – including examples.

How does the risk assessment work?

If the IPP satisfies the pre-conditions (including Gateways 1 and 2) then they are able to self-assess their risk against each of the three risk assessment factors to obtain corresponding scores as set out in Table 1. The aggregate of those scores is then taken and applied to Table 2 to determine the relative risk zone.

Table 1 – risk assessment factors

This table sets out the score for each risk assessment factor.

Table 2 – risk zones

This table sets out the risk level applicable to the scores obtained by using the previous table:

Taxpayers may assess themselves against the first two risk assessment factors only, instead of all three, where it is impractical for the IPP to accurately determine an appropriate commercial remuneration against which to benchmark. The Draft PCG sets out some guidance on what matters may be considered when determining an appropriate benchmark.

What does the risk rating mean?

The ATO will assess the IPP’s level of risk based on the above criteria and will then tailor their compliance approach based on that risk zone rating.

For instance, they suggest that they will only apply compliance resources to review the IPP’s allocation of profit in ‘exceptional circumstances’ and to confirm that the IPP’s calculations were done according to the Draft PCG.

However, failing either Gateways 1 or 2, or being in the amber or red zones may result in closer ATO scrutiny (e.g., review or audit) – although it does not necessarily mean that the ATO will apply Part IVA to negate any tax benefits from the distribution of firm profits to the IPP’s associated entities.

So then, what now?
IPPs should review their tax affairs to ascertain whether they will be ‘low-risk’ under the Draft PCG or whether they are eligible to apply the transitional rules.

ATO’s compliance approachThe IPP may need to take steps to remedy their tax affairs if they wish to be in a ‘low-risk’ category. This could be as simple as distributing fewer profits to associates for the 2022-income year and onwards. However, in some circumstances, it may necessitate undertaking a restructure of the firm and the IPP’s tax affairs. Caution should therefore be had as to the income tax, CGT, GST, transfer duty, and commercial implications of any such restructuring.

IPPs should also ensure that they document their assessment under the Draft PCG annually and keep records for at least five years. This includes documenting the calculations, application of the risk assessment factors, and the rationale as to why the pre-conditions are satisfied.

How can RSM help?

RSM can help provide IPPs, professional firms and medical practices with advice on whether they will satisfy the pre-conditions (including Gateways 1 and 2) and undertaking the risk assessment calculations.
We can also assist IPPs to determine and document the application of the risk assessment factors and can provide commercial and tax advice on any steps that may be taken to remedy or restructure the affairs of the IPP and the professional firm or medical practice to obtain a ‘low-risk’ rating. For more information, please get in touch with your nearest RSM office.

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