TAX FILES
Allocation of professional firm profits to individual practitioners ANDREW SHAW, SHAW LAWYERS
“I
like traffic lights. I like traffic lights. I like traffic lights. But only when they’re green.” – Monty Python, “Traffic Lights” (1980). On 1 March 2021 the Australian Taxation Office (‘ATO’) released a draft Guideline setting out the ATO’s proposed compliance approach to allocation of profits by professional firms.1 The Guideline explains how the ATO intends to apply compliance resources when considering the allocation of professional firm profit or income in the assessable income of the individual professional practitioner (‘IPP’). The Guideline is in draft for consultation. Once finalised, the Guideline is proposed to apply from 1 July 2021.2
Who comes within the Guideline? The Guideline applies to professional firms including the legal profession, medical, accounting, architectural, engineering, financial services, and others. The Guideline is directed at professional services income of IPPs (‘PSI’). An IPP is an individual who provides services to clients of the firm, or to the firm itself, in circumstances where the IPP and/or associated entities have a legal or beneficial interest in the firm. PSI is income earned mainly as a result of personal effort or skill of an IPP, rather than being generated by assets or employees of the firm. What is the ATO worried about? The ATO is concerned about arrangements where taxpayers alter their tax liability by redirecting, to an associated entity, their income from their professional services. The ATO accepts that the profit or income of a professional firm may comprise different components - reflecting a mixture of income from the efforts, labour, and application of skills of the firm’s IPPs (personal exertion) and income generated from the business structure.3 The ATO also accepts that IPPs may use corporate structures and that “there may also be good non-tax reasons as to why the controller of a business receives significantly less
24 THE BULLETIN May 2021
of the business’ profits than would otherwise be the case”. However, where a business involves the provision of services, the ATO will be concerned with arrangements “where the compensation received by the individual is artificially low while related entities benefit (or the individual ultimately benefits), and commercial reasons do not justify the arrangement”.4
Ideal outcome If you are an IPP, the ideal outcome is to pass both Gateways such that the Guideline applies to you, but to achieve a low-risk (green) rating. The ATO will apply compliance resources to review allocation of profits of an IPP in the green zone only in exceptional circumstances.7
Guideline is not a safe harbour The Guideline is not a “safe harbour” that makes a firm immune to ATO scrutiny. Nor is the Guideline a public ruling which is binding upon the ATO. Instead, the Guideline provides a “traffic light” rating system to assess the risk of ATO compliance activity. If a firm’s circumstances align with a low-risk rating (green zone), the ATO will generally not allocate compliance resources to test the tax outcomes of the firm’s arrangements. If the firm has a moderate risk rating (amber zone) the ATO is likely to conduct further analysis and may seek further information. If the firm has a high-risk rating (red zone) the ATO is likely to commence reviews as a matter of priority and cases may proceed directly to audit.5 The Guideline applies only if the IPP’s circumstances pass two “Gateways”. There must be a genuine commercial basis for entering into and operating the arrangement or structure (Gateway 1). The arrangement must not have certain highrisk features (Gateway 2). Some arrangements may come within the Guideline but are nonetheless regarded by the ATO as high-risk (red zone) because they are designed to ensure the IPP is not directly rewarded for services they provide to the business, or the IPP receives a reward which is substantially less than the value of those services. Failing a Gateway, or passing both Gateways but being in the red zone, does not necessarily mean that the general antiavoidance provisions will apply, but the ATO is likely to give closer scrutiny to profit allocation arrangements including a deeper consideration of whether the antiavoidance provisions apply.6
The starting point – Gateway 1 – commercial rationale The Guideline applies only if both Gateways are passed. Gateway 1 requires that there must be a genuine commercial basis for the arrangement and also for the way profits are distributed. The arrangement must reflect the commercial needs of the business. The ATO also requires that the arrangement must be “appropriately documented” and there must be evidence that the stated commercial purpose was achieved as a result of the arrangement. A mere assertion of “asset protection” for an IPP is not sufficient if the arrangement does not actually provide improved asset protection. Legal form and documentation must be consistent with the economic substance of how the professional firm operates in practice. The ATO may look at internal management documents, procedures, and practices to determine whether a documented arrangement has, in fact, been correctly implemented. Indicators that a profit allocation arrangement lacks a sound commercial rationale include unnecessary complexity, steps that serve no real purpose other than to gain tax advantages (e.g. interposed entities, related party dealings that merely produce a tax result, circularity of funds/no real money), negligible risk where risk would be expected (e.g. nonrecourse loans), and dealings on nonarm’s length terms.8 Gateway 2 – high-risk features If Gateway 1 is passed, the IPP must assess whether the arrangement contains any high-risk features such as those covered by Tax Alerts issued by the ATO. High-risk features include financing
