Allocation of profits by professional firms - draft guidelines released

In brief - Finalised guidelines will apply from 1 July 2021 although transitional provisions may apply to arrangements entered into before 14 December 2017

The Australian Taxation Office (ATO) has released its draft guidelines on the allocation of profits by professional firms in PCG 2021/D2.

The draft guidelines seek to provide a framework to assess the tax risk of arrangements under which a professional diverts profits from a professional services business of which they are a member to an associated entity to reduce income tax.

When finalised, the draft guidelines will replace the suspended and interim guidelines in place since 2014. My 2018 article Allocation of profits within professional firms interim guidelines released considers the suspended and interim guidelines in more detail. The ATO intends to review the new guidelines regularly and revise them if necessary.

Key features of the allocation of profits by professional firms draft guidelines

Key features include:

• they only apply to professional firms, including accountants, architects, engineers, financial services advisers, lawyers and medical practitioners

• when finalised, they will apply from 1 July 2021, although there are transitional provisions

• they provide some assurance that the ATO will not allocate compliance resources for arrangements that are assessed to be low risk, but they do not create any safe harbours

• there are a number of preconditions that must be satisfied before they can be applied, including two gateways that must be passed

• if the preconditions are satisfied, they allocate a risk rating to the arrangements based on three risk assessment factors

• if professional firms are in any doubt about their arrangements, they are encouraged to contact the ATO by email at ProfessionalPdts@ato.gov.au

Compliance with draft guidelines may result in higher tax liability for professionals

The draft guidelines are far more complex than the suspended guidelines and we expect they will be difficult to apply in practice. 

Where they can be applied, they will be more difficult to satisfy and many arrangements that were assessed to be low risk under the suspended guidelines will be assessed as higher risk under the draft guidelines. Therefore, compliance with the draft guidelines is likely to result in a higher tax liability for professionals.

Much of the complexity arises from the need to pass the two gateways which lack clarity. Also, the draft guidelines allow the ATO much flexibility to determine that they do not apply to particular arrangements.

Apart from the most straightforward arrangements, professional firms may need to engage with the ATO to obtain assurance that the arrangements are effective for tax purposes.

Gateways to be passed

The two gateways that must be passed are:

1. there must be a genuine commercial basis for the arrangement and the way in which profits are distributed, and the arrangement must achieve the claimed commercial outcome

2. there must not be any high risk features

For gateway one, the draft guidelines identify several circumstances that may attract scrutiny from the ATO. They include lack of documentation, lack of evidence that the commercial purpose has been achieved, unnecessarily complex arrangements, such as arrangements that include steps which serve no purpose other than to obtain a tax saving, arrangements that contain an unreasonable allocation of risk, and arrangements where profits have not been effectively distributed in substance.

The high risk features for gateway two include arrangements covered by a Taxpayer Alert, use of finance by the associated entity to acquire part of the professional's equity interest in the firm, 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 from the assignments that were held to be effective in the Everett and Galland cases and multiple classes of shares and units. 

Dividend access shares held by an associated entity of the professional is considered to be a high risk feature.

ATO's risk assessment framework

If the two gateways are passed, the risk level for an arrangement is assessed against three risk assessment factors:

1. the proportion of profit entitlement from the whole of the firm group including service entities returned in the hands of the professional (if the proportion is 100% there is no need to apply the other risk assessment factors)

2. the total effective tax rate for profits received from the firm by the professional and associated entities

3. the remuneration returned in the hands of the professional as a percentage of the commercial benchmark for the services provided to the firm

The ATO recognises that the commercial benchmark in the third factor may be difficult to determine so it is effectively optional for professional firms to apply it. The ATO thinks that it may be possible for an employment agency to determine the commercial benchmark based on the principles in the draft guideline, although this remains to be seen.

What the ATO may do if arrangement is assessed as low, moderate or high risk

There is a risk assessment scoring table which allocates a score of between 1 and 6 for each risk assessment factor. The score is determined by a range of numerical bands and the score for each risk factor is then added together to determine the risk rating. The lower the score the lower the risk rating.

If the arrangement is assessed to be: 

• low risk (green risk zone), the ATO will only apply compliance resources in exceptional circumstances

• moderate risk (amber risk zone), the ATO is likely to conduct further analysis

• high risk (red risk zone), the ATO is likely to commence a review or audit as a matter of priority

Transitional provisions

Arrangements entered into before 14 December 2017 are eligible to apply the suspended guidelines for the years ending 30 June 2018 to 30 June 2021 as long as they are commercially driven and do not exhibit any of the high risk features. 

As these requirements are the key elements of the two gateways under the draft guidelines, in essence professional firms will need to consider if they pass the gateways before they can continue to apply the suspended guidelines.

The ATO also recognises that arrangements are more likely to be assessed as higher risk under the draft guidelines than the suspended guidelines so will allow a grace period to allow those arrangements to be modified until 30 June 2023. The suspended guidelines can be applied until that time.