The distribution of profits made by professional firms to the controllers of a business and their associates may present tax complications. Professional firms here refers to professional practices such as accounting firms, architectural firms, engineering firms, financial services practices, legal firms, medical practices and so forth. The issue is the potential application of the general anti avoidance provisions where the allocation of profits is perceived by the ATO to constitute a scheme entered into to reduce or defer tax outcomes. The general anti avoidance rules (found in Part IVA of the Income Tax Assessment Act of 1936) may apply where the following elements exist:
- A scheme
- A tax benefit is achieved by someone in connection to the scheme
- The scheme was entered into with the sole or dominant purpose of obtaining a tax benefit.
The general anti avoidance provisions enable the ATO to cancel the taxation benefits received by the relevant taxpayer/s and impose further penalties. The threshold for a tax avoidance scheme can be surprisingly low for taxpayers. Importantly, the avoidance rules can apply even where there is no subjective intention to avoid tax.
In the context of the allocation of professional firm profits, the anti avoidance rules will tend to be relevant where the profits of a professional firm are strategically redirected to associated persons or entities on lower marginal tax rates in order to reduce or defer taxation outcomes. Examples include where:
- The individual professional practitioner IPP is not being directly rewarded for services provided to the professional firm.
- The IPP is being rewarded substantially less than the market value of services provided.
The reason these allocation techniques are attractive is because the IPP will often be on a higher marginal rate than their spouse or another associated person or entity e.g. a company which is a non base rate entity has a flat tax rate of 30%. Therefore, by allocating profits to an associate (e.g. a spouse), the distributed amount may be subjected to a lower tax rate despite the fact the IPP will continue to the enjoy the economic benefits of the allocated profit either by virtue of control over the associate entity or by virtue of shared wealth within a typical spousal relationship. Put another way, profits allocated to associated persons will be subjected to lower tax rates despite the controlling spouse generally retaining the advantage of the allocated profits. If not for the anti avoidance rules, there is a clear incentive for professional firms to allocate profits to these associated persons / entities.
To assist professional firms to mitigate the risk of profit allocations becoming subject to the general anti avoidance rules, the ATO has recently released Public Compliance Guidance PCG 2021/4. The PCG provides taxpayers with guidance on whether profit allocation arrangements made by the professional firm are a low risk, moderate risk or high risk of attracting scrutiny from the Australian Taxation Office. The risk assessment framework within the PCG is only available for eligible taxpayers. Eligibility includes that the IPP passes the two tests or i.e. gateways. The first gateway is that there is a sound commercial rationale for entering into and operating the arrangement or structure. The second gateway is that there are not any high risk features to the arrangement. Further eligibility criteria include that:
- The IPP must either provide professional services for the firm or be actively involved in managing the firm and have (or an associate have) a legal or beneficial interest in the firm.
- The professional firm income is not subject to the personal services income rules.
- The professional firm operates through a partnership, trust or company structure.
- The IPP holds equity, directly or indirectly, with rights to participate in voting, management and rights to receive income or capital distributions.
Remember that the risk assessment framework within the PCG requires self assessment that should be conducted on a yearly basis. Eligibility to actually use the risk assessment should also be determined on a yearly basis. Arrangements and risks may vary between years as profit allocation arrangements change over time. Records of self assessment results should be maintained for audit purposes.
Gateway 1 – Commercial Rationale
There must be a genuine commercial rationale for profit allocation arrangements, aside from the obvious commercial advantages achieved by the minimisation of tax. The commercial rationale should be recorded and documented as evidence to support satisfaction of this gateway.
The genuine commercial intentions of particular arrangements will be questionable where:
- The arrangement involves an excessive process or structure with no real commercial or economic benefit achieved. For example, the creation and use of interposed entities by an IPP to receive profit allocations with no commercial basis for doing so.
- The stated commercial purpose of the arrangement is not achieved under the arrangement.
- The arrangement is not carried out as planned.
- The remuneration received by an IPP does not reflect the market value of the personal services provided to the firm and is not linked to personal performance.
- The arrangement involves distributions which are not provided to and enjoyed by the person entitled. For example, where the associate of an IPP receives a distribution entitlement from the professional firm but does not physically receive a cash distribution. Or, if the distribution is physically received, the associate has limited control and enjoyment of the cash receipt.
Gateway 2 – High Risk Features
There must not be any high risk features to the profit allocation arrangement.
The PCG specifies that the following will constitute high risk features:
- Finance arrangements relating to non arms length transactions whereby an associated entity of an IPP obtains finance to acquire part of the IPPs equity interest in the professional firm.
- Exploiting the difference between accounting standards and tax law treatment of certain amounts that results in cash benefits to certain persons being disproportionate to resulting tax outcomes for those persons.
- An arrangement whereby a partner assigns partnership interests in a way other than that permitted in the Everett and Galland cases. The courts in these cases affirmed that (under certain narrow circumstances) a partner in a partnership could legitimately reduce income tax on partnership profits by assigning interests to an alternative person / entity even where that person / entity possessed a lower applicable tax rate.
- Where there are alternative classes of shares and / or units issued to non equity holders and which do not provide voting rights.
The Risk Assessment Framework
If the above described pre conditions are satisfied, the risk assessment framework may be used by the IPP to self assess the risk of profit allocation arrangements. The framework itself involves the three risk zones: low risk, moderate risk and high risk. There are three tests with a score available against the result of each test ranging from 1 to 6. The arrangement will be low risk where the total score achieved is 10 or less, moderate risk where the total score is 11 12, or high risk where the total score is 13 or greater. It is possible to only self assess against the first two tests where the third test is impractical to assess. However, this will change the scoring range listed above. Refer to the PCG for further information.
The three risk assessment tests are outlined below:
1. The proportion of profit entitlement from the whole of firm group returned in the hands of the IPP.
a. Score 1: If > 90%
b. Score 2: If > 75% to ≤ 90%
c. Score 3: If > 60% to ≤ 75%
d. Score 4: If > 50% to ≤ 60%
e. Score 5: If > 25% to ≤ 50%
f. Score 5: If ≤25%
2. The total effective tax rate for income received from the firm by the IPP and associated entities.
a. Score 1: If > 40%
b. Score 2: If > 35% to ≤ 40%
c. Score 3: If > 30% to ≤ 35%
d. Score 4: If > 25% to ≤ 30%
e. Score 5: If > 20% to ≤ 25%
f. Score 6: If ≤ 20%
3. Remuneration returned in the hands of the IPP as a percentage of the commercial benchmark for the services provided to the firm.
a. Score 1: If > 200%
b. Score 2: If > 150% to ≤ 200%
c. Score 3: If > 100% to ≤ 150%
d. Score 4: If > 90% to ≤ 100%
e. Score 5: If > 70% to ≤ 90%
f. Score 6: If 70%
It is best to understand the risk assessment framework by considering some examples.
Example 1: Scarlet is an IPP in a partnership. She is entitled to $300,00 from the partnership. However, she sells a 50% partnership interest to an associated company reducing her personal entitlement to $150,000. The commercial value of services provided by Scarlet to the firm is $100,000.
Per the risk assessment tests:
Test 1: The proportion of profit entitlement from the whole of firm group returned in the hands of the IPP = 50% ($150,000 / $300,000). This gives a score of 5.
Test 2: The total effective tax rate for income received from the firm by the IPP and associated entities = for Scarlet, the tax liability on the $150,000 partnership income entitlement is $40,567 (based on marginal rates). For the company, the tax liability on $150,000 is $45,000 (based on the non base rate entity corporate tax rate of 30%). The total tax on the $300,000 combined entitlement of Scarlet and the company is $85,567. The total effective tax rate is therefore 28.52%. This gives a score of 4.
Test 3: Remuneration returned in the hands of the IPP as a percentage of the commercial benchmark for the services provided to the firm = $150,000 / $100,000 = 150%. This gives a score of 3.
Total score: 12 (5 + 4 + 3). Therefore, the profit allocation arrangement with Scarlet, (as an IPP) has moderate (amber) risk under the risk framework.
Example 2: Abbie is an IPP in a partnership involving four partners acting as trustees of separate trusts. For the relevant financial year, Abbie’s discretionary trust is entitled to $1,000,000 as a one quarter interest in the $4,000,000 partnership profit. Of that $1,000,000 entitlement to the trust, $200,000 is distributed to Abbie and $800,000 is distributed to a corporate beneficiary of the trust which is held and controlled by Abbie’s spouse. The commercial value of the personal services provided by Abbie to the firm is $200,000.
Per the risk assessment tests:
Test 1: The proportion of profit entitlement from the whole of firm group returned in the hands of the IPP = 20% ($200,000 / $1,000,000). This gives a score of 6.
Test 2: The total effective tax rate for income received from the firm by the IPP and associated entities = for Abbie, the tax liability on the $200,000 trust distribution is $60,667. For the company, the tax liability on $800,000 trust distribution is $240,000 (based on the non base rate entity corporate tax rate of 30%). The total tax on the $1,000,000 combined entitlement of Abbie and the company is $300,667. The total effective tax rate is therefore 30.06%. This gives a score of 3.
Test 3: Remuneration returned in the hands of the IPP as a percentage of the commercial benchmark for the services provided to the firm = $200,000 / 200,000 = 100%. This gives a score of 4.
Total score: 13 (6 + 3 + 4). Therefore, the profit allocation arrangement with Abbie (as an IPP) has a high (red) risk under the risk framework.
There was previously ATO guidance available to taxpayers (now suspended) that provided a different framework for the purposes of assessing the risk of profit allocation arrangements. Those arrangements that were considered low risk under those suspended guidelines will continue to be treated as low risk under the new risk assessment framework until 30 June 2024.
This article is for general information only. It does not make recommendations nor does it provide advice to address your personal circumstances. To make an informed decision, always contact a registered tax professional.