Professional Firms & Allocation of Profits under ATO Scrutiny

Allocation of profits within professional firms is attracting the ATO’s attention. The ATO is taking a closer look at how certain professional firms carried on through a partnership, trust or company are allocating profits, and whether there are arrangements being utilised which could be giving taxpayers an unfair tax advantage. The ATO said it is reviewing remuneration arrangements to make sure people are using the structures correctly.

The ATO has released draft guidelines on how it will assess tax compliance risk applying to the allocation of profits from a professional firm, carried on through a partnership, trust or company, where the income of the firm is not personal services income. Specifically, the ATO is taking a look at whether the general anti-avoidance rules under the tax law would apply in certain circumstances.

ATO Deputy Commissioner Michael Cranston said the draft guidelines explain how professionals can assess the tax risks flowing from the use of partnerships of discretionary trusts and similar structures. “Professional practices may legitimately operate as a partnership of discretionary trusts or through similar structures, however the ATO is reviewing remuneration arrangements used by accountants, lawyers and other professionals to make sure people are using these structures appropriately,” he said. Firms which could be affected include, but are not limited to, those that provide architectural, engineering, financial, legal and medical services.

The ATO’s concerns

The ATO said in some cases practice income may be treated as being derived from a business structure, even through the source of that income remains, to a significant extent, the provision of professional services by one or more individuals. The ATO said it was concerned that the general anti-avoidance rules under the tax law may apply to schemes which are designed to ensure that the individual practitioner professional (IPP) is not directly rewarded for the services they provide to the business, or receives a reward which is substantially less than the value of those services. Where an individual attempts to alienate amounts of income flowing from their personal exertion (as opposed to income generated by the business structure), the ATO said it may consider cancelling relevant tax benefits.

The ATO said it acknowledged that the general anti-avoidance provisions have historically been applied to assess individuals on income generated by their personal exertion or application of their professional skills, rather than profits or income generated by a business. However, the ATO said it considers that the general anti-avoidance rules could apply where an IPP arranges for the distribution of business profits or income to associates without regard to the value of the services the individual has provided to the business. This is particularly the case where, for example, the level of income received by the individual, whether by way of salary, distribution of partnership or trust profit, dividend or any combination of these, does not reflect their contribution to the business and is not otherwise explicable by the commercial circumstances of the business.

Low-risk and high-risk arrangements

Mr Cranston said the draft guidelines set out what the ATO considers to be low risk, legally effective arrangements, and what the ATO considers to be high-risk arrangements that might attract attention. Broadly, a case would be considered “low risk” and not subject to compliance action if the IPP meets one of the following guidelines regarding income from the firm:

  • the IPP receives assessable income from the firm in their own hands as an appropriate return for the services they provide to the firm. In determining an appropriate level of income, the taxpayer may use the level of remuneration paid to the highest band of professional employees providing equivalent services to the firm, or if there are no such employees in the firm, comparable firms or relevant industry benchmarks eg industry benchmarks for a region provided by a professional association, agency or consultant; and/or
  • 50% or more of the income to which the IPP, and their associated entities, are collectively entitled (whether directly or indirectly through interposed entities) in the relevant year is assessable in the hands of the IPP; or
  • the IPP, and their associated entities, both have an effective tax rate of 30% or higher on the income received from the firm.

Where none of the low-risk guidelines is met, the ATO will consider the arrangement to be “higher risk”. In these cases, the lower the effective tax rate, the higher the ATO will rate the compliance risk and the greater the likelihood of compliance action. For example, an arrangement with an effective tax rate of 15% would be rated as higher risk than one with an effective tax rate of 25%. Note that in cases where other compliance issues are evident (e.g. late lodgement of returns, income injection to entities with carry forward losses, inappropriate access to low income tax offsets or other benefits), the taxpayer will be rated as higher risk.

Date of effect and review

The draft guidelines have been co-designed with industry representatives and have been issued as a working draft for ongoing public consultation. The ATO said the draft guidelines will be applied from the 2014–2015 income tax year. The guidelines will be reviewed during the 2016–2017 year, subject to the possibility of judicial guidance pending an appropriate test case being identified. If you have any questions or concerns, please contact Commercial Associates on 02 9299 1200 or click Email Firm below to arrange a complimentary discussion with one of our expert advisors.