/tax-controversy-partners-pty-ltd/images/FinalTCPLogo-02-q5053.png "Tax Controversy Partners Logo")
This article was originally posted on CCH iKnow prior to a webinar hosted by CCH Learning on the topic.
Taxation of members of professional firms has presented philosophical and tax administration problems for decades around the nature of profits/gains and on the ability to “alienate” income to associates (especially those with lower tax rates) - resulting in some very important tax cases and Tax Office responses along the way.
There is a general proposition that a business should be able to operate whatever ownership structure they may choose – meaning that those owners should be able to direct however much their share or interest in the profits or gains from that structure would distribute to them.
Conversely, if working as an individual providing the efforts of their personal exertion within that professional firm, the relevant individual professional would normally be expected to be remunerated for those efforts – at an appropriate [market] rate considering their time, experience and relevant qualifications.
This article looks at the history of this issue in practice, considers how the latest ATO risk assessment guidelines (PCG 2021/4) approach these risks and then discusses practitioner concerns about some aspects of this PCG.
As important context, the following professional firm structure cases are relevant:
Note: The introduction of CGT in 1985 acted as a brake on Everett assignments in practice. Between 2007 and 2018, there were some taxplanning advantages to Everett assignments – through use of the CGT small business concessions (Div 152 of ITAA 1997). From 8 May 2018, such assignments need to meet an additional condition to qualify for those concessions, essentially prohibiting the concession being available where the “membership interest” itself is not transferred, but merely the transfer of the right to future income from the partnership.
To provide further context, the following ATO rulings are also relevant:
IT 25: Incorporation of medical practices (1981)
The ATO accepts the incorporation of medical practices in accordance with the by-laws of the NSW Branch of the AMA if it does nothing more than reduce the amount of income a doctor might earn by the amount of an appropriate superannuation cover.
IT 2121: Income tax: family companies and trusts in relation to income from personal exertion (1984)
Sets out the ATO response to the Federal Court decision in Tupicoff v FC of T 84 ATC 4851
Part IVA will apply to arrangements that interpose a family company or trust with no substantial change to the taxpayer’s operations other than that they are paid by a different entity and the interposed entity is not carrying on business. Relies on the ATO position about “personal exertion” similar to the “doctor cases”.
IT 2330: Income Splitting (1986)
As well as looking at a range of other important income-splitting cases, this ruling sets out the ATO response to the High Court decision in FC of T v Gulland; Watson v FC of T; Pincus v FC of T 85 ATC 4765 (the doctor cases). This ruling is probably the best articulation of the ATO dichotomy between ‘Income from personal services’ (which should be taxable to that individual professional) versus ‘income from the business structure’ (which may be alienated within the law). These criteria are likely to be a feature of future test cases on such arrangements under the ATO program following the new PCG. [Echoing previous cases and the words in s 100A, this ruling talks about “ordinary business or family dealings” and what would now be described as a “not-merely incidental” test for any “avoidance of tax” resulting from the “income-splitting”.]
IT 2503: Income tax: Incorporation of medical and other professional practices (1988)
Provides further guidance on IT 25 and applies to those practice companies whose income flows directly or predominantly from the rendering of personal services by the professional practitioner.
Echoing similar concepts to the current concerns in the new PCG, this ruling accepts the incorporation of professional practices (with some caveats about commerciality and income-splitting).
IT 2540: Income tax: capital gains: application to disposals of partnership assets and partnership interests (1989)
This deals with entries and exits for “no-goodwill” partnership. An Everett assignment is disposal by a partner of part of their partnership interest and will be treated as a part disposal of their interests in partnership assets for CGT purposes. As an Everett assignment is not made on an arm’s-length basis, that disposal will be deemed to substitute the market value of those partnership assets in calculating any capital gain from the assignment. [See the note above under the case regarding the impacts of CGT on the attractiveness of Everett assignments.]
IT 2639: Income tax: personal services income (1991)
Sets out the ATO views on income derived from rendering personal services and the factors for determining whether particular income is derived from personal services.
Building on IT 2330, this ruling is a further articulation of the ATO position on the criteria for differentiating between “income from personal services” versus “income from the business structure”. Again, these criteria are likely to be hotly debated in any test cases emerging from the current ATO program under the new PCG.
Personal Services Income (PSI) regime
While dealing with more “one-person-band” cases, the operation of the Personal Services Income regime (Pt 2-42 of the Income TaxAssessment Act 1997) are also dealt with in:
ATO’s 2014 professional firm remuneration guidelines
These draft guidelines were released on 2 September 2014 on the allocation of profits within professional practices. They set out what “higher risk” professional practices look like and list a range of factors to be considered. The guidance was concerned about income splitting and alienation of profits through complex business structures to exploit tax thresholds – applying to an IPP (individual professional practitioner) operating through a [partnership, trust or company] firm structure (and not earning PSI).
The draft guidance provided 3 benchmark tests (at the IPP, not firm level) to determine when an IPP would be “low” risk. If none of the tests were satisfied, the IPP would be “higher risk”:
In 2017, the ATO “suspended” the draft 2014 guidelines, due to concerns about perceived abuse of those guidelines through what they saw as “higher-risk” structures.
On 16 December 2021, the ATO announced the finalisation of PCG 2021/4 Allocation of professional firm profits – ATO compliance approachwhich applies from 1 July 2022.
To work out the risk level, the final Guidelines only apply where the following two gateways are passed:
Perhaps the most challenging aspects of this PCG are discussed from paras 47 to 59 – which set out what may be considered “high-risk” – including “those covered by a Taxpayer Alert” and then looking at some specific “potentially high-risk features”. Considering the large number of Taxpayer Alerts issued to date and their tendency to cast a wide net, that criterion alone may generate significant concerns – on top of the specific features. The ATO also caveated that the “protection” of this PCG does not eliminate other tax risks, like s 100A, etc.
In addition to the gateways, the PCG largely adopts the application criteria from the 2014 draft guidance (putting the comparable benchmark rate for employees as the third criterion), but via a (somewhat complex) scoring methodology for the proportions of income to each of those criteria.
The taxpayer then totals their scores under at least the first two criteria – noting that the third (comparable benchmark rate) factor may be difficult to determine accurately, to arrive at a “traffic-light scale” risk rating.
Based on that “traffic-light scale”, the ATO then provides an advance indication of their proposed allocation of resources to examine the taxpayer’s case. However, many practitioners have criticised the caveats on the “Green zone” as eliminating any “real” certainty or “safe harbours”.
Responding to feedback on the draft, the ATO provided some “transitional arrangements”, flowing from the suspended 2014 guidance and the ATO’s new risk assessment approach in the PCG. The request for taxpayers to notify the ATO of their intention to change to “lower-risk” structures creates some real tensions around negative tax consequences of changing structures (given potential CGT and even SMSF impacts) and whether some practitioners may be hesitant to recommend notification, given heightened prospects of review or audit.
The draft Guidelines were heavily criticised by many professionals and their representative bodies (see the Compendium PCG 2021/4EC). Despite having made some textual corrections to clarify areas of potential confusion in the draft, the main thrust of the draft Guidelines remains unchanged in the current version.
Reviewing that Compendium and commentary from professionals/associations reveals that the ATO has been variously criticised for allegedly:
The Guidelines are also silent on whether an entirely new “green-fields” structure may be more difficult for the ATO to challenge than a change to an existing structure – sometimes called a “Friday night/Monday morning” situation. We expect that answering this question may be part of the potential test case process, given the large number of such structures likely put in place in recent years.
While we all await a test case (or more likely several) on these matters to see whether the ATO is overreaching or not, all tax advisors should be carefully considering the ownership structures or profit distribution transactions for themselves and their IPP clients under this PCG.
Bruce Collins, Founder and Principal Solicitor at Tax Controversy Partners Pty Limited ran a webinar “
Bruce Collins, Founder and Principal Solicitor at Tax Controversy Partners Pty Limited ran a webinar “PCG 2021/4 – Allocation of professional firm profits – How risky are you/your clients?” with CCH Learning on Thursday 27 April at 1pm. Please join us for the discussion by clicking this link to watch the recording for 1 CPD unit.
At Tax Controversy Partners, our experienced lawyers can represent your best interests in providing advice and representation with the ATO to ensure you are protected. Please contact us for help using our online contact form, via email at admin@taxcontroversypartners.com.au or by phone at 02 8513 3813.