On 8 October 2014, the Australian Taxation Office (ATO) released its guidelines on “Assessing the risk: Allocation of profits within professional firms” (Guidelines). The ATO later revised the Guidelines on 30 June 2015.
The Guidelines explain how the ATO will assess the risk of Part IVA of the Income Tax Assessment Act 1936 (Cth) (Part IVA) applying to the allocation of profits from the business structure of a professional firm carried on through a partnership, trust or company, where the income of the firm is not personal services income.
The ATO will apply the principles stated in the Guidelines in conducting its audit activity for the 2014/2015 income tax years and beyond. The ATO intends to review the Guidelines during the 2016/2017 income tax year, or pending the outcome of any “test case” it runs.
PURPOSE AND APPLICATION OF THE GUIDELINES
The Guidelines explain how the ATO will assess tax compliance risks associated with the allocation of profits from the business structure of a professional firm carried on through a partnership, trust or company.
Specifically, the Guidelines will be applied by the ATO if:
- an individual profession practitioner (IPP) services clients of a professional services firm, or is actively engaged in the management of a professional services firm;
- the IPP or their associated entities have a legal or beneficial interest in the professional services firm;
- the professional services firm is operated through an effective partnership, trust or company; and
- the income of the professional services firm is not personal services income.
From these application principles, it is clear that the ATO’s compliance activity will not be directed towards the business structure through which a professional firm is conducted, but rather how IPPs deal with their entitlement to the income generated by the professional firm.
The Guidelines apply to relevant arrangements within professional firms, including, but not limited to, those providing services in the accounting, architectural, engineering, financial services, legal and medical professions. The Guidelines do not apply to businesses where the equity holders contribute to the business through the provision of their skilled labour, including tradespeople.
COMPLIANCE RISK ASSESSMENT FACTORS – “THE BENCHMARKS”
An IPP taxpayer will be treated by the ATO as a low compliance risk, and not likely subject to compliance action, if the IPP meets one of the following benchmarks (Benchmarks) regarding the income the IPP derived from the professional firm:
BENCHMARK 1: EQUIVALENT REMUNERATION
The IPP receives assessable income from the professional firm in their own hands as an appropriate return for the services rendered.
To determine an “appropriate return” the IPP may use, as a minimum, the level of remuneration paid to the upper quartile of the highest paid professional employees providing equivalent services to the frim. If there are no such employees in the firm, a salary based on relevant market data is acceptable to the ATO.
BENCHMARK 2: 50% ENTITLEMENT
The IPP receives in their own hands 50% or more of the income from the firm to which the IPP and their associated entities are entitled.
BENCHMARK 3: 30% EFFECTIVE TAX RATE
The effective tax rate must be 30% or higher for both:
- income from the firm to which the IPP is entitled; and
- income from the firm to which the IPP and their associated entities are collectively entitled.
Where none of the above benchmarks can be satisfied, the IPP’s arrangement will be classified by the ATO as high risk for ATO compliance action. Further, the lower the effective tax rate achieved by the IPP and their associated entities, the greater the risk of compliance action.
GUIDELINES AND SERVICE ENTITIES
In applying the Benchmarks, the ATO has stated that income received by a related service entity will be considered when determining whether the IPP and their associated entities meet any of the Benchmarks.
GUIDELINES AND EVERETT ASSIGNMENTS
An Everett assignment draws its name from the type of assignment contemplated inFederal Commissioner of Taxation v Everett (1980) 143 CLR 440.
An Everett assignment occurs when a partner assigns their partnership interest to an individual or other entity (usually related to the assignor).
The ATO had previously noted that Part IVA (and its predecessor) does not apply to an Everett assignment as an Everett assignment is a mere disposition of an income producing asset (i.e. the partnership interest).
However, the ATO now considers that an Everett assignment produces a result whereby income which is only capable of being produced by the personal efforts of a partner is derived by other persons or entities, a factor which leads the ATO to the conclusion that Part IVA may apply.
For Everett assignments entered into by an IPP after 1 July 2015, the ATO will assess the income of the IPP against the Benchmarks to determine whether the assignment is a low or high compliance risk activity. The ATO has also flagged that it may consider the application of Part IVA to an assignment entered into before 1 July 2015 where after 30 June 2015 either:
- a further assignment occurs or a power of appointment or other discretion is exercised; and
- as a result, the IPP does not satisfy any of the Benchmarks in the Guidelines.
LIMITATIONS OF THE GUIDELINES
The ATO concedes that the Guidelines have no basis at law and that they will need to be revised once a suitable “test case” is run. Therefore, in addition to determining that an IPP has failed to satisfy any of the Benchmarks, the ATO would also need to establish a Part IVA argument that is yet to be tested in the Courts.
The Guidelines have been released by the ATO as guidance material only, meaning the views expressed by the ATO in the Guidelines are not binding on the ATO.
However, taxpayers that rely on the Guidelines in managing their affairs may be protected against false or misleading statement penalties and general interest charges.
MANAGING AN IPP’S INTEREST IN A FIRM IN THE CONTEXT OF THE GUIDELINES
IPPs that are concerned with the application of the Guidelines may wish to complete an analysis to determine their compliance with the Guidelines.
IPPs that are already complying with one of the Benchmarks can rest easy and maintain the course as they are at a low risk of compliance action being initiated against them by the ATO.
IPPs that determine they do not comply any of the Benchmarks have a number of options available to them, including:
- maintain the course, accepting the higher risk of being subjected to ATO compliance action;
- seek to effect a change of remuneration policy within their professional services firm to ensure that all of the firm’s IPPs satisfy Benchmark 1; or
- amend their own income distribution habits from income derived by the firm to ensure that they and their associated entities satisfy either Benchmark 2 or Benchmark 3.