In a welcome move, the ATO has released practical guidelines on how it will assess the risk of professional practices, such as accounting and legal firms, making profit distributions to non-principals. The guidelines set some useful parameters for what the ATO considers high risk and low risk behaviour.
Why the ATO interest?
In recent years the ATO has expressed concerns about the use of different structures for owning and operating professional firms.
This largely emanated from the previous ‘crack-down’ on the use of service entities. Following the release of service entity safe harbour guidelines, the ATO had expected to see a reduction in the profits of service entities and a corresponding increase in the profits of individual partners. The former certainly occurred, but not the latter!
On further analysis, the ATO noticed a large volume of professional firms had restructured from traditional partnerships of individuals to a range of new structures such as partnerships of trusts, unit trusts and companies. As a result, the individual principals were not deriving the profits. Instead, entities associated with them derived the profits and, in many cases, distributed the profits to a range of beneficiaries.
Some accounting and law firms were selected for risk reviews and the ATO commenced looking for potential test cases to challenge issues such as the movement to new structures and the decision to distribute income to taxpayers other than the relevant principals. No takers have emerged to date!
The ATO also put together a working group comprising senior ATO officers and representatives of the various accounting and legal professional bodies to discuss its concerns and get feedback. Michael Parker is a member of the working group, representing CPA Australia.
In late 2013, a Taxpayer Alert - TA 2013/3 - was issued to put taxpayers and their advisors on notice about the ATO’s concerns with the use of practice structures. Three main concerns were raised:
- are the CGT and other tax outcomes being correctly identified when practices restructure;
- is the business actually being operated by the purported practice structure or by the individual principals; and
- does Part IVA apply to the restructure or the annual distribution choices that are made.
The first two concerns are entirely valid. The third is far more controversial.
The ATO has seen cases of firms restructuring and not reporting the correct CGT treatment on the sale of business from one structure to another.
This may be because the parties have not understood the market value substitution rules operate in non-arm’s length and cashless transactions. It may also be because the parties have argued there is no value in the business and they can simply shut up shop on Friday night and open on Monday morning in a new structure.
The 50% CGT discount and small business CGT concessions may also have been applied to effectively wipe out any capital gain.
Is the structure effective?
The ATO is also seeing cases where the business is not being operated by the purported structure. In those cases, the practical reality is the business continues to be operated by the individual principals.
The third concern expressed in TA 2013/3 is whether Part IVA could apply.
The ATO is contemplating whether Part IVA could apply to the restructure of an existing professional practice.
It is also looking at whether Part IVA could apply to the annual distribution decisions of practices that have already restructured or practices that have been set up from scratch in the relevant structure.
This is the issue where the professional body representatives and the ATO have competing views. The professional bodies argue that a professional practice is just a business and like any other business it should be possible to own it in a structure of choice (subject to any regulatory limitations).
The ATO argue that a professional practice involves the professional skill of the relevant principals and that the profits, at least in part, are attributable to those principals.
The ATO would ultimately like to test these issues through the courts.
In the meantime, the ATO has released guidelines for determining where it will focus audit activity for the 2014/15 and subsequent years. The guidelines will be reviewed during the 2016/17 year.
The ATO has released the guidelines to provide taxpayers with an indication of when they will be considered a high or low risk of Part IVA applying. The ATO is proposing to focus audit activity on high risk taxpayers. Low risk taxpayers will not be subject to compliance action on this issue.
The guidelines only apply where:
- an individual professional practitioner provides services to the firm’s clients and has a direct or indirect interest in the firm;
- the firm is effectively structured as a partnership (including a partnership of trusts or companies), trust or company; and
- the firm’s income is not personal services income, i.e it is not mainly a result of personal efforts or skills, as opposed to being generated by the firm’s assets and employees.
Three guidelines are provided and taxpayers who meet at least one of these guidelines will be considered low risk by the ATO. Taxpayers who meet none of the three guidelines will be considered high risk.
The guidelines are:
- Does the individual professional practitioner receive assessable income from the firm of an appropriate amount based on the services they provide? The individual may use the level of remuneration paid to the highest band of professional employees performing the same tasks. If there are no other comparable professionals within the firm, the comparison can be to comparable firms or industry benchmarks for the same region.
- Is the relevant individual professional practitioner assessable on 50% or more of their and their related entities’ share of the overall practice profit entitlements? This could be in the form of salary, director fees, distributions and dividends. The form of the income is irrelevant so long as the individual principal receives at least 50% in their own capacity.
- Is the effective rate of tax payable by both the relevant individual professional practitioner and their related parties on their share of the practice profits at least 30%. This guideline also requires the individual principal to receive at least some income from the practice.
However, even if one or more of the guidelines are met, the individual taxpayer will be treated as higher risk where there are other compliance issues evident, such as non-recognition of net capital gains, income injection to loss entities, trust reimbursement arrangements, avoidance of Div 7A and inappropriate access to low income tax offsets and low income transfer payments.
These guidelines provide taxpayers with practical parameters. If you stick within those parameters, and don’t display any of the other higher risk issues, you’re low risk.
Of course, taxpayers who choose not to meet any of the guidelines are free to do so. The guidelines are not legislation. However, these taxpayers will need to be able to defend their position and this will likely mean being prepared to test it through the courts.