"What every lawyer, accountant, architect, engineer, financial advisor, and medical professional should read: the ATO and professional partnerships"
It is vital that professional partnerships become familiar with the new guidance from the ATO about how the income of those partnerships may be taxed. It is clear now that this is a key area of focus for the ATO.
This is a must-read for any new or existing partnership.
A preferred method of structuring professional partnerships is as a partnership of discretionary trusts. Instead of forming a partnership of natural persons, each partner in the firm is the trustee of a discretionary trust. Other entities might also be partners, such as companies, or trustees of another forms of trusts.
Natural persons (Individual Professional Practitioners, or IPPs) provide services to clients of the firm, and/or are actively involved in the management of the firm. Commonly, the partner entities will receive shares of the firm's income each year, which may then be distributed to the IPPs and other beneficiaries. In this way, the income is "split", meaning that part of the income that would otherwise be assessable to an IPP is assessable to a different entity. This could result in a lower overall effective tax rate.
What does the ATO say?
The new guidance follows the ATO's release last year of Taxpayer Alert TA 2013/3, which set out the ATO's concerns about these types of arrangements. In the ATO's view, in some cases these arrangements:
- may be ineffective in alienating the individual's income;
- may have CGT consequences for the individual which have not been correctly recognised; or
- may involve a scheme to which the income tax general anti-avoidance rules apply.
The ATO's guidance now makes clear that where an IPP attempts to alienate amounts of income flowing from their personal exertion (as opposed to income generated by the business structure), the ATO may consider cancelling relevant tax benefits under Part IVA.
However, the guidelines are expressed only to apply where the income is generated by a business structure, and does not constitute income from personal services.
The ATO has released "risk assessment guidelines", which set out the circumstances in which taxpayers will be treated as low risk, and generally not subject to compliance action. These include where a taxpayer meets at least one of the following set of criteria:
- The IPP receives assessable income from the firm in their own hands as an appropriate return for the services they provide to the firm (what is an appropriate return may be determined by comparing the level of remuneration paid to the highest band of professional employees providing equivalent services to the firm, or if there are none, comparable firms or relevant industry benchmarks).
- 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.
- 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 these guidelines can be satisfied, the arrangement will be treated as higher risk. The ATO's position is that the lower the effective tax rate, the higher the ATO will rate the compliance risk, and the greater the likelihood of ATO compliance action.
What do you do?
Whether a firm falls into the higher risk category will depend on many factors, and may include the way the firm is structured, the level of input from each IPP, the way income is treated at year end, and the way the income is taxed.
The ATO has made it clear that these are live issues it intends to apply compliance resources to in the 2014-15 year and beyond. We suggest that those firms that fall into the higher risk category should review their current arrangements, or they may find themselves receiving an unexpected knock at the door.