In September 2014 the Tax Commissioner released a document headed “Assessing the risk: allocation of profits within professional firms.”
In broad terms, the Commissioner is very unhappy that professional firms can use trusts and other structures so that less tax is paid than if the relevant profits were taxed directly in the hands of the individual lawyers or accountants who own the business.
The ATO position is that professionals who structure their firms as partnerships of discretionary trusts, for example, may be doing so for the dominant purpose of getting a tax benefit, so that the anti-avoidance rules in Part IVA of the Income Tax Assessment Act 1936 will apply.
Why it is that professionals who use discretionary trusts may now be tax avoiders when the hundreds of thousands of other businesses operating through trusts with owners who provide skilled input are not targeted by the ATO campaign has not been fully explained.
We do know that the ATO has had professionals and income generated from personal services on its radar for more than 30 years, through cases like Everett, Galland, Tupicoff and Mochkin (and many others), multiple tax rulings and the introduction of the Personal Services Income (PSI) regime in 2000.
The law in this space can be stupendously complex, but what the ATO is now saying (as best we can understand it) is this:
- If you are a sole practitioner and operate through a discretionary trust (for example) and the PSI rules don’t otherwise apply, the ATO may apply Part IVA to tax you on the trust income personally, on the basis that all that income is generated by your effort and skill;
- If you are involved with a firm that has discretionary trust partners and the ATO accepts that the firm income is generated by a “business structure” (because of its size or number of employees, for example) the ATO says that you must still be taxed on those parts of profit that accrue to the discretionary trust partner which represent the income derived by the firm from your professional input.
Just how you work out your value to the firm is another question, but the Commissioner has sidestepped that issue by providing us with these guidelines which tell us the ATO view of the tax outcomes that can make you a low risk audit target.
The ATO says you will not be audited for Part IVA purposes if one of the following tests is satisfied:
- You receive income representing an “appropriate” return for your services to the firm – perhaps equal to the highest paid employee or reflecting industry benchmarks;
- 50% or more of the income which flows to you and associated entities is taxed in your hands; or
- Your associated entities and you have an effective tax rate or 30% or more on income from the firm.
If you can’t tick the box on even one of these three tests you become a high risk, high priority target for a tax audit and the application of Part IVA.
What to Do
The Commissioner’s campaign is targeting 2015 and later financial years, so the ATO is providing a clear choice for professionals using these structures - roll on as before and prepare to engage with the ATO auditors when they come knocking, or satisfy one or more of the tests in the ATO guidelines, pay more tax for 2015 and beyond, and continue to enjoy the quiet life.
These are clearly important decisions which will impact on the bottom line, whichever choice you make.