Professional Bodies Respond to Allocation of Profits Draft Guidelines

The professional bodies have released their joint submission to Draft Practical Compliance Guideline PCG 2021/D2 (Draft). It makes for some interesting reading. Chartered Accountants ANZ has also released its separate, additional submission.

The due date for comments on the Draft closed on 16 April 2021 (extended from the original deadline of 26 March 2021).

Background

On 1 March 2021, the ATO finally released the long-awaited Draft, which sets out the ATO’s proposed compliance approach to the allocation of professional firm profits and also provides a risk assessment framework to assist individual professional practitioners to self-assess their risk.

However, by way of reminder, the Draft applies to arrangements that have a genuine commercial basis (including in relation to how profits are distributed) and do not include any high-risk features. Draft PCG 2021/D2 refers to the genuine commercial requirement as “Gateway 1” and the no high-risk features requirement as “Gateway 2”.

  • Gateway 1 – sound commercial rationale: The first gateway is that there must be sound commercial rationale for entering into, and operating, the arrangement or structure.
  • Gateway 2 – arrangement must not contain “high-risk features”: The second gateway is that the arrangement must not contain certain “high-risk features”.

Taxpayers who satisfy these gateways can self-assess their compliance risk. Those who do not will need to engage with the ATO before seeking to apply Draft PCG 2021/D2.

The ATO’s draft risk assessment methodology comprises 3 risk zones – low (green), moderate (amber) and high (red) – for assessing a profit allocation arrangement. The applicable risk zone is determined by combining the scores obtained for each of three risk assessment factors.

Taking a step back, it can be seen that the Draft is aimed at arrangements where an “individual professional practitioner” (IPP) redirects their share of the income from a professional practice (or a portion thereof) to an associated entity or entities – such as a trust, company or family member – where that has the effect of reducing the IPP’s tax liability (because the recipient entity has a lower tax rate).

Among others, the proposed rules can affect the accounting, architectural, engineering, financial services, legal and medical professions.

Ian Murray-Jones, Senior Tax Writer, Thomson Reuters

Relevantly, in December 2017, the ATO suspended its guidelines on the risks surrounding the allocation of profits within professional firms. The concern is that arrangements which would have previously been considered “low risk” will now fall into the “high risk” category as a result of applying the Draft.

In other words, its potential impact should not be underestimated. This perhaps explains the fairly blunt and direct language of the professional bodies, as set out below. It is also worth keeping in mind the timeframe. The Draft provides for the following transitional arrangements.

  • Firms that entered into their current structure/arrangements prior to 14 December 2017 are able to continue to rely on the suspended guidelines for the years ending 30 June 2018, 30 June 2019, 30 June 2020 and 30 June 2021.
  • Firms that are required to take steps to modify their structure/arrangements to be lower risk are allowed a grace period to 20 June 2023, during which they can continue to apply the suspended guidelines.

Joint submission

Chartered Accountants ANZ, CPA Australia, Institute of Public Accountants, the Business Law Section of the Law Council of Australia and The Tax Institute (joint bodies) have made a joint submission on PCG 2021/D2. The submission leaves scope for the joint bodies to provide separate submissions (see under heading below for the CA ANZ submission). To describe the joint submission as feisty may not be sufficiently apt.

The submission makes it clear that at no time were any of the associations involved in consultation and no detail of any kind was provided to them. Accordingly, the Draft does not reflect the views of the joint bodies.

It states that there has been a significant shift in the risk scoring of arrangements between the suspended guidelines and the Draft. Not only is the ATO’s basis for that shift not explained, it is not justified by reference to either the apparent rationale for suspending the original guidelines or the Pt IVA provisions.

The exclusionary “Gateways” and risk assessment framework are not necessarily constructed to align with Pt IVA factors. Rather, the Draft “uses broad, unadjusted measures as proxies” for Pt IVA risk. As a result, the risk scores reflect neither the nuance nor the specificity required to properly assess the level of risk.

The submission states that “Gateway 1 – commercial rationale” is the closest the Draft comes to any conventional consideration of matters relevant to the application of Pt IVA – but it does so through the abstract notions of “commercial rationale” or “commercially driven”. The submission states that it does not consider this approach to be “correct, practical or useful”.

It states that “Gateway 2 – high-risk features” may be a useful guide to identifying specific issues that should be considered when risk-assessing the arrangements of an IPP. However, other than perhaps to serve as examples of arrangements the ATO considers would not pass Gateway 1, it is unclear why the identified arrangements should feature as an exclusionary gateway to the application of guidelines dealing with the profit allocation of a business.

For the pugilists out there, the submission comes out swinging. It states that the joint bodies reject the 3 foundational propositions that, explicitly or implicitly, underpin the Draft.

  1. There is no general principle of taxation law dealing with, or proscribing, the so-called “alienation of income”. That is, absent specific statutory provisions such as the personal services income or general anti-avoidance rules, there is no general principle which brings about the result that the income or profit beneficially derived by a partnership, company or trustee of a trust, that has arisen from the personal exertion or skilled labour of an individual, can be regarded as the profit or income of that individual.
  2. In the context of the ATO proposing a compliance approach to the taxation of income or profits from the provision of services, no proper justification for singling out the services provided by “professional firms” has been provided. It cannot be rationally argued that the income derived by an accounting or law firm is so different to the income derived by, say, a plumbing or management consulting business to permit the ATO to apply compliance resources differently.
  3. There is no general principle of taxation law that the individual “owner” of a business receives any particular amount of compensation or remuneration for the individual’s “efforts, labour and application of skills”. That is, absent specific statutory provisions, an “owner” of a business can decide whether to receive nothing, a little, a lot or something in between and be taxed accordingly.

CA ANZ submission

Chartered Accountants Australia and New Zealand has released its separate submission on the Draft.

Its submission states (with presumably admirable restraint) that the “precipitous manner” in which the ATO suspended the former guidelines still “rankles” its members.

The submission states that the structure of the Draft fundamentally reverses the approach under the prior guidelines, “but no justification has been provided for this change”. The structure of the suspended guidelines was that if an IPP met one of the 3 criteria, there was an assumption that their arrangements were commercially justified, and no further work was required in this regard. The Draft now requires the commercial justification to be made out as a Gateway and then having made this out, if the economic outcomes are not at acceptable levels, the justification is effectively rejected. CA ANZ members have queried why there has been such a fundamental change and what is the ATO’s justification.

The predominant observation made by its members is to question the ATO’s categorisation of “professional men and women” as a sub-set within the individual taxpayer segment deserving special compliance treatment vis-à-vis other self-employed individuals who offer services, but whose ability to structure their business operations is (leaving aside the legislated PSI rules) largely “unfettered” by the ATO. Some members have remarked to CA ANZ that they regard PCG 2021/D2 as an ATO gambit, without legal foundation, designed to ensure professionals (but not other service providers) pay a greater level of tax than equivalent business operators in other sectors.

Other points of note include the following.

  • Members ask why the ATO did not, having apparently seen examples of egregious behaviour, take compliance action against the particular IPP instead of saddling all professionals with additional, annual compliance obligations.
  • The Draft remains committed to an over-arching range of tests which purport to be applicable to all IPPs (and the broad range of firms – large and small – they manage), founded on the notion that, in the professional services sector, a proportion of their income continues to be generated by their personal services. In many firms however, a not insubstantial number of IPPs have no or nominal direct client service roles (ie charged time). This reflects the nature of their role as a business owner and operator.
  • The Draft envisages that each IPP will individually familiarise themselves with the ATO’s compliance guidance and take steps to annually assess whether they pass the Gateway Tests and their green, amber or red status on the ATO’s risk assessment table. However, newly admitted IPPs have little choice other than to accept the professional firm structure offered to them. They may have no knowledge of the reasoning behind, or ability to address, the structural arrangements. Another common complaint received about the Draft is the vagueness of the language used and the way in which the ATO retains plenty of options to go on the offensive where it sees behaviour it doesn’t like.
  • The ATO guidance on the transitional rules for IPP’s that had arrangements covered by the suspended guidelines is also unclear. Members have called for a grandfathering of arrangements which were compliant with the suspended guidelines, where the IPP has a higher risk rating under the Draft.

This article was first published in Thomson Reuters’ Weekly Tax Bulletin.

Ian has worked at Thomson Reuters for over 15 years as a senior tax analyst with expertise in income tax and GST. He has been involved in tax publishing for over 25 years.

Prior to his tax writing career, Ian worked as a manager for a Big 4 accountancy firm and then with a firm which provided specialist tax advice for the music and recording industry.

Ian holds a Bachelor of Economics degree, is a Chartered Accountant and a registered tax agent. Among other things, Ian is the author of the Australian GST Handbook, the GST Commentary Service, the Australian Financial Planning Handbook and the specialist income tax commentary services, as well as being a regular contributor to the news services.

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