background
The tax and accounting profession has shown great interest in the latest ATO guidelines on the distribution of professional corporate profits, which are in the form of a draft guideline for practical compliance with PCG 2021 / D2 (Draft of a PCG) on March 1, 2021. This follows the withdrawal of the previous ATO guidelines on December 14, 2017.
The guidelines have been developed in consultation with high-level professional organizations and concern arrangements involving taxpayers who transfer their income from a company or activity that includes their professional services to an affiliate. Such a taxpayer is called an individual professional practitioner (IPP).
The guidelines do not apply to corporate income which is income from personal services (and which is subject to the PSI regime).
The draft PCG explains how the ATO intends to use compliance resources when considering the allocation of profit or income of professional companies to the assessable income of the IPP, and provides a risk diagnostic tool that taxpayers use to self-assess against the risk assessment framework can change the type of compliance attention that is given to their arrangement. Upon completion, it is suggested to apply for the PCG from July 1, 2021.
When the PCG is finalized in its current form, the ATO will have clarified that the suspended guidelines for agreements made before December 14, 2017 will remain in effect until June 30, 2021. However, there is a further transition period until June 30, 2021 June 2023. As a result, the start will be postponed until July 1, 2023 (i.e. the income year 2023–24) for those agreements that are concluded before December 14, 2017 were closed and have a higher risk rating under the new PCG.
Note that a PCG is not a legal interpretative document. PCGs are not public decisions and do not have the legally binding effect of a judgment. A PCG is only a statement about the ATO’s risk approach. It is a flagship product designed to give taxpayers a clear understanding of where the ATO believes they live in a risk assessment framework.
The draft PCG is designed to reassure you that, in general, the ATO will not allocate compliance resources to test the relevant tax outcomes of your agreement if you determine that your circumstances are “low risk”.
Conditions for the application of the guidelines
A taxpayer cannot apply the risk assessment framework to the distribution of his professional business profits unless his circumstances pass two “gates”. As the circumstances of an IPP pass through Gateways 1 and 2, the practitioner and ATO can use the risk assessment framework to understand what compliance attention is generally given to the agreement.
The first gateway requires a solid commercial rationale for entering and operating the device or structure. The way in which the operational structure is designed and the profits distributed should be based on commercial terms. The draft PCG contains the various conditions that should be taken into account when reviewing the business substance of professional corporate structures.
Under the second gateway, the arrangement must not contain any of the specified “high risk functions”, including the following:
- those who fall under a Taxpayer Alert;
- Financing agreements for transactions on customary market terms;
- Exploiting the difference between accounting standards and tax law;
- Arrangements in which one partner assigns a portion of a partnership interest that is fundamentally different from Everett and Galland; and
- multiple classes of stocks and shares held by non-shareholders.
Once you have gone through the “gateways” you can move on to the risk assessment framework.
Understand the risk assessment matrix
The Risk Assessment Framework is a “scoring system” and effectively brings the three criteria contained in the suspended Business Professional Guide into a single risk assessment framework. The higher the score, the riskier the agreement and the greater the likelihood that the agreement will attract ATO’s attention.
If you meet Gateways 1 and 2, you can self-assess your risk level using any of the following three risk assessment factors:
- Share of the profit entitlement of the entire group of companies in the hands of the IPP.
- Overall effective tax rate on income received by the company from IPP and its affiliates (excluding any levy based on taxable income such as the Medicare levy and the Medicare surcharge).
- Compensation was returned in the hands of the IPP as a percentage of the commercial benchmark for the services provided to the company.
The circumstances are measured against each of these risk assessment factors to determine an appropriate rating. The scores are then aggregated to determine which risk zone the agreement falls into.
If the agreement scores 10 or less using all three risk assessment factors, it is considered low risk (green zone). If it is impractical to pinpoint reasonable commercial compensation for the benchmark, the first two risk score factors (instead of all three) can be used. In this case, a rating of 7 or less would be required to be considered low risk. The ATO will only use compliance resources in exceptional cases to review the distribution of profits within the framework of a Green Zone agreement.
If the score is 11 or 12 using all three risk assessment factors (or 8 based on the first two risk assessment factors) then the arrangement is considered to be moderate risk (Amber Zone). The ATO is likely to conduct further analysis on amber zone arrangements.
If the score is 13 or higher using all three Risk Scoring Factors (or 9 or higher based on the first two Risk Scoring Factors) then the arrangement is considered high risk (red zone). The ATO is expected to begin reviewing the red zone regulations as a matter of priority. Cases can even be forwarded directly for review.
Observations
There are a number of difficulties with the draft directive. Of particular concern are the following:
- Effective tax rate: Benchmarking against the effective tax rate is becoming increasingly problematic due to the lower corporate tax rate that applies to companies with a base tax rate. When the original guidelines were published by the ATO, the corporate tax rate was generally 30%. Lowering the rate to 25% from July 1, 2021 results in a rating of 5 using a risk score of 2, which makes falling into the amber or red zone a lot easier. Add to this the recent increases in income tax thresholds, which means that a person who wants an average tax rate of 30% must have an income of just over $ 195,000.
- Amounts not known during the income year: The trustee of a discretionary trust may decide to distribute 50.1% to the IPP on June 30th on a percentage rather than a dollar basis without knowing the actual amount of profit. This results in a rating of 4 using a risk score of 1. This can be problematic for a company that needs to distribute profit on an equity basis and is unlikely to know final year-end profit to ensure that more than 50% of the IPP can be assigned.
- Too easy to switch between zones: Slight changes in the profit distribution can easily cause the assembly to move from the amber zone to the green zone, or indeed from the green zone to the red zone. The risk zones could be recalibrated to expand the overall rating so that minor changes would not result in agreements being inappropriately classified as moderate or high risk.
The draft PCG states: “The ATO continues to work to identify taxpayers whose circumstances are not covered by this directive or who wish to nominate themselves as a test case for further judicial guidance.” It will be interesting to see if a taxpayer is brave enough to nominate himself.
The tax institute has formed a sub-committee that works with members to determine the impact of the draft PCG. Public submissions are due by April 16, 2021.
Robyn Jacobson, Senior Attorney at the Tax Institute
Sharing the Profits of Professional Companies: Understanding the New Rules
Robyn Jacobson, the tax institute
Last updated: March 26, 2021 Published: March 26, 2021