Thinking | 12 March 2021

Some things stay the same, but the numbers have changed: Draft PCG 2021/D2 – Allocation of professional firm profits

By Michael Parker and Adam Dimac

After more than three years, and with much anticipation, the ATO has now released Draft Practical Compliance Guideline PCG 2021/D2 Allocation of professional firm profits - ATO compliance approach (Draft PCG).[1] The Draft warrants close examination and this considered article seeks to analyse it in some detail.

Back in December 2017, the ATO had suspended its guidelines on the risks surrounding the allocation of profits within professional firms (Suspended Guidelines). In many respects, the Draft PCG addresses a number of valid issues that were identified regarding the manner in which the Suspended Guidelines were being applied, and relied upon, by professional firms. For those who were accustomed to the Suspended Guidelines, the framework for assessing risk in the Draft PCG is more complex.

Some relatively minor adjustments to the manner in which risk is measured (ie the numbers) has resulted in a significant change. Arrangements which would have previously been considered ‘low risk’ will now fall into the ‘high risk’ category. We provide various examples illustrating the point.

This change has come as an unpleasant and counterintuitive surprise, particularly given the progressive decrease in the company tax rates since the introduction of the Suspended Guidelines.

However, there is no need for immediate panic. The Draft PCG is still a draft, and subject to change.

Additionally, the Draft PCG also proposes a transitional arrangement that will allow some professional firms to continue to apply the Suspended Guidelines for the 2021 income year, and allow a grace period of over three years (to 30 June 2023) for those that need to modify their arrangements.

Unfortunately, modifying to meet the Draft PCG will still be an issue for some professional firms that may need to restructure, and trigger taxable gains and possibly duty, in order to be considered lower risk under the Draft PCG.

Why something new?

When the ATO first suspended the Suspended Guidelines, it noted that they were being misinterpreted in relation to arrangements that went beyond their scope. Specific examples given by the ATO at the time were the use of related-party financing and self-managed super funds.

Following a review of the Suspended Guidelines in 2018, the ATO set out a list of specific concerns, which were as follows:

  • Lack of any meaningful commercial purpose regarding arrangements including, but not limited to:
    • disposal of an equity interest through multiple assignments;
    • the creation of new discretionary entitlements such as Dividend Access Shares; and
    • utilising amortisation leading to differences between tax and accounting income.
  • Disregard for CGT consequences and inappropriate use of CGT concessions.
  • Assignments where profit sharing is not directly proportionate to the equity interest held.
  • The creation of artificial debt deductions.
  • Undertaking an assignment to dispose of an equity interest to a self-managed super fund.
  • Assignments where the arrangement is not on all fours with the principles of the Everett and Galland

Ultimately, these concerns not only led to the suspension of the Suspended Guidelines, but have also impacted what is now found in the Draft PCG.

Scope of the Draft PCG

Put simply, the Draft PCG explains the ATO's risk-based approach to individual professional practitioner’s (IPPs) and how professional firms allocate profit.

This Draft PCG does not:

  • Replace, alter or affect the operation of the law in any way.
  • Create any safe harbour administrative concessions.
  • Impact the ATO’s compliance approach to other tax issues that might arise in connection your professional firm arrangements (for example, Division 7A).

Gateways

In order for the Draft PCG to apply, 2 'gateways' must be passed. Where the gateways are not passed, the risk assessment framework set out in the Draft PCG will not apply.

The gateways are not necessarily an addition to what was in the Suspended Guidelines. In many respects, the gateways simply expand on or clarify conditions and rules which were set out in the Suspended Guidelines.

The gateways also reflect many of the valid concerns identified by the ATO with the Suspended Guidelines.

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. While this is explained in detail in the Draft PCG, there are some key elements as follows:

  • The arrangement should reflect the commercial needs of the business. Put simply, there must be genuine commercial rationale for the arrangement.
  • The arrangement must also be appropriately documented and actually achieve its commercial purpose. For example, the arrangement must actually provide improved asset protection if that is part of its purpose.
  • The legal form and documentation must be consistent with the economic substance of how the professional firm operates in practice. The more complicated the arrangement, the more difficult the compliance burden. This is a specific issue that we have seen in practice on a number of occasions.

Gateway 2 – arrangement must not contain 'high-risk features'

The second gateway is that the arrangement must not contain certain 'high-risk features'. While this is explained in detail in the Draft PCG, some examples are as follows:

  • Financing arrangements relating to non-arm's length transactions, for instance, using deductible borrowings to repay non-deductible debt.
  • Exploitation of the difference between accounting standards and tax law.
  • Arrangements where a partner assigns a portion of a partnership interest that are materially different in principle from Everett and Galland, such as fixed draw/salaried partners.
  • Multiple classes of shares and units held by non-equity holders, including discretionary shares and units.

Risk assessment

Where the gateways are passed, the risk assessment framework described below can be used to determine a risk rating, and therefore understand what compliance attention will generally be given by the ATO to the arrangement.

The risk assessment factors in the Draft PCG are the same as those that were in the Suspended Guidelines, but the numbers have changed and it is no longer a case of just satisfying one of the factors.

Risk assessment scoring table

Risk assessment factor Score
1 2 3 4 5 6
(1) Proportion of profit entitlement from the whole of firm group returned in the hands of the IPP >90% >75% to ≤90% >60% to ≤75% >50% to ≤60% >25% to ≤50% ≤25%
(2) Total effective tax rate for income received from the firm by the IPP and associated entities >40% >35% to ≤40% >30% to ≤35% >25% to ≤30% >20% to ≤25% ≤20%
(3) Remuneration returned in the hands of the IPP as a percentage of the commercial benchmark for the services provided to the firm >200% >150% to ≤200% >100% to ≤150% >90% to ≤100% >70% to ≤90% ≤70%

 

Risk zones

Risk zone Risk level Aggregate score against first two factors Aggregate of all three factors
Green Low risk ≤7 ≤10
Amber Moderate risk 8 11 & 12
Red High risk ≥9 ≥13

The numbers

Under the previous Suspended Guidelines, a return of profit of 50% in the hands of the IPP would have been considered low-risk on its own (ie without needing to meet any other risk assessment factor). Similarly, an effective tax rate of 30% for income received from the firm by the IPP and associated entities would have been considered low-risk on its own.

However, under the Draft PCG, the same circumstances would receive a score of 9 and a high-risk rating. A difference of 1% for either measure (ie 51% of income return in the hands of IPP or an effective tax rate of 31%) would still yield a score 8, and a moderate risk rating.

The reason for this change has not been explained in the Draft PCG and, given the decrease in the company tax rates since the introduction of the Suspended Guidelines, it is counterintuitive.

At the time the Suspended Guidelines were released, the company tax rate was 30%, and it was understood that having a risk factor that required an effective tax rate of 30% was reflective of the company tax rate and the ability for many professional firms to incorporate (including some well-known listed firms).

The tax rate for base rate entities (BRE) under the relevant threshold in the 2021 income year is 26%. Practically, this would include many companies associated with an IPP and in receipt of firm profit entitlements.

Applying the BRE tax rate to the risk assessment in the Draft PCG shows that:

  • In general, participants in firms with higher total income will have a reduced risk rating as income returned by the IPP will be subject to higher marginal rates, therefore bringing the total effective tax rate up.
  • Where total firm income received by an IPP and associated entities is $300,000, and 60% of income is returned by the IPP, a moderate-risk rating will still be applied. That is, over 60% of the income would need to be returned by the IPP in order to receive a low-risk rating.
  • Where total firm income received by an IPP and associated entities is between $300,000 and $1 million, a high or moderate risk rating (as the case may be) will still be applied even where 60% of income is returned by the IPP.

The tables below provide some practical examples, using the BRE and marginal tax rates for the 2021 income year and assuming that all firm profits not returned by an IPP are returned by a BRE company (either directly, or via trust distributions).

Table 1 - 50% of income returned in the hands of IPP

Total firm income Income retuned by IPP (50%) Tax payable Income returned by company (50%) Tax payable Effective tax rate Risk rating
$300,000 $150,000 $40,567 $150,000 $39,000 26.5% 9
$500,000 $250,000 $83,167 $250,000 $65,000 29.6% 9
$750,000 $375,000 $139,417 $375,000 $97,500 31.6% 8
$1,000,000 $500,000 $195,667 $500,000 $130,000 32.6% 8

 

Table 2 - 60% of income returned in the hands of IPP

Total firm income Income retuned by IPP (60%) Tax payable Income returned by company (40%) Tax payable Effective tax rate Risk rating
 $300,000.00  $180,000.00  $51,667.00  $120,000.00  $31,200.00 27.6% 8
 $500,000.00  $300,000.00  $105,667.00  $200,000.00  $52,000.00 31.5% 7
 $750,000.00  $450,000.00  $173,167.00  $300,000.00  $78,000.00 33.5% 7
 $1,000,000.00  $600,000.00  $240,667.00  $400,000.00  $104,000.00 34.5% 7

 

Table 3 - 70% of income returned in the hands of IPP

Total firm income Income retuned by IPP (70%) Tax payable Income returned by company (30%) Tax payable Effective tax rate Risk rating
 $300,000.00  $210,000.00  $65,167.00  $90,000.00  $23,400.00 29.5% 7
 $500,000.00  $350,000.00  $128,167.00  $150,000.00  $39,000.00 33.4% 6
 $750,000.00  $525,000.00  $206,917.00  $225,000.00  $58,500.00 35.4% 5
 $1,000,000.00  $700,000.00  $285,667.00  $300,000.00  $78,000.00 36.4% 5

Restructures

One of the issues identified by the ATO in respect of the original Suspended Guidelines related to restructures. To provide a simple example, a professional firm would undertake a restructure into a new, and more tax-effective structure, which met the Suspended Guidelines. However, the CGT implications of the restructure would be ignored, and/or the restructure would provide little or no commercial or asset protection benefits – that is, it appeared to be dominantly tax-driven.

While the restructured professional firm and its related IPPs may have considered themselves low risk under the Suspended Guidelines, the Suspended Guidelines were not intended to sanction or provide a safe harbour for such restructures. The Suspended Guidelines were simply a tool to measure the risk rating of a current structure.

Similarly, the Draft PCG does not sanction, or provide a safe-harbour, for a professional firm to undertake a restructure.

Professional firms considering a restructure are strongly encouraged to engage with the ATO, and must be considered in the context of the applicable law, and in particular Part IVA.

Transitional arrangements and next steps

Although the measure of risk has shifted significantly under the Draft PCG, there is no need for immediate panic.

Importantly, the Draft PCG 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.

The transitional arrangements appear to indicate that unless there is a practical impendent to a firm structure/arrangement that will prevent a lower-risk rating, firms will be expected to apply the more stringent risk rating in the Draft PCG on and from the 2022 income year.

Where modifications to a structure/arrangement are required, this will generally be possible where a firm structure includes a discretionary trust. This is on the basis that more income can be distributed through a discretionary trust to the IPP.

However, modification may be an issue for:

  • Structures including a discretionary trust, where the IPP has been excluded as a beneficiary. Some firms have implemented such arrangements based on an understanding that the exclusion of the IPP as a beneficiary was required in order to be on all fours with Everett and Galland. In these circumstances, trust deeds may need to be amended (keeping in mind the possibility of causing a resettlement), or a restructure undertaken with the possibility of triggering taxable gains and duty.
  • Structures including companies or unit trusts, with fixed entitlements to income. In these circumstances, a restructure may need to be undertaken with the possibility of triggering taxable gains and duty.

Once finalised, the Draft PCG will apply prospectively from 1 July 2021. Comments on the Draft PCG can be made any time before the due date of 26 March 2021.


[1] Reported in the Weekly Tax Bulletin – Thomson Reuters Australia.

Contact

Michael Parker

Michael’s practice focuses on tax disputes, capital gains tax, business sales and acquisitions and restructuring. He also acts in...

Adam Dimac

Adam is an experienced tax lawyer, and advises clients on a range of matters including tax planning and structuring,...

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