The structuring of professional services businesses has historically been an area of interest for the Australian Taxation Office (ATO), particularly around income-splitting arrangements adopted by individual professional practitioners (IPP’s) and whether these arrangements are tax-avoidance schemes.
In light of the ATO’s draft guideline PCG 2021/ D2 (the Guideline), which provides a glimpse at the ATO’s compliance approach for professional services businesses, the onus is on taxpayers to assess the riskiness of their current income-splitting arrangements and to determine whether corrective action is required.
The current income-splitting rules that apply to professional firms have been extrapolated from the following pivotal cases:
- The Everett and Galland cases established that partner practitioners could assign a right to income to their spouse or family trust whereas sole practitioners were, typically, viewed as deriving non-assignable income from their personal exertions
- The Phillips case established that professionals could divert professional services income through a services trust, provided the fees paid were commercially justifiable and there was a business case for the arrangement.
In October 2014, the ATO released generic audit risk guidelines which contained the following alternative low risk indicators for service businesses:
- The practitioner receives an appropriate return (based on salaries typically paid for the services being provided)
- At least 50 per cent of the income entitlement of the practitioner (including any entitlement of a service trust) be assessable to them, and/ or
- There is an effective tax rate of at least 30 per cent on the income attributed to the practitioner.
Although these guidelines were withdrawn on 14 December 2017 due to the purported abuse of the “concession” they provided, it is commonplace in industry to interpose discretionary trusts between an IPP and their service business, and to distribute income from the service business within the parameters of the ATO’s withdrawn guidelines.
The Guideline explains the ATO’s risk-based approach to IPP’s and how their professional firms allocate profits, including:
- An arrangement will either be: low (green), moderate (amber) or high risk (red). This is determined using a point-based system and is dependent on the characteristics of the arrangement
- There are two “gateways” which must be passed: the requirement that the arrangement has a commercial rationale (Gateway 1), and that the arrangement must not contain any “high risk features” (Gateway 2).
In general, arrangements that result in the IPP receiving a disproportionately lower level of income compared to the value of services they provided to the services business will be considered high risk by the ATO and, therefore, more likely to be audited or reviewed.
The ATO’s use of the term ‘professional firms’ in PCG 2021/D2 is intentionally broad, with the Guideline expected to extend to any business that derives income from the personal exertion of its IPP’s.
The Guideline was proposed to apply from 1 July 2021, however the commencement date has been deferred until 1 July 2023 for arrangements that have a higher risk rating under the Guideline, as long as they were entered into before 14 December 2017, and assuming they are commercially driven with no additional risk factors.