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  • Assessing the risk: allocation of profits within professional firms

    We've published PCG 2021/4 Allocation of professional firm profits – ATO compliance approach for individual professional practitioners (IPPs) when considering the allocation of profits by professional firms. First, assess whether you can use the risk assessment framework in PCG 2021/4, then find out how we will assess your risk and apply our compliance approach.

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    Practical compliance guideline

    PCG 2021/4 replaces the web material published in 2015, Assessing the Risk: Allocation of profits within professional firms guidelines. We suspended this in December 2017 (suspended guidelines) as we became aware that it was being misinterpreted in relation to arrangements that go beyond the scope of the guidelines.

    PCG 2021/4 is about arrangements where:

    • taxpayers redirect their income from a business or activity to an associated entity
    • that income includes income from their professional services
    • the outcome is that they significantly reduce their tax liability.

    PCG 2021/4 applies from 1 July 2022 and clarifies how we assess the risk and our compliance approach to the allocation of profits in professional firms.

    Before you apply PCG 2021/4

    Before you apply PCG 2021/4, you must assess if your arrangement is commercial and does not have high-risk features. We call these 'gateways', which you must pass before you can apply PCG 2021/4.

    Commercial rationale gateway

    You must assess if your arrangement is commercial. An arrangement that shows a lack of commercial rationale can:

    • seem more complex than necessary to achieve the relevant commercial objective
    • appear to serve no real purpose other than to gain a tax advantage
    • have a tax result that appears to be at odds with its commercial or economic result
    • result in little or no risk in circumstances where significant risks would normally be expected
    • operate on non-commercial terms or in a non-arm's length manner
    • present a gap between the substance of what is being achieved and the legal form it takes.

    No high-risk features gateway

    You must also assess that your arrangement does not have high-risk features.

    Arrangements with high-risk features can:

    • have financing arrangements relating to non-arm's length transactions
    • exploit the difference between accounting standards and tax law
    • be materially different in principle from Everett and Galland (refer to Everett assignments for information on high-risk features of Everett assignments)
    • involve multiple classes of shares and units, including creating discretionary entitlements such as dividend access shares
    • involve multiple assignments or disposals of an equity interest
    • misuse the superannuation system, including assignments or disposals of an interest to associated self-managed super funds (SMSFs)
    • distribute income to entities, other than the IPP, with losses.

    If you don't pass both gateways

    If we identify arrangements that lack apparent commercial rationale or have high-risk features, we may consider applying anti-avoidance provisions under Part IVA or other integrity rules.

    If you do pass both gateways

    If, as an IPP, you pass the gateways, you can then self-assess against the Risk assessment framework to see the type of compliance attention that we will give to your arrangement.

    Risk assessment framework

    After you have passed the gateways, you can then self-assess against the risk assessment framework to see the type of compliance attention that we will give to your arrangement.

    PCG 2021/4 combines 3 risk assessment measures into a single method. This gives a risk rating of low, moderate or high risk.

    Complete the risk assessment scoring table

    As an IPP, you can self-assess your risk level against each of the risk assessment factors in the risk assessment scoring table.

    Table: Risk assessment scores

    Risk assessment factor

    Score 1

    Score 2

    Score 3

    Score 4

    Score 5

    Score 6

    Factor 1: Proportion of profit entitlement from the whole of firm group returned in the hands of the IPP

    More than 90%

    More than 75% to 90%, inclusive

    More than 60% to 75%, inclusive

    50% or more to 60%, inclusive

    More than 25% to less than 50%

    25% or less

    Factor 2: Total effective tax rate for income received from the firm by the IPP and associated entities

    More than 40%

    More than 35% to 40%, inclusive

    30% or more to 35%, inclusive

    More than 25% to less than 30%

    More than 20% to 25%, inclusive

    20% or less

    Factor 3: Remuneration returned in the hands of the IPP as a percentage of the commercial benchmark for the services provided to the firm

    More than 200%

    More than 150% to 200%, inclusive

    More than 100% to
    150%, inclusive

    More than 90% to 100%, inclusive

    More than 70% to 90%, inclusive

    70% or less

    As an IPP, if you return 100% of the profit entitlement from the firm in your personal tax return, you:

    • are automatically in the green zone
    • don't need to assess against the other risk assessment factors.

    Total effective tax rate

    The total effective tax rate is the average rate of tax for the entire income received from the firm by the IPP expressed as a percentage. It is calculated using the following formula and excludes any levies such as Medicare levy, Medicare levy surcharge or the Temporary budget repair levy.

    The calculation is:
    Total tax paid by the IPP, and associated entities of the IPP, on professional firm income ÷ Total firm income collectively received × 100

    Work out your risk zone

    After you complete your self-assessment, use your total score to work out your risk zone, then check it against the risk assessment framework to see the type of compliance attention that we will give to your arrangement.

    Assessing against the 3 risk assessment factors

    If you are self-assessing using all 3 risk assessment factors, your arrangement is considered low risk (green zone), if your aggregate score of all 3 risk assessment factors is 10 or less.

    Assessing against factors 1 and 2 only

    As an IPP, you can self-assess against the risk assessment factors 1 and 2 only. You can only do this if it is impractical to accurately determine an appropriate commercial remuneration against a benchmark for risk assessment factor 3.

    Your arrangement is considered low risk (green zone), if your aggregate score for risk assessment factors 1 and 2 is 7 or less.

    Table: Risk zone and risk rating

    Risk zone

    Risk level

    Aggregate score against first 2 factors

    Aggregate of all 3 factors

    Green

    Low risk

    7 or less

    10 or less

    Amber

    Moderate risk

    8

    11 and 12

    Red

    High risk

    9 or more

    13 or more

    We are likely to further analyse the facts and circumstances of the arrangement or initiate compliance activity if either the:

    • IPP's profit allocation arrangement exhibits high-risk features
    • arrangement has a moderate or high-risk rating.

    Example: low-risk arrangement

    Brooke, a management consultant, assigns 30% of her partnership interest in the Better Business partnership to her discretionary trust. Brooke's total income entitlement from the partnership is $425,000. The beneficiaries of the trust include Brooke, her spouse Brody, and a corporate beneficiary BB Pty Ltd whose shares are jointly held by Brooke and Brody.

    Brooke and Brody also jointly own a rental property that has a net rental loss of $10,000 and they each claim $5,000 net rental loss on their tax return.

    Brooke includes $297,500 (70% of the income entitlement) in her tax return and the trustee distributes the balance of $127,500 (30% of the income entitlement) as follows:

    • $50,000 to Brody
    • $77,500 to BB Pty Ltd.

    The total income of $425,000 from the partnership is taxed in the hands of Brooke and her associates as follows:

    • Tax on Brooke's share of $297,500 is $104,542 (applying 2020–21 individual tax rates).
    • Tax on Brody's share of $50,000 is $6,717 (applying 2020–21 individual tax rates).
    • Tax on BB Pty Ltd's share of $77,500 is $20,150 (applying 2020–21 company tax rate of 26%).

    The total effective tax rate on the income from the partnership is
    $104,542 + $6,717 + $20,150 = $131,409 ÷ $425,000 × 100 = 30.92%

    When determining the effective tax rate on the income from the partnership, the rental losses are disregarded as they are unrelated to the professional firm income.

    The risk assessment for this arrangement is as follows:

    • Brooke returns 70% of her profit entitlement from the partnership in her personal tax return, which gives her a score of 3 against the first risk assessment factor.
    • Brooke and her associates pay an effective tax of 30.92% on the income received from the partnership, which gives her a score of 3 against the second risk assessment factor.
    • Brooke has worked out that in the circumstances it is impractical to accurately determine an appropriate commercial remuneration to benchmark against, so she self-assesses against the first 2 risk assessment factors only.

    As the total score under the first 2 risk assessment factors is 6, this arrangement is considered low risk.

    End of example

     

    Example: moderate-risk arrangement

    Julie and 3 other individuals run a legal practice through Legal Services Pty Ltd. Julie's family trust, JJ Trust, is a shareholder in the company. The beneficiaries of JJ Trust include Julie, her spouse Kurt and a corporate beneficiary, Company X Pty Ltd, whose shares are held by Julie.

    Julie’s total income entitlement from the company, which includes her salary and wages and franked dividends to her family trust, is $800,000. She includes $380,000 received as salary and wages from the company in her tax return. She reflects this is an appropriate return for her services she provides. The tax paid on this amount is $141,667.

    The trustee of the JJ Trust receives $420,000 as a fully franked dividend ($294,000 as cash and $126,000 as franking credits). The trustee distributes:

    • $370,000 to the corporate beneficiary Company X Pty Ltd; and the tax paid on this amount is $96,200 (applying 2020–21 company tax rate of 26%)
    • $50,000 to Julie's spouse, Kurt; and tax on this amount is $6,717 (applying 2020–21 individual tax rates).

    The total tax paid by Julie and her associates is $244,584 ($141,667 + $96,200 +$6,717). This gives a total effective tax rate of 30.57% ($244,584 ÷ $800,000 × 100). This arrangement is considered moderate risk as Julie:

    • returns 47.5% of her profit entitlement from the partnership in her personal tax return, which gives her a risk score of 5 against the first risk assessment factor
    • and her associates pay an effective tax of more than 30% on the income received from the partnership, which gives her a score of 3 against the second risk assessment factor
    • has determined the appropriate commercial remuneration to benchmark her remuneration against for the services she provides to the firm  
      • The industry benchmark for the provision of equivalent or similar services is $325,000.
      • As she personally returns $380,000 (which is 116.9% of the benchmark remuneration ($380,000 ÷ $325,000 × 100)), this gives her a score of 3 for the third risk assessment factor.

    Julie's total score against the 3 risk assessment factors is 11, which places her arrangement in the moderate risk category.

    End of example

     

    Example: high-risk arrangement

    Ashley, Peta and Raj operate an accounting practice as an equal partnership of 3 discretionary trusts with each of Ashley, Peta and Raj as trustees of their respective discretionary trusts. The practice generates a profit of $2,100,000 for the income year. The partnership distributes Ashley’s $700,000 profit share to Ashley Trust. Ashley, in her capacity as the trustee, distributes the profits as follows:

    • Ashley receives $147,000, which is 21% of the profits; with tax of $39,457 (applying 2020–21 individual tax rates).
    • Ashley’s spouse James receives $130,000; with tax of $33,167 (applying 2020–21 individual tax rates).
    • Ashley Investments Pty Ltd (of which Ashley and James are equal shareholders), receives $423,000; with tax of $109,980 (applying 2020–21 company tax rate of 26%).

    The total tax paid by Ashley and her associates on the total profit entitlement of $700,000 from the practice is $182,604, ($39,457+$33,167+ $109,980), which gives an effective tax rate of 26.09% ($182,604 ÷ $700,000 × 100).

    This arrangement is risk assessed as follows:

    • Ashley returns 21% of the total income entitlement from the practice in her tax return, which gives her a risk score of 6 for the first risk assessment factor from the risk assessment scoring table.
    • The effective tax rate of 26.09% paid by Ashley and her associates on the total income entitlement of $700,000 from the practice is less than 30%, which gives her a risk score of 4 for the second risk assessment factor.
    • After reflecting on her duties, responsibilities, risks and roles she undertakes in the firm, Ashley determines that a commercial remuneration for similar roles is $250,000. This results in Ashley's remuneration as a percentage of the commercial benchmark for her services being less than 70% ($147,000 ÷ $250,000 × 100). This gives her a score of 6 for the risk assessment factor 3.

    As the aggregate score against all the risk factors is 16, this is a high-risk arrangement.

    End of example

    Certainty for 1 July 2017 to 30 June 2024

    If you have existing arrangements, you can continue to rely on the suspended guidelines for 1 July 2017 to 30 June 2022 if your arrangement:

    • complies with the suspended guidelines
    • is commercially driven
    • does not exhibit any of the high-risk factors outlined in the No high-risk features gateway.

    If you satisfy these conditions, your arrangement will be considered low risk for 1 July 2017 to 30 June 2022.

    You may find that your arrangement was low risk under the suspended guidelines but has a higher risk rating under PCG 2021/4. If so, you can continue to apply the suspended guidelines until 30 June 2024. If you wish to transition your high-risk rating arrangement to a lower risk zone you can engage with us by emailing ProfessionalPdts@ato.gov.au.

    If you have concerns

    If you are contemplating entering into new arrangements or have concerns about potential high-risk factors within your existing arrangements, email us at Professionalpdts@ato.gov.au.

      Last modified: 01 Mar 2022QC 42218