Edited version of private ruling

Authorisation Number: 1011486715681

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Ruling

Subject: Business restructure, personal services income and application of Part IVA

Question 1

Will the alienation of personal services income rules apply to the proposed partnership of trustees of discretionary trusts trading as the business?

Answer

No

Question 2

Will the Commissioner apply the provisions contained in Part IVA of the Income Tax Assessment Act 1936 to the proposed partnership restructure?

Answer

Part IVA is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled.

Yes.

This ruling applies for the following periods:

n Year ending 30 June 2011

n Year ending 30 June 2012

n Year ending 30 June 2013

The scheme commences on:

1 July 2010

Relevant facts

The current business structure is a professional partnership of three individuals and one private company. The partnership operates out of three neighbouring towns.

The practice presently engages an associated service trust to provide professional and support staff, premises, supplies and equipment.

The service trust is a unit trust with the four principal practitioners' family trusts as unit holders.

The four principal practitioners are directors and shareholders of the corporate trustee of the service trust.

The existing partnership has traded for many years, but does not have a written partnership agreement. There is however, a service agreement between the partnership and the trustee of the service trust.

In addition to the work performed by the 4 principal practitioners, the practice employs 6 additional practitioners on long term contracts, as well as a Practice Manager, receptionists and various other support staff.

The principal practitioners have received legal advice that for asset protection purposes, it would be preferable for the employment functions to be separated from the asset ownership.

The existing partnership comprises three individuals and one private company. The three individuals in particular are at risk because their personal assets are exposed in the event of a malpractice suit. Furthermore, the partner's exposure extends to not only claims against the partners in respect of their individual roles but they are also vicariously exposed to any claims from the conduct of any of the employed/contracted professionals and other staff.

Under the proposed new arrangement, a new partnership of trustees for discretionary trusts, will be created to undertake the head contractor/employer functions of the practice. The ownership of the buildings will remain with the service trust. The applicant has now advised, however, that the private company may in fact remain a partner, rather than that principal setting up a family discretionary trust.

It is the intention that the principal practitioners will be providing their services to the practice via their respective discretionary trusts, rather than contracting directly.

The trust deeds of the discretionary trusts will allow the trustees to distribute to a wide range of beneficiaries including the principal practitioner's immediate extended families.

Assumption

The trustees of the proposed discretionary trusts distribute income received from the partnership to the spouses and or children of the principal practitioners and the marginal tax rates of the spouses and or children is less than the marginal tax rate of the principal practitioner.

Reasons for decision

Issue 1

Question 1

Summary

The Commissioner is satisfied that the income to be derived by the proposed new partnership of trustees of discretionary trusts will be income from a business structure and not personal services income. The alienation of personal services income rules will not apply to the proposed new partnership.

Detailed reasoning

Personal services income

The measures contained in Divisions 84 to 87 of the Income Tax Assessment Act 1997 (ITAA 1997) only apply if a taxpayer has income that is personal services income (of an individual). The definition of personal services income is contained in subsection 84-5(1) of the ITAA 1997 which states:

Your ordinary income or statutory income, or the ordinary income or statutory income of any other entity, is your personal services income if the income is mainly a reward for your personal efforts or skills (or would mainly be such a reward if it was your income).

The definition refers to income (including ordinary income or statutory income of any entity) that is mainly a reward for an individual's personal efforts or skills. Subsection 84-5(3) of the ITAA 1997 extends the definition of personal services income to income that is for doing work or for producing a result. The result must be produced from the individual's personal efforts or skills.

The fact that the income is payable under a contract does not stop the income being mainly a reward for an individual's personal efforts or skills (subsection 84-5(4) of the ITAA 1997).

Mainly

The reference to mainly requires more than half of the relevant amount or item of the ordinary income or statutory income be a reward for the personal efforts or skills of an individual. Where the income is derived under a contract, and that contract is for the rendering of personal efforts or the provision of the skills or expertise of a particular individual, the income derived under that contract would mainly be a reward for that individual's personal efforts or skills.

Income from a business structure is not personal services income

The alienation measure does not apply to businesses that have a substantial profit-yielding structure. The distinction between income that is mainly a reward for personal efforts or skills and income from a business structure will need to be made having regard to factors such as the number of arms length employees or others engaged to perform work, the presence of goodwill, the extent to which income-producing assets are used to derive the income, the nature of the activities carried out, the size of the operation and the extent to which the income is dependent upon a particular individual's own personal skills, efforts or expertise.

Taxation Ruling TR 2001/7 Income tax: the meaning of personal services income provides examples of the distinction between income derived from personal services and income derived from the supply and sale of goods, use of income-producing assets, and business structure.

Example 7 in TR 2001/7 considers income derived from a business structure in paragraphs 94-96 and states:

John is a partner in a large accounting partnership which has 20 partners and 200 employees.

As a partner, John's income from the partnership flows from property, namely, his proprietary interest in the partnership. The interest is an interest in, among other things, the profit derived by the partnership as a whole, ie in the profits generated by the other partners and employees from custom attracted by the goodwill of the partnership, and use of the partnership assets. When a partner participated in profits generated not merely in law, but as a commercial reality, from the efforts of the entire firm, it is properly attributed to the taxpayer's interest in the business structure or organisation of the partnership (which is his capital).

Accordingly, as a partner in the partnership, John's income is income of a business structure rather than his own personal services income. The partnership has numerous employees and business assets and the income of the partnership is generated by these employees and the partnership assets and goodwill.

Taxation Ruling IT 2639 Income Tax: Personal Services Income expands upon the factors listed above. At paragraph 7 it states:

Income from the business structure defined

7. In this Ruling income from the business structure refers to income other than income from personal services. Income derived by a firm or practice which has substantial income producing assets, or many employees, or both, is more likely to be generated from the income yielding structure of the business rather than from the rendering of personal services.

Then in paragraph 8 the significance of the factors is explained:

8. Whether a taxpayer derives income from rendering personal services is a question of fact and degree to determine in the circumstances of each case. The crucial issue is the extent of the connection between the income concerned and the services rendered by the particular taxpayer involved. The following factors need to be considered in determining whether a taxpayer derives income from personal services, though no one factor is determinative.

a. The nature of the taxpayer's activities

The activities of salary and wage earners and professionals practicing on their own account clearly generate personal services income. Radiologists or pathologists who operate on their own account, however, often employ many technical staff and operate an array of technical equipment. Their income is generated from the business structure rather than from their rendering of personal services. The activities of consultants, salespersons, journalists, life insurance agents and tradespersons are also likely to give rise to income from personal services. These examples are far from being exhaustive.

b. The extent to which the income depends upon the taxpayer's own skill and judgment

The more the income producing activities involve the exercise of the taxpayer's own skill and judgment the more probable it is that the income will be derived from personal services rather than from the business structure.

c. The extent of the income producing assets used to derive the income

The more substantial the income producing assets employed within a practice the more likely it is that the income of the practice will be derived from the business structure rather than from the rendering of personal services. For example, the array of equipment used by radiologists and pathologists may often suggest that their income is being derived from the business structure. However, minor equipment such as the drawing board of an architect or the heart monitor/blood pressure machine of a medical practitioner would not suffice to change what would otherwise be personal services income into income from the business structure. The expression income producing assets is used in this context to include any investment of the practice in tangible business assets such as premises, fixtures and fittings, plant, equipment and industrial or intellectual property (whether owned or leased). However, the significance of these assets would have to be weighed against their relevance to the derivation of income given the other factors mentioned in this paragraph.

d. The number of employees and others engaged

The more substantial the number of employees, practitioners or technicians used in a practice the more probable it is that the income is derived from the business structure rather than from the rendering of personal services (see Henderson v F.C. of T. 70 ATC 4016; (1970) 1 ATR 596). For example, large accounting and legal firms with tens, or even hundreds, of practitioners but without extensive or substantial equipment would also be considered to be generating their income from their business structure.

The individual weighting of the above factors will depend on the circumstances of each case.

Application of IT 2639 to your circumstances

Taxation Ruling IT 2639, at paragraph 10, states as the general rule of thumb, if the practice company or trust has at least as many non-principal practitioners as principal practitioners, then income is considered to be derived from the business structure.

Currently, in addition to the four principals, the Practice engages six further practitioners on long term contracts. The Practice also employees other support staff. Therefore the Practice currently has at least as many non-principals as principals.

Accordingly, the Commissioner is satisfied that the income to be derived by the new partnership will be income from a business structure and not personal services income. The alienation of personal services income rules will not apply to the new partnership.

Question 2

Summary

Part IVA is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled.

It is the view of the Commissioner that the proposed restructure of the Practice is for business management reasons. However the use of a partnership of trustees of discretionary trusts and the distribution of income to beneficiaries other than the principal practitioners by those trusts in circumstances where those beneficiaries' marginal tax rates are less than those of the principal practitioner indicates that the dominant purpose of the scheme is to achieve a tax benefit for the purposes of Part IVA.

Detailed reasoning

The general anti-avoidance provisions

Part IVA applies to a scheme in connection with which a taxpayer has obtained a tax benefit if, having regard to the eight factors specified in section 177D of the ITAA 1936, it would be concluded that a person who entered into or carried out the scheme, or any part of it, did so for the dominant purpose of enabling the taxpayer to obtain the tax benefit.

Part IVA does not prevent the interposition of entities per se. But where the interposition of an entity is part of a scheme to split income which would have been (or might reasonably have been expected to have been) derived by the principal and having regard to the section 177D factors, it would be concluded that a person who entered into or carried out the scheme, or any part of it, did so for the dominant purpose of enabling the taxpayer to obtain the tax benefit, it will attract the application of Part IVA.

Dominant purpose

Where it can be concluded that there are two or more purposes for entering into a scheme, the purpose of obtaining a tax benefit must be the dominant purpose: subsection 177A(5).

The dominant of two or more purposes is the ruling, prevailing or most influential purpose.

It is possible for Part IVA to apply notwithstanding that the dominant purpose of obtaining the tax benefit was consistent with the pursuit of commercial gain. Furthermore, the fact that a particular course of action is both 'tax driven' and bears the character of a rational commercial decision does not determine whether a person has entered into or carried out a scheme for the dominant purpose of enabling the taxpayer to obtain a tax benefit. This is made clear in Federal Commissioner of Taxation v. Hart (2004) HCA 26; 217 CLR 216; 206 ALR 207; 2004 ATC 4599; 55 ATR 712at {16} per Gleeson CJ and McHugh J:

Even so, the transaction may take such a form that there is a particular scheme in respect of which a conclusion of the kind described in s 177D is required, even though the particular scheme also advances a wider commercial objective.

And at [64] per Gummow and Hayne JJ:

But so too, as was held in Spotless, there is a false dichotomy between a "rational commercial decision" and the "obtaining of a tax benefit as 'the dominant purpose of the taxpayers in making the investment'". Pointing to the "commercial end" of the scheme reveals the adoption of the same, or at least a substantially similar, false dichotomy. The presence of a discernible commercial end does not determine the answer to the question posed by s177D.

Interposing an entity will commonly achieve one or more commercial purposes. For example, interposition of a corporation may effect asset protection and limit personal liability of the principal. The fact that such a commercial objective is achieved does not of itself mean that Part IVA will not apply. For one thing, the manner in which a commercial end is achieved may reveal a dominant purpose of enabling the taxpayer to obtain a tax benefit. For another, although achieving a commercial end may be one purpose, nevertheless it may be concluded that the dominant purpose is to obtain a tax benefit.

The mere assertion of a commercial purpose will not prevent Part IVA from applying where having regard to the 177D factors, it would be concluded that a person who entered into or carried out the scheme, or any part of it, did so for the purpose of enabling the taxpayer to obtain the tax benefit. Therefore, if adoption of a particular entity structure is said to have taken place to achieve a particular (commercial) end, but other facts are inconsistent with this, it may be doubted that the entity structure was adopted to achieve the commercial end.

Is there a scheme

For Part IVA to apply there must be a scheme within section 177A of the ITAA 1936, by which a taxpayer obtains a tax benefit. Under section 177A, a scheme is defined to include any agreement, understanding, promise or undertaking and whether or not enforceable and any scheme, plan, proposal, action, course of action or course of conduct.

Under the proposed restructure, the current partnership will cease and a new partnership will be formed consisting of discretionary trusts. This new partnership will undertake the head contractor/employer functions of the Practice. The ownership of the buildings will remain with the service trust.

Under the existing arrangement, the income from the Practice is distributed to the principal practitioners as a partnership distribution. Under the proposed restructure, the partnership will consist of trustees of discretionary trusts, with the result that the income can be streamed away from the individual practitioners at the discretion of the trustee of each of the discretionary trusts. This ruling has assumed that significant amounts of partnership income are distributed to the spouses and children of the principal practitioners.

The Commissioner is of the opinion that the proposed arrangements which include the establishment of new trusts with corporate trustees; the formation of a partnership between the trustees of the new trusts; the new partnership conducting the business of the current partnership and service trust; and subsequent distributions to trust beneficiaries other than the principal practitioner, constitute a scheme.

Is there a tax benefit

The anti-avoidance provisions only apply where there is a tax benefit from the scheme. Under section 177C of the ITAA 1936 a tax benefit received in relation to a scheme is any of the following four amounts:

· An amount that was not included in the assessable income of the taxpayer, where that amount would have been included, or might reasonably be expected to be included, in the assessable income of the taxpayer if the scheme had not been entered into.

· An amount for a deduction being allowable to the taxpayer, where that deduction would not have been allowable, or might reasonably be expected not to have been allowable, to the taxpayer if the scheme had not been entered into.

· An amount of a capital loss being incurred by the taxpayer, where that amount would not have been, or might reasonably be expected not to have been, incurred by the taxpayer if the scheme had not been entered into.

· An amount of a foreign tax credit being allowable to the taxpayer, where that foreign tax credit would not have been allowable, or might reasonably be expected not to have been allowable, to the taxpayer if the scheme had not been entered into.

Currently, the net income from the Practice flows through to the four principal practitioners on the basis of their individual interest in the net income of the partnership. In the case of three practitioners, the partnership interest is held personally, and in the case of the other practitioner, the partnership interest is held by his private company. This practitioner receives wages equivalent to he amount oreceived by his company from the partnership.

Following the restructure, the income from the Practice will flow through from the partnership to the principal practitioners' discretionary trusts, and it will be at the discretion of the respective trustee as to how much, if any, of this income will be distributed to the principal practitioner.

Should one or more of the trustees choose not to distribute the income to the relevant practitioner and instead distribute the income to another member of the practitioner's family there will be a tax benefit, in that the practitioner's assessable income might reasonably be expected to be less than it would have otherwise been if the scheme had not been entered into. In these circumstances there will be a reduction of the tax otherwise payable by each of the principal practitioners. However, the quantum of this amount may be offset by tax payable by other family members. As the family trusts will be discretionary trusts it is not possible to quantify the amount of tax benefit from year to year until each trustee exercises the discretion to distribute the trust income.

A tax benefit arises within the meaning of section 177C of the ITAA 1936, when income is distributed to family members of the principal practitioner from the discretionary trusts and as such the purposes of the scheme requires consideration in the context of the criteria specified in section 177D of the ITAA 1936.

Part IVA factors

Under subsection 177D(b) of the ITAA 1936 the Commissioner must have regard to:

i) the manner in which the scheme was entered into or carried out;

ii) the form and substance of the scheme;

iii) the time at which the scheme was entered into and the length of the period during which the scheme was carried out;

iv) the result in relation to the operation of this Act that, but for this Part, would be achieved by the scheme;

v) any change in the financial position of the relevant taxpayer that has resulted, will result, or may reasonably be expected to result, from the scheme;

vi) any change in the financial position of any person who has, or has had, any connection (whether of a business, family or other nature) with the relevant taxpayer, being a change that has resulted, will result or may reasonably be expected to result, from the scheme;

vii) any other consequences for the relevant taxpayer, or for any person referred to in subparagraph (vi), of the scheme having been entered into or carried out; and

viii) the nature of any connection (whether of a business, family or other nature) between the relevant taxpayer and any person referred to in subparagraph (vi)

in concluding that the person who entered into or carried out the scheme or any part of the scheme did so for the purpose of enabling the relevant taxpayer to obtain a tax benefit in connection with the scheme or of enabling the relevant taxpayer and another taxpayer or other taxpayers each to obtain a tax benefit in connection with the scheme (whether or not that person who entered into or carried out the scheme or any part of the scheme is the relevant taxpayer or is the other taxpayer or one of the other taxpayers).

In Spotless, the High Court held that a scheme can fall within the meaning of Part IVA even though there is a commercial purpose as long as the dominant purpose is to obtain a tax benefit.

In Hart, the High Court held that the fact that a scheme is directed to a commercial end does not preclude the operation of Part IVA if the particular means adopted was predominantly for the purpose of obtaining a tax benefit. In considering whether a scheme was entered into predominantly for the purpose of obtaining a tax benefit, the alternative forms which the transaction might have taken must be considered.

The factors under subsection 177D(b) of the ITAA 1936 are examined below in regard to the proposed restructure of the Practice.

The manner in which the scheme is carried out

The scheme proposed to be entered into involves each principal practitioner establishing a discretionary trust with a corporate trustee. A new partnership of corporate trustees for the discretionary trusts will then be formed. This new partnership will be responsible for all the employment functions of the Practice. Ownership of the Practice buildings will be retained in the existing service trust and a lease agreement will be entered into between the service trust and the new partnership for the lease of these buildings.

The practitioners consider that this new arrangement is necessary for asset protection purposes. The practitioners have received legal advice that the entity that contracts with the practitioners, employs staff and provides services to clients should not be the entity that also holds substantial assets. Under the current arrangement this is not the case - it is the service trust that is the head contractor/employer, and also the entity that owns the assets, in particular, the real properties.

Under the proposed restructure, the new partnership of trustees of the discretionary trusts will carry the ultimate liability for any claims made arising out of any alleged negligence occurring in relation to services provided by the Practice. As neither the service trust, nor the individual principal practitioners of the Practice will be providing the services, the only entities at risk will be the corporate trustees for the discretionary trusts.

Therefore, the manner in which the scheme is entered into does have a clearly demonstrable commercial purpose.

However, it is considered that the scheme achieves more than providing increased asset protection in that a tax benefit may also arise. The principal practitioner's share of the Practice income will no longer be taxable to them individually as partnership distributions (or in the case of one practitioner, as wages through a private company), but instead may be distributed to various beneficiaries of the discretionary trusts.

The form and substance of the scheme

The applicant has advised that the two main reasons for undertaking the restructure are:

· provide increased asset protection; and

· reduce the administrative burden of having a number of entities in the practice structure.

Under the existing structure, the principal assets, being the buildings, are held by the corporate trustee of the service trust. This trust is also the head contractor/employer of the professional and other staff of the Practice. As a result the trust is ultimately liable in the event of any actions being taken for breaches of duty of care by any of the Practice staff.

Under the new structure, the assets will remain with the service trust, however the head contractor/employer will be the new partnership. Thus, the holding of the assets will be separated from the employing entity, and therefore protected in the event of any malpractice claims etc.

The new partnership will be one of trustees for discretionary trusts and the trustees will carry the ultimate liability for any claims made arising out of any alleged negligence of staff. It is expected that these entities will have little, if any, assets available to meet any such claims.

As the existing partnership is between three of the principal practitioners, and one company, if the employment functions were to be taken on by the existing partnership, the three individual principal practitioners in the partnership would be personally exposed to liability.

The current partners are personally exposed, not only to claims against them in respect of their individual roles, but are also vicariously exposed to any claims from the conduct of any of the employed/contracted staff. It is not obvious why this is the case if it is actually the service trust that is currently providing all staff. However, under the current arrangement, the assets (ie the buildings) of the service trust being the employing entity, are at risk in the event of any claims made against the service trust.

The same stated goals of greater asset protection and administrative simplicity could also be achieved by the new partnership being established as a partnership of private companies.

It is considered that the use of a partnership of trustees for discretionary trusts goes beyond the stated goals of providing increased asset protection and reducing the administrative burden of having a number of entities in the practice structure. Apart from income splitting, there would seem to be no other business reason for the establishment of discretionary trusts for each principal practitioner when a partnership of the individual practitioner's private companies alone is sufficient to achieve asset protection.

Another alternative which would not result in the application of Part IVA would involve the trustee of each respective discretionary trust distributing all income received from the new partnership to the principal practitioners.

The manner and substance of the scheme point towards a conclusion that the scheme was entered into for the dominant purpose of enabling the principals to obtain a tax benefit.

The time at which the scheme was entered into

The proposed restructure will not occur until after the ruling has issued.

It is considered that this factor is neutral in determining whether or not the proposed scheme is tax driven.

The tax, financial and other consequences of carrying out the scheme

Subparagraphs 177D(b) (iv) to (viii) focus on the tax, financial and other consequences of carrying out a scheme. They include the tax result, financial change or other consequences for you and related parties.

Under the current arrangement, the partnership income is being distributed to three of the principal practitioners directly, and to the fourth via a private company. Under the proposed new structure, the partnership income will be distributed to the discretionary trusts.

Trust deeds are not currently available for these discretionary trusts, however you have advised that they will be standard family trust deeds which will provide for the trustee to distribute to a wide range of beneficiaries, including the practitioners' immediate and extended families.

Therefore, the opportunity exists for the discretionary trusts to distribute income to other than the principal practitioners. If this does in fact occur, there could be reduced tax payable overall.

Conclusion

It is the view of the Commissioner that the proposed restructure of the Practice is for business management reasons. However the use of a partnership of trustees of discretionary trusts and the distribution of income to beneficiaries other than the principal practitioner by those trusts in circumstances where those beneficiaries' marginal tax rates are less than those of the principal practitioner indicates that the dominant purpose of the scheme is to achieve a tax benefit for the purposes of Part IVA.