Edited version of your private ruling

Authorisation Number: 1011992864980

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Ruling

Subject: Professional practice restructure

Issue 1

Question 1

Are there any CGT consequences on conversion from a partnership to a corporate limited partnership?

Answer

No

Question 2

Does the Commissioner agree that a roll over is available under subdivision 122-B by virtue of the operation of section 94J?

Answer

No

Question 3

Will CGT event E1 occur when a general partner who holds an investor partner interest disposes of that interest by creation of a trust over that interest?

Answer

Yes

Question 4

Will the market value substitution rules in Division 116 of the ITAA 1997 apply when a partner enters or exits the partnership in circumstances where no money is paid in respect of the entry or exit?

Answer

Yes

Question 5

Will all distributions to partners be a distribution of profits?

Answer

Yes

Question 6

Will any amount of a partner's undrawn entitlement to profit be a deemed dividend pursuant to Division 5A of the ITAA 1936?

Answer

No

Issue 2

Question 1

Will the Commissioner exercise his discretion under section 205-70(6) in respect of the reduction in the tax offset in relation to franking deficit tax that is anticipated to occur in the first year of income of the limited partnership?

Answer

Yes

Issue 3

Question 1

That the limited partnership structure contemplated is a normal commercial structure and prima facie does not offend Part IVA of the Income Tax Assessment Act 1936?

Answer

No

This ruling applies for the following periods:

1 July 2010 to 30 June 2011

1 July 2011 to 30 June 2012

The scheme commences on:

1 July 2010

Relevant facts and circumstances

1. A professional practice currently operates under the following structure:

· Partnership of equity partners and fixed income partners

· Service Trust (Unit holders being the family trusts of some of the partners)

2. Incoming partners make a payment for an interest in the assets of the partnership and outgoing partners are paid for their interest in the assets of the partnership. The assets of the partnership include goodwill. Fixed income partners have no interest in the assets of the partnership.

3. Following the publication of TR 2006/2 and the Commissioner's guidelines in Your service entity arrangements (NAT 13086), the applicant was requested to undertake a review of the professional practice operating structure. The review was to consider 'operational efficiency, partner interests, entry and exit of partners, ATO rulings and guidelines and any other matters considered relevant' by the applicant.

4. This review recommended that the existing partnership be restructured so that the entire professional practice be carried on by the one entity, a limited partnership.

5. The restructure to a limited partnership involves:

· conversion of the partnership to a limited partnership to meet the registration requirements of the relevant state Partnership Act;

· the creation of Limited Partners Class 2 interests on conversion; and

· the amendment of the partnership agreement to move to a 'no goodwill partnership'.

Proposed arrangement

6. The limited partnership will have the following classes of partners:

· General Partners - full Equity Partners. These partners will receive a fixed income share and a final variable distribution. General partners have unlimited liability and provide management of the practice.

· Limited Partners Class 1 - fixed income partners. The current fixed income partners will become limited partners Class 1. These partners will receive the first share of net income of the partnership and have no further entitlement to profit. They have limited liability under the terms of the partnership. They have the lowest risk and lowest return of all partner interests and have no involvement in the management of the partnership. There will be no change in the nature or value of the current fixed income partners' interests under the new structure. On exit the Limited Partners Class 1 will not be entitled to any capital payment.

· Limited Partners Class 2 - Investor Partners (family investment vehicles of general partners). These partners will be entitled to a non cumulative fixed percentage return as a preference distribution after the fixed income partners. They will also be entitled to receive a second variable distribution after the General Partners have received a fixed distribution. The total potential distribution to a Limited Partner Class 2 will be limited to a percentage of profit after tax, Fixed Income Partner's distribution and the fixed income distribution to General Partners. They will have limited liability. They will have no involvement in the management of the practice.

7. Only people or entities associated with general partners can own investor partner interests in the partnership.

8. On initial setting up of the limited partnership, all class 2 investor partner interests will be held by the relevant General Partner. It is intended that at some point in time after the restructure, the General Partners will each create a trust over their respective Class 2 interests. Once this occurs, the Class 2 interests will be held by the general partners in trust (or as nominee) for the investor partners. This will be done for value with the value being independently determined.

9. Therefore, immediately on conversion to the new structure the current Equity Partners will hold both General Partner and Class 2 interests. The effect of this is that immediately following conversion, the General Partners will, in substance, enjoy the same rights to income, capital and management as they enjoyed immediately before conversion.

10. The partners have agreed to move to a no goodwill partnership for entry and exit of general partners and fixed income partners in the normal course of business.

11. It is intended that fixed income partners will ultimately progress to general partners by agreement of the then current general partners.

Rationale for the proposed arrangement

12. The rationale for undertaking the restructure has been stated to be:

· to preserve the professional status of senior practitioners

· provide real and effective protection to the fixed income partners

· provide simplicity and efficiency

· allow for future business expansion

· avoids complex issues around remuneration or deemed remuneration for owner employees

· does not have any cost impediments of employee on-costs that are associated with some of the alternatives

· it is a structure used in both the UK and the USA

· it provides for efficient tax management of unpaid 'profit shares'.

13. The alternative structures that were considered by the applicant prior to recommending the proposed structure to the partnership were:

· traditional partnership

· traditional partnership and service entity (present structure)

· incorporated practice

· partnership of trusts

· limited partnership

14. The corporate limited partnership was chosen as the preferred new structure because it 'ticked all the boxes'.

Distributions from the new limited partnership

15. Class 1 Fixed Income Partners will receive a fixed distribution at least as great as that currently received.

16. The General Partner's fixed distribution will be at least 20% higher than that of Fixed Income Partners.

17. Class 2 Investor Partners' fixed percentage return is expected to be an amount roughly equivalent to the notional cost of borrowing funds to acquire an interest.

The final variable distribution percentages to the class 2 Investor Partners and to General Partners has not been finalised. The percentage of income that will flow to the class 2 investor interests will ultimately determine the value of those interests. The value of the class 2 interests will be determined on the basis of how much of the value of the asset the current equity partners (collectively) agree to realise, the income that will or may flow to that realised portion and the appropriate risk weighted return on that potential income.

Relevant legislative provisions

Income Tax Assessment Act 1936 section 44

Income Tax Assessment Act 1936 Division 5A

Income Tax Assessment Act 1936 section 94D

Income Tax Assessment Act 1936 section 94J

Income Tax Assessment Act 1936 section 94K

Income Tax Assessment Act 1936 section 94L

Income Tax Assessment Act 1936 section 94M

Income Tax Assessment Act 1936 section 94N

Income Tax Assessment Act 1936 section 94P

Income Tax Assessment Act 1936 Division 7A

Income Tax Assessment Act 1936 Part IVA

Income Tax Assessment Act 1936 section 177A

Income Tax Assessment Act 1936 section 177C

Income Tax Assessment Act 1936 section 177D

Income Tax Assessment Act 1997 Part 3-1

Income Tax Assessment Act 1997 section 104-10

Income Tax Assessment Act 1997 section 104-25

Income Tax Assessment Act 1997 section 104-35

Income Tax Assessment Act 1997 section 104-55

Income Tax Assessment Act 1997 section 104-250

Income Tax Assessment Act 1997 Subdivision 106-A

Income Tax Assessment Act 1997 section 106-5

Income Tax Assessment Act 1997 section 108-5

Income Tax Assessment Act 1997 Division 116

Income Tax Assessment Act 1997 section 116-20

Income Tax Assessment Act 1997 section 116-20

Income Tax Assessment Act 1997 section 116-30

Income Tax Assessment Act 1997 subdivision 122-B

Income Tax Assessment Act 1997 section 205-20

Income Tax Assessment Act 1997 section 205-40

Income Tax Assessment Act 1997 section 205-45

Income Tax Assessment Act 1997 section 205-70

Income Tax Assessment Act 1997 Division 725

Reasons for decision

Issue 1

Question 1

Summary

There are no CGT consequences on conversion from a partnership to a corporate limited partnership.

Detailed reasoning

CGT event A1 happens if you dispose of a CGT asset (subsection 104-10(1) of the ITAA 1997).

Subsection 104-10(2) of the ITAA 1997 provides that you dispose of a CGT asset if a change in ownership occurs from you to another entity, whether because of some act or event or by operation of law.

The conversion of the partnership to a limited partnership will occur with the consent of all the current partners, by varying the terms of the existing partnership agreement to limit the liability of one or more partners and registering the limited partnership under the relevant state partnership act. This conversion does not cause the original partnership to cease, it merely varies the mutual rights and duties that exist between the partners.

Under the operation of Division 5A of the ITAA 1936 a limited partnership that satisfies the definition of corporate limited partnership in section 94D of the ITAA 1936 is treated as a company for certain income tax purposes. Division 5A does not modify the operation of CGT event A1 in section 104-10 so that the event happens to the partnership assets on the commencement of corporate limited partnership status.

Section 94J of the ITAA 1936 provides that a reference in the income tax law to a company or to a body corporate includes a reference to the partnership.

The Explanatory Memorandum to the Bill which became Act No 227 of 1992 which introduced Division 5A into the ITAA 1936 advised that, while corporate limited partnerships are generally treated as companies for the purposes of the income tax law, this does not convert them into companies for other purposes, including criminal law, monetary claims, and so on.

This is consistent with the view that the treatment of a corporate limited partnership as a company for the purposes of the ITAA 1997 and ITAA 1936 does not deem there to be for those purposes a transfer of the ownership of partnership assets to the company nor does it change the ownership of partnership assets under general law.

Thus, as there has been no change of ownership of the partnership assets, CGT event A1 does not happen upon conversion of the partnership to a limited partnership.

Question 2

Summary

The Commissioner does not agree that a roll over is available under subdivision 122-B of the ITAA 1997 by virtue of the operation of section 94J of the ITAA 1936.

Detailed reasoning

As discussed in question 1 above, no relevant CGT event will happen on the commencement of the corporate limited partnership.

In the absence of CGT event A1, the roll-over relief in subdivision 122-B of the ITAA 1997 is not needed and may not be chosen.

Question 3

Summary

CGT event E1 occurs when a general partner creates a trust over the limited partner class 2 interests.

Detailed reasoning

Under section 104-55 CGT event E1 will occur if you create a trust over a CGT asset by declaration or settlement. The time of the event is when the trust over the asset is created. If you are the trustee of the trust and no beneficiary is absolutely entitled to the asset as against you the first element of the asset's cost base in your hands is its market value when the trust is created.

The ATO has released a publication titled Market valuation for tax purposes which states that, depending on the situation, a market valuation may be undertaken by a:

· registered valuer,

· member of a recognised professional valuation body, or

· person without formal valuation qualifications whose assessment is based on reasonably objective and supportable data.

Accordingly, a valuation using commercially acceptable principles in line with the above, would be acceptable.

Question 4

Summary

The market value substitution rules in Division 116 of the ITAA 1997 will apply when a partner enters or exits the partnership in circumstances where no money is paid in respect of the entry or exit.

Detailed reasoning

The CGT consequences of a partner retiring or transferring their interests in a partnership are dealt with in Part 3-1 of the ITAA (in particular, paragraphs 108-5(2)(c) and (d) and Subdivision 106-A). However as a result of the operation of section 94K of the ITAA 1936 corporate limited partnerships are specifically excluded from the CGT statutory rules regarding partnerships and where relevant, the partner's partnership interest is treated as a share.

CGT event A1 happens if you dispose of a CGT asset (section 104-10 of the ITAA 1997).

CGT event C2 happens when there is a cancellation, surrender or similar ending of an asset. The time of the event is when the contract ending the asset is entered into, or if no contract, when the asset ends. (section 104-25 of the ITAA 1997)

Section 116-20 of the ITAA 1997 contains the general rules about capital proceeds.

Under subsection 116-20(1) of the ITAA 1997 the capital proceeds from the disposal of an asset are the total of:

· the money you have received, or are entitled to receive, in respect of the event happening; and

· the market value of any other property you have received, or are entitled to receive, in respect of the event happening (worked out as at the time of the event).

Subsection 116-20(2) of the ITAA 1997 states that the market value substitution rule is relevant if you receive no capital proceeds for a CGT event.

Where CGT event A1 or C2 happens and you do not receive any capital proceeds from that event, the market value substitution rule states that you are taken to have received the market value of the CGT asset that is the subject of the event. (subsection 116-30(1) of the ITAA 1997)

In the case of CGT event C2 happening, subsection 116-30(3A) states that the market value of the asset that is the subject of the CGT event C2 is worked out as if the event had not occurred and was never proposed to occur.

Application to your circumstances

Where a retiring partner disposes of their interest in the corporate limited partnership to a new partner CGT event A1 will happen on the disposal.

CGT event C2 will happen when a retiring partner's interest in the corporate limited partnership ends in one of the ways described in subsection 104-25(1) of the ITAA 1997.

Where no capital proceeds are received for CGT event A1 or CGT event C2, the market value substitution rules in subsection 116-30(1) of the ITAA 1997 will apply.

What is the market value of an asset (in this case, a partner's interest in the corporate limited partnership) is a question of fact.

The ATO has released a publication titled Market valuation for tax purposes which states that, depending on the situation, a market valuation may be undertaken by a:

· registered valuer,

· member of a recognised professional valuation body, or

· person without formal valuation qualifications whose assessment is based on reasonably objective and supportable data.

The limited concessions outlined in:

· Income Tax Ruling IT 2540 for the admission and exit of partners in traditional partnerships

· Taxation Determination TD 2011/26 for the admission and exit of shareholder-practitioners to proprietary limited companies

· will not apply to admissions to and exits of partners (or other entities) to the corporate limited partnership.

If a new general partner is admitted to the partnership without the retirement of an existing partner, CGT event A1 will not happen for the existing partners due to the operation of section 94K of the ITAA 1936 'turning off' section 106-5 of the ITAA 1997. Nor will CGT event D1 (bringing into existence a CGT asset) happen by virtue of the exclusion contained in paragraph 104-35(5)(c).

When a new partner interest is created in the partnership (that is, where a retiring partner does not transfer their interest to an incoming partner) no CGT event will happen for the existing holders of General Partner interests for which the market value substitution rule would apply.

However, it should be noted that as an effect of the operation of Division 5A of the ITAA 1936, the value shifting rules contained in Division 725 of the ITAA 1997 (and CGT event K8 in section 104-250 of the ITAA 1997) may have application where new partner interests are issued at a discount to market value, and this causes a reduction in the market value of existing partner interests.

Question 5

Summary

All distributions made to partners will be appropriations of profit.

Detailed reasoning

Sections 94L and 94M of the ITAA 1936 specifically address the taxation consequences of payments, credits and distributions made to a partner in a corporate limited partnership.

Section 94L of the ITAA 1936 specifically includes as a dividend any distribution, whether money or property, paid to a partner in a corporate limited partnership, but not if the distribution is attributed to profit or gain from a year when the partnership was not a corporate partnership.

Likewise, section 94M of the ITAA 1936, deems that where a corporate limited partnership pays or credits a partner from profits, anticipated profits, or otherwise in anticipation of profits, the amount is taken to be a dividend paid out of profits derived by the partnership.

A salary paid to a partner in a corporate limited partnership is not necessarily paid from profits and may be paid in anticipation of profits. In applying section 94M of the ITAA 1936, such payments are considered a distribution of profits and will be taxed as a dividend.

Taxation Ruling TR 2005/7 discusses the taxation implications of 'partnership salary' agreements. TR 2005/7 confirms that a salary paid to a partner in a partnership will not be an allowable deduction to the partnership. Rather, in cases where a bona fide salary has been paid it will represent a distribution of profits by the partnership.

Similarly, any payments made to fixed income, general or investor partners paid during the year, although not termed 'salary' are considered to be paid in anticipation of profits, and such are considered to be a distribution of profits.

Consequently any distributions paid to a partner of the corporate limited partnership will be assessable income and subject to taxation as dividends under subsection 44(1) of the ITAA 1936.

Question 6

Summary

Will any amount of a partner's undrawn entitlement to profit be a deemed dividend pursuant to Division 5A of the ITAA 1936?

Detailed reasoning

Sections 94L and 94M of the ITAA 1936 specifically address the taxation consequences of payments, credits and distributions made to a partner in a corporate limited partnership.

Section 94L of the ITAA 1936 includes a distribution, whether money or property, to a partner in a corporate limited partnership, as a dividend, but not if the distribution is attributed to profit or gain from a year when the partnership was not a corporate partnership.

Likewise, section 94M of the ITAA 1936, deems that where a corporate limited partnership pays or credits a partner from profits, anticipated profits, or otherwise in anticipation of profits, the amount is taken to be a dividend paid out of profits derived by the partnership.

Therefore, any amounts that have been credited to an individual partner's account (whether capital or current account) in the books of the partnership will be deemed to be a dividend at the time that the amount is credited.

Where the corporate limited partnership makes a distribution of profits which includes an amount previously paid or credited in anticipation of such profits, the Commissioner must take such steps, if any, to ensure that a partner is not subject to double taxation (subsection 94M(2) of the ITAA 1936). This ensures that if a partner has been taxed on a distribution when it was credited, the partner will not be taxed again when the distribution is actually paid.

It should be noted that Division 7A of the ITAA 1936 applies to certain distributions (including loans, payments and debt forgiveness) made by closely held corporate limited partnerships to partners and their associates.

Issue 2

Question 1

Summary

The Commissioner will exercise his discretion under subsection 205-70(6) of the ITAA 1997 in respect of the reduction in the tax offset in relation to franking deficit tax that is anticipated to occur in the first year of income of the limited partnership.

Detailed reasoning

A corporate tax entity may frank a frankable distribution only if it is a franking entity that is an Australian resident at the time that it makes the frankable distribution and it allocates franking credits to that distribution. Corporate tax entities that may frank a distribution are Australian resident:

· companies

· corporate limited partnerships

· corporate unit trusts, and

· public trading trusts.

Section 205-40 of the ITAA 1997 states that when there are more franking debits than credits in the franking account, there is a franking deficit.

If an entity's account is in deficit at the end of an income year, subsection 205-45(2) of the ITAA 1997 provides that the entity is liable to pay franking deficit tax (FDT). FDT is an amount equal to the amount of the deficit in the franking account. The object of applying FDT is to prevent entities relying on franking credits that they anticipate to arise for an indefinite period into the future.

Subsection 205-70(1) of the ITAA 1997 provides that a corporate tax entity is entitled to a tax offset arising from a FDT liability for an income year for which it meets certain residency requirements if at least one of the following applies:

· the entity has incurred a liability to pay franking deficit tax in that year

· the entity incurred a liability to pay franking deficit tax in a previous income year for which it did not satisfy the residency requirements, and the entity has not already received a tax offset in relation to it, or

· when the entity was last entitled to a tax offset under the section for a previous income year, that offset exceeded the amount that would have been its income tax liability for that year if it did not have that offset (but had all its other tax offsets).

The amount of the tax offset is usually equal to the amount of the FDT liability. However, the offset will be reduced by 30% in certain circumstances. The 30% reduction applies where the FDT liability attributable to certain debits that arose in the franking account for a year is greater than 10% of the total franking credits that arose in the franking account for that year.

Subsection 205-70(5) of the ITAA provides a specific exclusion from the 30% FDT reduction for private companies in certain specified circumstances. However, section 94N of the ITAA 1936 specifically excludes a corporate limited partnership from being treated as a private company in terms of the income tax law.

Tax Laws Amendment (2006 Measures No. 2) Act 2006 introduced subsection 205-70(6) of the ITAA 1997 to give the Commissioner a discretion to allow the 30% offset if the franking deficit occurred as a result of events that were outside of the entity's control.

The Explanatory Memorandum to the Tax Laws Amendment (2006 Measures No. 2) Bill 2006 states at paragraph 5.15 and 5.16:

5.15 This measure was announced by the former Minister for Revenue and Assistant Treasurer in Press Release no. 30 of 10 May 2005. That press release stated that the Commissioner's discretion would apply 'where, broadly, events that caused the over franking were outside of the company's control or were unanticipated, and did not involve any broader exploitation of the imputation system'. Subsection 205-70(6) has not been drafted using the same words as the press release. However, it is considered that the wording of the subsection has the same effect as the wording in the press release.

5.16 That is, an event that is outside an entity's control includes (but is not limited to) an event that is unanticipated. In addition, in exercising the discretion, the Commissioner must consider whether the taxpayer has any broader intention to exploit the imputation system. That is, if the deficit in the franking account arose in circumstances where the taxpayer intended to exploit the imputation system, the events that gave rise to the deficit would be within the taxpayer's control and the Commissioner's discretion would not be exercised.

Section 94M of the ITAA 1936 deems to be dividends any amounts paid to partners of a corporate limited partnership from profits or anticipated profits of the partnership.

Subsection 205-20(3) precludes a taxpayer from making a voluntary payment of tax in order to obtain a franking credit.

Application to your circumstances

In your case, the potential franking deficit will arise because in its first year of operation, the corporate limited partnership will not have made any PAYG instalments and accordingly will not have any franking credits against which the deemed dividends paid to the partners can be paid as franked dividends.

Division 5A of the ITAA 1936 deems any payments made by the corporate limited partnership to the partners to be dividends.

You also claim that if the Commissioner does not exercise his discretion under subsection 205-70(6), and the dividends are paid unfranked there will be double taxation of these dividends - once in the hands of the partners as unfranked distributions and again taxed as profit to the limited partnership.

The circumstances that will lead to the corporate limited partnership having a FDT liability are clearly not unanticipated. However it is accepted that they are outside the entity's control.

It is also accepted that the restructure is not being undertaken for a purpose to exploit the imputation system.

Accordingly, it is considered that the Commissioner will exercise his discretion to allow the full FDT offset.

Issue 3

Question 1

Summary

The Commissioner considers that the provisions contained in Part IVA of the ITAA 1936 will apply to the proposed partnership restructure.

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, 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 be 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.

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.

The Commissioner is of the opinion that the proposed arrangements which include the conversion of the existing partnership to a corporate limited partnership; the creation of three classes of partner interests, including limited Partners Class 2 investor interests in the new corporate limited partnership; the new corporate limited partnership conducting the business of the current partnership and the Service Trust; and subsequent distributions to family members of the general partners by way of distributions to Class 2 investors, constitute a scheme.

The counterfactual and 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.

Paragraph 69 of Law Administration Practice Statement 2005/24: Application of General Anti-Avoidance Rules (PSLA 2005/24) states that the identification of a tax benefit necessarily requires consideration of the income tax consequences, but for the operation of Part IVA, of an 'alternative hypothesis' or an 'alternative postulate'. This is what would have happened or might reasonably be expected to have happened if the particular scheme had not been entered into or carried out. This alternative hypothesis or postulate also forms the background against which the objective ascertainment of the dominant purpose of a person occurs in accordance with section 177D. The alternative hypothesis(es) or postulate(s) is referred to in this practice statement as the 'counterfactual(s) (Federal Commissioner of Taxation v. Hart 217 CLR 216)

Currently, the net income from the Professional Practice flows through to the principals on the basis of their individual interest in the net income of the partnership. The net income is calculated after the Professional Practice claims a deduction for the service fee paid to the Service Trust. Principals of the Professional Practice who are also Unit Holders in the Service Trust also receive a distribution from the profits of the Service Trust.

The 'do-nothing' counterfactual

A possible construction of the counterfactual is that if the principals of the Professional Practice do not enter into the proposed arrangement they would retain their current business structure. If this counterfactual is adopted then following the conversion of the partnership to a corporate limited partnership, the net income of the Practice will be distributed in accordance with the entitlements attached to the different classes of partner interests. There is likely to be no change to the income received by the fixed income partners,

The taxpayer submits that under the scheme:

· Firstly, Class 1 Fixed Income Partners will receive a fixed distribution at least as great as that currently received;

· Secondly, the 5 General Partners under the new scheme will receive a fixed distribution;

· Thirdly, Class 2 Investor Partners' fixed percentage return is expected to be an amount roughly equivalent to the notional cost of borrowing funds to acquire an interest.

That aside, under the scheme the General Partners are to receive a fixed distribution that will be at least 20% higher than the Class 1 Fixed Income partners. The final variable distribution percentages to the Class 2 Investor Partners and to General Partners have not been finalised. However:

· The percentage of income that will flow to the class 2 investor interests will ultimately determine the value of those interests;

· The value of the class 2 interests will be determined on the basis of:

o how much of the value of the partnership interest the current General Partners (collectively) agree to realise;

o the income that will or may flow to that realised portion; and

o the appropriate risk weighted return on that potential income

Furthermore, under the scheme the Service Trust, being the service entity for the partnership will be wound up. The unit holders of the Service Trust are the family trusts of some of the General Partners in the partnership. Under the scheme the Class 2 Investor Partner interests will initially be held by the General Partners however at some point in time after the restructure, the General Partners will each create a trust over their respective Class 2 interests. The General Partners will have higher income levels until such time when they declare a trust over their Class 2 Investor Partner interests. The amount that will be distributed to the Class 2 investor shareholders is a tax benefit for the purposes of section 177C of the ITAA 1936.

In this situation, the Commissioner is of the opinion that a tax benefit, within the meaning of section 177C of the ITAA 1936, may arise when income is distributed to the Limited Partners Class 2 and as such the purpose of the scheme requires consideration in the context of the criteria specified in section 177D of the ITAA 1936.

However the applicants have submitted that the current business structure does not meet their current business objectives. When they commissioned a review of the firm's current operating structure they considered a range of alternative structures, none of which are outlined in detail in the application. An alternative construction of the counterfactual is that the applicants would restructure using an alternative business model which aligns with their business objectives. The more likely alternative is that the applicants would have restructured the current partnership into a partnership of discretionary trusts or incorporated legal practice.

The partnership of discretionary trusts counterfactual

If the applicants chose to restructure from a partnership of natural persons to a partnership of discretionary trusts they would need to modify their existing partnership agreement to allow discretionary trusts to hold ownership interests in the partnership. The applicants identified in their rationale for adopting a partnership model was that it provides simplicity for partners entering and exiting the practice. Furthermore, the applicants explained that a feature of the restructure is that they would move from a partnership that recognises goodwill to a business model that does not recognise goodwill (a 'no goodwill' practice).

Simplicity for the admission and retirement of partners from the practice for 'no goodwill' partnerships is explained in IT 2540. In Income tax: capital gains tax: if a share in a 'no goodwill' incorporated professional practice is disposed of for no consideration, will the Commissioner accept, for the purposes of calculating the market value of the share upon a possible application of subsection 116-30(1) of the Income Tax Assessment Act 1997 that the goodwill of the company can be taken to have a value of nil? ('TD 2011/26') the Commissioner further clarifies his view in IT 2540 and explains that the simplified approach does not apply where the partners in the partnership are not natural persons (paragraph 18). For this reason, taking into consideration their objectives it is unlikely that the applicants would restructure to a partnership of discretionary trusts.

The incorporation counterfactual

If the applicants restructured to an incorporated legal practice it is likely that they would also want to restructure from a goodwill partnership to a 'no goodwill' incorporated legal practice. In order to obtain the ease of admission and exit of the 'no goodwill' incorporated practice the applicants would need to restructure their practice in accordance with the conditions specified in TD 2011/26. The most significant of the conditions in paragraph 3 is for the purposes of this analysis is that the shares in the 'no goodwill' incorporated practice will need to be held by natural person practitioners both legally and beneficially. If they do not hold the shares in this manner a shareholder practitioner will incur CGT when there is a change in ownership during the natural ebb and flow of the practice. However the applicant has not recognised this in the application and based on submissions received in relation to the draft version of TD 2011/26 it is likely the agent believes that the interest acquired by the 'investor partners' will qualify for the concessional CGT treatment on exits from the practice.

However it is uncertain how this particular restructure would take place. Whilst the applicants would be required to complete the formal requirements for establishing a company, the applicant has not provided any information on what steps would be taken to convert the practice from a practice that recognises goodwill to a practice that does not recognise goodwill, and so fundamental facets of such an arrangement remain unclear if not problematic.

The applicants also state that the rationale for not adopting a corporate structure in the first instance is that the structure has challenges which may compromise their competitive position. Principally, this concerns the disclosure of sensitive operating information and employee imposts on partners. It is uncertain what sensitive operating information would be required to be disclosed if the applicants were classified as a large proprietary company in accordance with subsection 45A(3) of the Corporations Act 2001 and subject to reporting requirements.

If this counterfactual is adopted then following the conversion of the partnership to a corporate limited partnership, the net income of the Professional Practice will be distributed in accordance with the entitlements attached to the different classes of partner interests. Again, there is likely to be no change to the income received by the fixed income partners. For the reasons previously discussed under the counterfactual the natural person practitioners would be required to hold the shares in the incorporated practice both legally and beneficially in order to obtain the concessional CGT treatment under TD 2011/26 for exits from the practice. As the ownership interests would not change as a result of the restructure, under the counterfactual there will be no tax benefit obtained because income would continue to be distributed in accordance with the practitioner's equitable interests in the professional practice.

However, when the scheme is compared to this counterfactual it is anticipated that the total share of the net income being distributed to the general partners will decrease under the scheme because there will be a reduction in the tax otherwise payable by each of the general partners once they declare a trust over the Class 2 Investor Share interests. The amount that will be distributed to the Class 2 investor shareholders is a tax benefit for the purposes of section 177C of the ITAA 1936.

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).

When determining the dominant purpose, the person who's purpose is relevant is the person or persons who entered into or carried out the scheme (FC of T v Spotless Services Ltd (1996) 186 CLR 404 at 416 ('Spotless')). Furthermore, s.177D of the Act is not concerned with the subjective intentions of scheme participants, but with ascertaining an objective purpose by having regard to objective facts.

The dominant of two or more purposes is the ruling, prevailing or most influential purpose. The test is would a reasonable person conclude that the relevant taxpayer in entering and carrying out the particular scheme had, as the most influential and prevailing or ruling purpose, the obtaining of a tax benefit?

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) 217 CLR 216 ('Hart') at [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 improve 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.

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 (Spotless (1996) 186 CLR 404 at 415 and 416).

In Hart (2004) 217 CLR 216 at 243, 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.

The first factor in subparagraph 177D(b)(i) - manner in which the scheme is entered into or carried out

The applicants have not yet carried out the scheme. The scheme proposed to be entered into involves the conversion of the current partnership into a corporate limited partnership.

The background to the scheme is supposed to be the release of the Commissioner's view on service arrangements within Taxation Ruling TR 2006/2: Income tax: deductibility of service fees paid to associated service entities: Phillips arrangements and the Commissioner's guidelines within the booklet Your Service Entity Arrangements (NAT 13086). The applicant commissioned a review of the firm's current operating structure, which took into consideration it's operational efficiency, partner interests, entry and exit of partners, the Commissioner's view on service arrangements and 'other matters considered relevant'. However, it can be noted that the service entity material issued over 5 years ago so it is unclear why there has been such a time delay between the release of the material and the conclusion that the business structure should be reviewed.

The current equity partners will hold General Partner shares in the limited partnership. The current fixed income partners will hold Limited Partners class 1 shares in the new limited partnership. A third class of shares - Limited Partners Class 2 - will be created, and these will initially be held by the General Partners. However, it is anticipated that after the limited partnership is created, these Class 2 shares will be held by the relevant General Partner in trust (or as nominee) for the investor partners (family investment vehicles of the general partners).

This new limited partnership will be responsible for the entire operation of the Professional Practice, including activities that are currently undertaken by the service trust.

The partners consider that this new arrangement is necessary for the following reasons:

· to preserve the professional status of senior practitioners as partners

· to provide real limited liability for the non equity (fixed income) partners

· to provide simplicity. efficiency and cost effectiveness (through a single entity)

· avoids complex issues around remuneration or deemed remuneration for owner employees

· does not have any cost impediments of employee on-costs that are associated with some of the alternatives

· it is a structure used in both the UK and the USA

· it provides for efficient tax management of unpaid 'profit shares'.

Under the new structure the business will be operated by one entity as opposed to the current partnership and service trust however the choice of a limited partnership with three classes of shares is not an administratively simple structure. Furthermore, the current structure already allows for the mixture of salaried and equity partners. It is not clear how the proposed new arrangement is either simpler or more efficient than the existing arrangement.

Asset protection - general partners

The applicant has advised that there will be no change in the nature or value of the general partner's interests in the current partnership. It is common practice in the industry that asset protection is achieved by placing the personal assets of the equity partners into trusts (normally their family trust). Creditors frequently have little, if any, recourse to the assets of equity partners of professional firms for this reason.

Under the scheme the equity partners will become general partners in a limited liability partnership. The general partners will have unlimited liability for any debt, obligation or other liability of any kind of the partnership, wherever and however incurred. Although the level of asset protection the general partners currently have as equity partners is not known, there is no change in those circumstances when they become general partners.

The Commissioner notes the lack of commercial rationale in this matter.

Asset protection - fixed income partners

Another common practice in the legal industry is for equity partners to provide indemnities to fixed entitlement partners in order for the fixed entitlement partners to have limited liability. Under the scheme the fixed income partners will become Class 1 Limited Partners and will have limited liability under the terms of the relevant state partnership act as it applies to limited partnerships (in the absence of a written Partnership Agreement). There will be no change in the nature or value of the current fixed income partners' interests under the new structure. The arrangement purports to provide 'real asset protection' to the fixed interest partners compared to the previous arrangement under the indemnity model. Under the previous partnership model the equity partners had full liability exposure. Also, under that model the equity partners attempted to provide protection to the fixed income partners by providing an indemnity over the fixed income partner's partnership interests. However, it is uncertain how much additional asset protection will be achieved for the fixed interest partners when they enter into this arrangement because their current level of personal asset protection (eg not holding assets personally) is unknown.

We note that we have no certainty to the extent of this limited liability because we have not been provided with a copy of the partnership agreement which will be entered into by the limited liability partners.

Therefore, it is also not apparent as to how the proposed new structure will provide additional asset protection to the fixed income partners. We note here we have no information as to the current asset protection methods used and therefore we cannot comment on whether the proposed arrangements materially increase the asset protection.

We also note that the partners that are potentially subject to Part IVA are the equity partners rather than the fixed income partners whose income remains the same irrespective of the scheme. On the information provided by the applicant there has been no major changes in interests in the partnership over the last few years and no major changes (in practitioners) is proposed, therefore devising an entire scheme merely to benefit those presently in the practice who have the least interest in the practice, and with no business plan to recruit more of those interests, does not appear to be commercial.

Despite the above stated reasons for implementing the scheme, there is considered to be little or no commercial purpose for the creation and sale of the Limited Partners Class 2 interests, and that moving to a structure that is not subject to the Commissioner's service entity rules creates a tax benefit by allowing a significant share of the net income of the Legal Practice to be distributed to the family investment vehicles of the General Partners.

The direction the first factor points

The first factor points toward the conclusion that the taxpayer entered into or carried out the scheme, or any part of it, for the dominant purpose of enabling the taxpayer to obtain a tax benefit under the counterfactual.

The second factor in subparagraph 177D(b)(ii) - form and substance of scheme

The scheme involves the conversion of the current partnership into a corporate limited partnership.

As previously explained a third class of shares - Limited Partners Class 2 - will be created, and these will initially be held by the General Partners. However, it is anticipated that after the limited partnership is created, these Class 2 shares will be held by the relevant General Partner in trust (or as nominee) for the investor partners. It is not known who the Limited Partner Class 2 investor shareholders will be however we assume that the General Partners will declare a trust over them for the benefit of their family investment vehicles (possibly the previous unit holders in the Service Trust).

In order for the General Partners to give effect to the arrangement they will be required to declare a trust over their interest. This appears to essentially be a mechanism for introducing separate discretionary trusts as partners into the firm under the guise of 'investor partners'. If an individual lawyer as partner purported to also act as Trustee for his discretionary trust as an investor partner he would be contracting with himself, and such a dual role is not permitted at law.

Another alternative characterisation for the form of this arrangement does not match the substance of the transaction because they are creating an Everett like assignment over the Limited Partners Class 2 shares rather than creating actual partnership interests. Although a partner has a beneficial interest in each and every asset of the partnership, an assignment of an interest in a partnership "does not constitute the assignee a partner or pass to him the powers of management, administration and inspection of books and accounts which repose in the assignor as a partner. What is more, legal title to the assets of the partnership continues to vest in the partners to the exclusion of the assignee and he has no access to the assets. The extent of the assignee's equitable interest is ascertainable only on dissolution" (Federal Commissioner of Taxation v Everett (1980) 143 CLR 440 at 448). This structure clearly purports that the assignee will be a separate equity partner in the firm which contradicts the High Court's explanation of the result of an assignment of a partnership interest. The contention that the interests are partnership interests is made despite the fact that no management rights or liabilities are to be transferred with the interests, and therefore the claimed form of the arrangement is inherently incorrect at law.

The applicant has advised that the value of the class 2 interests will be determined on the basis of how much of the value of the asset the current equity partners (collectively) agree to realise, the income that will or may flow to that realised portion and the appropriate risk weighted return on that potential income.

There are also concerns with the workability of the proposed scheme. A profit approximate to the amount of taxable income recorded in the 2009 financial year will be released each year after the Service Trust is wound up under the scheme. The applicants submitted that they produce no other sources of business income so there is no explanation where the additional income required under the scheme will be sourced from.

It is not clear from the information provided as to the exact valuation methodology to be used in determining the equity value of the partnership, to be used in setting a value on the class 2 interests. In addition no explanation has been provided in relation to the chosen capitalisation rate.

As result there would appear to be little or no commercial purpose behind the creation of the Limited Partner Class 2 interests for the benefit of the family investment vehicles of the general partners. The substance of the arrangement is to provide an income-splitting arrangement for income derived from the professional practice.

The direction the second factor points

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

The third factor in subparagraph 177D(b)(iii) - timing at which the scheme was entered into and the length of the period during which the scheme was carried out

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

The direction the third factor points

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

The fourth factor in subparagraph 177D(b)(iv) - The result in relation to the operation of this Act that, but for this Part, would be achieved by the scheme

The income tax result that was achieved by the scheme (but for Part IVA) for the taxpayer when compared to the counterfactual is the avoidance of assessable income by the General Partners once they declare a trust over their Limited Partner Class 2 interests in the partnership. By declaring trusts over these interests the applicants will alienate a portion of their income that otherwise would have been assessable to them in the year the scheme is carried out.

The direction the fourth factor points

The fourth factor points toward the conclusion that the applicants will enter into or carry out the scheme, or any part of it, for the dominant purpose of enabling the taxpayer to obtain a tax benefit under the counterfactual.

The fifth factor in subparagraph 177D(b)(v) - change in financial position of the taxpayer resulting from scheme

The financial consequence for the General Partners (who obtain the tax benefit under the counterfactual) that result from the scheme is the disposal of a part of their interest in the Partnership when the General Partners declare a trust over the Limited Partner Class 2 interests. The holding of Limited Partner Class 2 interests on trust is a result of purported technical compliance with relevant state legislation.

Although the precise value of the Class 2 limited shares are yet to be finally determined and consequently the percentage of overall profits to be distributed to the Class 2 investors, it is expected that the current equity partners will be receiving a reduced distribution under the proposed new arrangement. The fact that an arrangement said to be in serious contemplation has not yet determined how much income is to be retained by the principals of the Partnership does not support the contention that the arrangement is explicable on a commercial basis.

The result is that professional fees derived by General Partners will receive a fixed income share after the Class 1 and 2 limited partners' preferred distributions and a further variable distribution on a proportionate basis with the class 2 limited partners' non preferred distribution. Furthermore the professional fees of the General Partners would be income-split via the Limited Partner Class 2 shareholdings and the possibility that Limited Partner Class 1 shareholders would earn more than General Partner's remuneration (absent Limited Partner Class 2 shareholder distributions back to the General Partner).

The fixed income partners receive a fixed distribution from the net income of the partnership. Under the scheme the fixed income partners will hold Limited Liability Class 1 interests in the practice. These partners will receive the first share of the net income of the limited partnership and have no further entitlement to any distributions from the limited partnership. There is likely to be no change in the amount of income received by fixed interest partners.

The direction the fifth factor points

The fifth factor points toward the conclusion that the applicants will enter into or carry out the scheme, or any part of it, for the dominant purpose of enabling the taxpayer to obtain a tax benefit under the counterfactual.

The sixth factor in subparagraph 177D(b)(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

Under the current arrangement, the partnership pays the Service Trust a management fee for its services, which is kept within the acceptable benchmarks and is therefore deductible to the partnership. The unit holders in the Service Trust are the family investment vehicles of the General Partners.

Under the proposed scheme the entire business will be operated through the limited liability partnership, therefore the existing unit holders of the service trust will no longer be in receipt of any distributions from the service trust. However, it is expected that the overall share of the net income of the business to be distributed to the Class 2 investor partners will be greater than the percentage of the current overall business income that is distributed through the current service trust. Accordingly, there is likely to be a net increase in the income flowing through to the family investment vehicles of the general partners and a reduced percentage flowing through to the general partners.

The direction the sixth factor points

The sixth factor points toward the conclusion that the applicants will enter into or carry out the scheme, or any part of it, for the dominant purpose of enabling the taxpayer to obtain a tax benefit under the counterfactual.

The seventh factor in subparagraph 177D(b)(vii) - Any other consequence for the relevant taxpayer, or for any person referred to in subparagraph (vi), of the scheme having been entered into or carried out

There appears to have been no other consequences for the applicants or any of their associated entities connected with the scheme other than the financial consequences referred to above in this submission and obtaining the tax benefit derived under the counterfactual.

The direction the seventh factor points

The seventh factor would appear to be neutral in indicating whether the applicants will enter into or carry out the scheme, or any part of it, for the dominant purpose of enabling the taxpayer to obtain a tax benefit under the counterfactual.

The eighth factor in subparagraph 177D(b)(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)

At all times the applicants are all business partners in the Partnership. The family investment vehicles who currently hold units in the Service Trust (and are expected to hold the Limited Partner Class 2 interests after the General Partners declare trusts over their interests) are all controlled by the equity partners in the Partnership.

The direction the eighth factor points

If it were not for this connection between the applicants and the family investment vehicles the tax benefit could not be obtained by the applicants in connection with the scheme. Had the Limited Partner Class 2 interests been acquired by an unrelated third party, the applicants would not retain the same economic ownership interest in the law firm and would not have retained control of the money generated from the partnership interest disposed of. Therefore, the eighth factor points toward the conclusion that the applicant will enter into or carry out the scheme, or any part of it, for the dominant purpose of enabling the taxpayer to obtain a tax benefit under the counterfactual.

Conclusion

It is the view of the Commissioner that there is little commercial benefit to the proposed conversion of the partnership to a limited partnership and that the dominant purpose of the scheme is to achieve a tax benefit for the purposes of Part IVA.