The Australian Taxation Office (‘ATO’) is set to release and implement new guidelines from 1 July 2021 which will set out how the ATO proposes to apply compliance resources in examining the way profits by professional services firms are allocated to individual professional practitioners (“IPP”). In this article, we discuss the ATO’s recently released Draft Practical Compliance Guideline PCG 2021/D2 (“draft PCG”), the precursor to the new guidelines yet to be released.
The draft PCG is controversial with professional commentators calling it discriminatory and not based in law.
Major Factors and Implications
The draft PCG sets out three factors to assess the risk of a particular professional firm’s profit allocation procedure. These factors are:
- Proportion of profit entitlement from the whole of firm group returned in the hands of the IPP;
- Total effective tax rate for income received from the firm by the IPP and associated entities;
- Remuneration returned in the hands of the IPP as a percentage of the commercial benchmark for the services provided to the firm.
There are various scores applicable to each factor.
The performance for each factor shall be assessed on a scale of 1 to 6.
Scores of 10 or less (7 or less where only the first two factors are applied) would result in a low-risk (green zone) rating.
A score of 13 or more (9 or more on a two factors basis) would result in a high risk (red zone) rating.
A red zone rating for a firm will result in a priority review or audit by the ATO. Green zone indicates that all guidelines have been correctly applied by the firm and their IPPs.
By way of further explanation, the following table is taken from the draft PCG:
|1) Proportion of profit entitlement from the whole of firm group returned in the hands of the IPP||>90%||>75% to <90%|
|2) Total effective tax rate for income received from the firm by the IPP and associated entities||>40%||>35% to <40%|
|3) Remuneration returned in the hands of the IPP as a percentage of the commercial benchmark for the services provided to the firm||>200%||>150% to <200%|
Legal Basis for the Guidelines
The draft PCG are not based on any relevant law and are only applicable to professional services firms. Other businesses fall outside the scope of the application of the draft PCG. The lack of a solid legal foundation on which the draft PCG should be based, raises serious concerns about their validity and fairness.
There are two ‘Gateway’ criteria critical to the application of risk assessment framework as per the draft PCG. These are as follows:
- The first ‘Gateway’ criteria will consider the profit allocation procedure and whether it is commercially motivated.
- If the firm passes the first ‘Gateway’, the second ‘Gateway’ criteria is aimed to check factors which the ATO considers to be of high risk.
If either of these criteria are not satisfied, the profit arrangement shall be subject to a greater scrutiny from the ATO.
Who do the Guidelines apply to?
The draft PCG are applicable to professional firms providing accounting, architectural, engineering, financial services, legal and medical professional services.
For taxpayers following the profit allocation arrangements that applied before 14 December 2017 and that complied with the ATO’s previous guidelines, those taxpayers may continue to rely on those guidelines for the financial years ending 30 June 2018 to 30 June 2021 (inclusive). This is, however, applicable only if the arrangement complies with those previous guidelines, is commercially driven and doesn’t display any of the high-risk features within the second Gateway.
Arrangements which are rated low risk by the ATO under the previous guidelines and that now have a higher rating under the draft PCG may rely on the previous guidelines until 30 June 2023.
If you have any queries or require legal assistance in making empowered choices for your valued business, please contact our excellent Commercial Team today. We welcome the opportunity to assist you.
Insight written by Meghan Warren