Professional Services Practices – ATO’s View on Treatment of Profits

|by Jason Cordner|Taxation and Compliance

The ATO recently release updated guidance (PCG 2021/D2) on their view of the treatment of profits earned by professional practices, in particular whether the profits earned by a practice entity or entities ought better be characterised as personal exertion income (i.e. taxable in the hands of the practitioner) rather than business profits.

This guidance explains when the ATO will consider certain arrangements to be high risk and hence undertake further investigation and / or compliance action; it does not take the form of a binding ruling, however once finalised, the Commissioner ought to follow the guidance provided the tax payer follows the guidelines in good faith.

The ATO strongly make the point that the guidance does not provide a safe harbour but provides guidance on their allocation of resources and their likely view given certain circumstances. Basically, they are keeping their options open!

To apply the guidance, there are two gateways that must be passed first –

  1. There are sound commercial reasons for any business structure used; and
  2. There must not be ‘high risk’ factors present.

These include:

  • Aggressive financing arrangements
  • Exploiting differences between accounting standards and tax law
  • Partnership assignments (that differ from principles established in Everett and Galland)
  • Multiple classes of shares issued to non-equity holders

Should the two gateways be passed, then the risk assessment framework may be relied upon. In a prior version of this guidance, there were three broad tests that could be relied upon, now those tests have a degree of weighting and it is the combined application of those tests to a given set of circumstances that produces a score that indicates risk (lower the better). Those broad tests are:

  1. Proportion of profit entitlement included in the practitioner’s taxable income (the higher proportion, the lower the score);
  2. Total effective tax rate for income received from the firm by the practitioner and associated entities (the higher the rate the lower the score); and
  3. Remuneration included in the practitioner’s taxable income compared to a commercial benchmark (the higher the practitioner’s income compared to the benchmark the lower the score)

Note that the third test is optional and would only be considered if a commercial benchmark was able to be determined accurately.

The above represent a higher level of complexity than what was previously considered in the ATO’s last PCG on the topic. To be a low risk overall, the practitioner would likely have to show:

  • 60% or more of their practice entitlement in their own return; and
  • A total effective tax rate (for the them and their associated entities) of 30% - 35%; and if using the third test then
  • Remuneration of at least equal to the commercial benchmark

Unfortunately, it appears that there will no longer be a simple test or two to check whether particular circumstances are low, medium or high risk but rather a matrix of factors will need to be taken into account. These factors ought to be considered when conducting year end tax planning or considering any practice restructures.

For more information or to discuss any potential personal impact, please do not hesitate to contact us.

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