New ATO PCG mitigates risk for professional firms

This article was current at the time of publication.

Thousands of professional services firms around Australia may be deemed high risk by the Australian Taxation Office (ATO) under new profit allocation compliance guidelines set to apply from 1 July 2022.

It’s the expected outcome from the ATO’s release of Practical Compliance Guideline (PCG) PCG 2021/4 in late December last year.

The new PCG replaces previous guidelines on the allocation of profits within professional services firms published in 2015 and subsequently withdrawn in 2017.

That followed an ATO review which determined the previous guidance was being misinterpreted by some individual professional practitioners (IPPs).

 The PCG sets out the ATO’s future approach to assessing the risks associated with the arrangements and ownership structures used by professional firms such as trusts and holding companies to allocate profits to their IPPs.

It also introduces a new annual risk assessment framework the ATO will use to determine whether it considers a firm’s profit distribution arrangements to IPPs either low, medium, or high-risk.

How the framework applies

The risk framework will only apply after two “gateways” are passed. First, there must be a sound commercial rationale for entering into and operating a certain arrangement or structure.

Second, the arrangement or structure used must not have features the ATO is likely to consider highly risky and potentially lead to inappropriate tax outcomes.

If both gateways are passed, firms will be assessed based on aggregate scores achieved against the following:

• the proportion of profit entitlement from the whole firm returned in the hands of an IPP;
• the total effective tax rate for income received from the firm by an IPP and associated entities; and
• optional factors of remuneration returned in the hands of an IPP as a percentage of the commercial benchmark for the services provided to the firm.

Focus on income splitting

“The ATO is concerned about some circumstances where taxpayers redirect income earned from professional services provided through a business in which they hold an ownership stake,” the ATO’s Acting Deputy Commissioner Private Wealth Jade Hawkins says.

“Splitting this income with a family member or associated trust has the effect of altering their tax liability.”

Hawkins says the PCG outlines ATO concerns that arrangements that seem to be more complex than necessary can indicate an arrangement lacks sound commercial rationale. 

“IPPs should be able to demonstrate why complex features are sound commercial decisions and necessary to enable the arrangement to meet their commercial objectives.”

Hawkins reiterates that outlining the ATO’s compliance approach provides professionals with certainty about whether their arrangements are considered low, medium, or high-risk. 

IPPs can self-assess their risk rating to determine the likelihood the ATO will conduct compliance activity to analyse the facts and circumstances of their arrangement.

“We anticipate some IPPs may reorganise their affairs to align their risk tolerance with the PCG risk ratings,” Hawkins adds.

“The ATO recognises the scoring matrix will result in IPPs with lower incomes having to return a higher proportion of their profit allocation to achieve a lower risk status.

“The PCG is a risk framework which acts as an indication of risk only. Where the scoring matrix results in anomalies, additional ATO profiling work may rule out compliance action.”

He says the PCG provides a method for IPPs to self-assess their arrangements to determine the level of risk they are comfortable managing.

“It does not set out the ATO’s view on the application of taxation laws but [does] support IPPs to better understand whether the ATO is likely to undertake compliance activity to consider assessable income and allocation of profits or income from the professional firm.”

A two-year transitional period until 30 June 2024 may apply to arrangements that were deemed lower risk under the previous guidelines, but moderate or high under the new PCG.

Interpreting the guidelines

Arnold Bloch Leibler Tax Partner, Paul Sokolowski, believes the design of the ATO’s gateways and risk assessment framework does not usefully connect to existing tax laws around anti-avoidance provisions (Part IVA) or personal income services.

“Absent the application of anti-avoidance provisions there’s no general principle of tax law that just because you work for – or have input into – a business that you have to be paid for the things you do,” Sokolowski says.

“But the first pillar [of the PCG] is that if you’re a professional and hold equity in a professional firm and provide services, then you ought to be somehow remunerated for what you do.

“What the ATO is saying is, ‘we can’t tell you the legal pathway that applies to a particular arrangement. But we want to use this document so our officers and taxpayers can get an indication of whether there’s a risk’.”

“A risk of what? Well, the risk is of the ATO actually engaging with the taxpayer using the compliance framework. That is not useful, as there is no attempt to explain how the ATO’s scoring matrix relates to the law. Fear of the tax collector to move behaviour is a very old story. This is just the latest chapter.”

Sokolowski says the main idea is for professional firms and individuals to self-assess their risk and work out where they sit on the spectrum. They can then choose whether to [adjust] and if they have any concerns, contact the ATO.

Next steps

Robert McDowall FCPA, Director Arabon Accountants, says beyond considering their own compliance risk profile, accounting firms will need to assess the profiles of their clients.

“Tax practices will have to tell some of their clients that they will need to review their position, which will be an added cost,” McDowall warns.

“You’re going to have to have this conversation with them where you point out that they’re actually doing everything correctly, but nonetheless, now deemed a high risk from a tax office compliance perspective.

“This will have to be driven by the accounting profession. You’re going to have to proactively reach out and talk to clients to make sure they understand the consequences of what’s happened.”