For professional service practitioners, staying ahead of regulatory changes is crucial. The Australian Taxation Office (ATO) has recently provided a guidance through its Practical Compliance Guide (PCG 2021/4), shedding light on profit allocation within professional firms, such as legal practices, medical professionals, engineering firms, financial planning firms, accounting firms and any other business engaging in professional services where profit distribution is a key consideration. In this article, we’ll explore what PCG 2021/4 entails, who can rely on the risk assessment framework, and how professional firms can leverage this guide for prudent profit allocation.
What is a Practical Compliance Guide, Specifically PCG 2021/4, and How Will the ATO Use It?
A Practical Compliance Guide (PCG) is a tool crafted by the ATO to provide practical guidance and compliance criteria for specific areas of taxation. PCG 2021/4 is dedicated to the Allocation of Profits within Professional Firms, offering a roadmap in the form of a risk assessment framework to navigate the complexities of profit distribution. PCG 2021/4 relates specifically to arrangements where:
- Taxpayers redirect their income from a business or activity to an associated entity.
- That income includes income from their professional services.
- The outcome is that they significantly reduce their tax liability.
The ATO intends to use this guide as a benchmark for assessing and ensuring compliance within professional firms, offering clarity on best practices and regulatory expectations.
Who can use the risk assessment framework in PCG 2021/4?
Before applying PCG 2021/4, you must first assess if your arrangement shows commercial rationale and that it does not include a number of “high-risk” features; these two checks are referred to as ‘gateways’.
Commercial Rationale Gateway:
An arrangement that shows a lack of commercial rationale can:
- Seem more complex than necessary to achieve the relevant commercial objective.
- Appear to serve no real purpose other than to gain a tax advantage.
- Have a tax result that appears to be at odds with its commercial or economic result.
- Result in little or no risk in circumstances where significant risks would normally be expected.
- Operate on non-commercial terms or in a non-arm’s length manner.
- Present a gap between the substance of what is being achieved and the legal form it takes.
No High-Risk Features Gateway:
To pass through the no high-risk features gateway, an arrangement must not:
- Have financing arrangements relating to non-arm’s length transactions.
- Exploit the difference between accounting standards and tax law.
- Be materially different in principle from Everett and Galland cases.
- Involve multiple classes of shares and units, including creating discretionary entitlements such as dividend access shares.
- Involve multiple assignments or disposals of an equity interest.
- Misuse the superannuation system, including assignments or disposals of an interest to associated self-managed super funds (SMSFs)
- Distribute income to entities, other than the IPP, with losses.
In addition to not being able to self-assess under the risk assessment framework, if the ATO determines an arrangement doesn’t show commercial rationale or has high-risk features, they may consider applying anti-avoidance provisions under Part 4 A of the Income Tax Assessment Act 1997 or other integrity rules. On the other hand, if as an IPP you do pass both gateways, you can self-assess under the risk assessment framework to determine what type of compliance attention the ATO will give your arrangement.
Risk Assessment Framework
Each individual professional practitioner (IPP), not the practice as a whole, who has passed through both gateways, can self-assess risk level against each of the three risk factors in the below risk assessment scoring table.
| Risk Assessment Factor | Score 1 | Score 2 | Score 3 | Score 4 | Score 5 | Score 6 |
|---|---|---|---|---|---|---|
| Factor 1: Proportion of profit entitlement from the whole of firm group returned in the hands of IPP | More than 90% | More than 75% to 90%, inclusive | More than 60% to 75%, inclusive | 50% or more to 60%, inclusive | More than 25% to less than 50% | 25% or less |
| Factor 2: Total effective tax rate for income received from the firm by the IPP and associated entities | More than 40% | More than 35% to 40%, inclusive | 30% or more to 35%, inclusive | More than 25% to less than 30% | More than 20% to 25%, inclusive | 20% or less |
| Factor 3: Remuneration returned in the hands of the IPP as a percentage of the commercial benchmark for the services provided to the firm | More than 200% | More than 150% to 200%, inclusive | More than 100% to 150%, inclusive | More than 90% to 100%, inclusive | More than 70% to 90%, inclusive | 70% or less |
As an IPP, if you return 100% of the profit entitlement from the firm in your personal tax return, you:
- Are automatically in the green zone.
- Don’t need to assess against the other risk assessment factors.
In summary, risk increases where:
- The percentage of firm income you declare in your personal tax return is low compared to the total firm income collectively received by all of your associated entities/individuals.
- The percentage of tax you pay on firm income you declare in your personal tax return is low compared to the total tax paid on firm income received by all of your associated entities/individuals.
- The firm income you declare in your personal tax return is low compared to others in your profession, assessed using commercial benchmarks (if available)
Once you have self-assessed against each of the three factors, or only the first two factors if it is impractical to accurately determine an appropriate commercial remuneration against a benchmark per the third factor, you can use the below table to determine your level of risk of the ATO investigating/auditing your arrangement:
| Risk Zone | Risk Level | Aggregate score against first 2 factors | Aggregate of all 3 factors |
|---|---|---|---|
| Green | Low risk | 7 or less | 10 or less |
| Amber | Moderate risk | 8 | 11 and 12 |
| Red | High risk | 9 or more | 13 or more |
Being High Risk According to the PCG
Being classified as high risk according to PCG 2021/4 doesn’t necessarily imply wrongdoing. It signifies that the firm falls within a category that the ATO closely scrutinizes. Businesses in this category should be aware of the ATO’s focus and proactively ensure that their profit-sharing arrangements align with the guide’s principles. Regular compliance audits and seeking professional advice can be instrumental in addressing any concerns and ensuring alignment with regulatory expectations.
Navigating profit allocation within professional firms requires a nuanced understanding of regulatory guidelines. PCG 2021/4 serves as a roadmap, providing clarity on compliance standards for business owners and executives. By embracing the principles outlined in this practical compliance guide, professional firms can not only ensure regulatory adherence but also foster an environment conducive to sustainable growth and success in the ever-evolving landscape of professional services. Contact your Altitude Adviser today to embark on a journey towards compliant and equitable profit allocation, ensuring a solid foundation for your firm’s sustained success.
