Are you at risk? Allocation of profits within professional firms

12 Dec 2014

By Shadforth Financial Group

The Australian Taxation Office (ATO) has released draft guidelines on the tax compliance risks flowing from the use of partnerships of discretionary trusts, or similar structures, for professional practices. As a result, the ATO will be reviewing remuneration arrangements used by accountants, lawyers and other professionals to ensure such structures are properly used.

The new guidelines in action

Following the ATO's Taxpayer Alert TA 2013/3 "Purported alienation of income through discretionary trust partners" released in November 2013, the ATO have released DRAFT guidelines entitled "Assessing the risk: allocation of profits within professional firms".

The guidelines outline the ATO's concerns about the way in which professional practitioners including legal and medical practitioners, architectural, engineering and accounting firms are structured. In particular, the ATO have expressed concern on how principal practitioners allocate practice profits and outline how to classify a professional practice as high or low risk for further compliance action.

The guidelines are aimed at professional practices which are carried on through a trust, company or partnership structure (including a partnership of trustees or companies). More specifically, the guidelines will apply where:

  • An individual professional practitioner (IPP) provides professional services to clients of the firm or is actively involved in the management of the firm and in either case, the IPP and or associated entities have a legal or beneficial interest in the firm
  • The firm operates by way of a legally effective partnership, trust or company, and
  • The income of the firm is not personal services income.

Income received from a service entity arrangement ie, an entity which provides administrative and other services to the practice entity, will also be considered when determining whether the IPP and/or associated entities meet the specific guidelines.

Who would be considered as low risk?

Professionals will be rated low risk where they meet one of the following benchmarks regarding income derived from their professional practice - whether that be via salary, distribution of partnership or trust profit, distribution from associated service entities, dividends from associated entities or any combination of these:

  • You receive assessable income from the firm directly as an appropriate return for services provided ie, commensurate income is taxed in your hands
  • 50% or more of the income to which you and your associated entities are collectively entitled in the relevant year is assessable (taxed) in your hands
  • You and your associated entities have an effective tax rate of 30% or higher on the income received from the firm.

Where an arrangement does not satisfy any of the guidelines outlined above, the ATO will consider the arrangement to be high risk and potentially subject to ATO scrutiny.

Time to review

Given the ATO have specifically indicated that income received from a service entity arrangement will be considered in determining whether you meet the specific guidelines, you may wish to revisit your current service entity arrangement to ensure that service entity payments correctly reflect the services provided. In recent years, service entity arrangements have been the target of compliance risk and may be scrutinised as part of this next review process.

The ATO guidelines on allocation of profits within professional practices states that the ATO will only target businesses which are being carried on by a legally effective partnership, trust or company and derive income, or share in practice profits, for income tax purposes.

As a result you should review your contractual relationships with the clients of your firm and the practice entity, as the ATO's guidelines are set to ensure that your level of income does in fact reflect your contribution to the business.

The ATO have also indicated that the guidelines will not apply to personal services income arrangements. To determine whether income is related to personal services income the ATO will continue to follow their existing guidelines.

You should ensure that income earned mainly as a result of personal efforts or skills, rather than being generated by a business structure ie, via investment in assets or employees, have been correctly classified and recorded as personal services income and attributed to the practitioner providing the services.

Although the guidelines do not apply to personal services income, the ATO will still be required to ensure personal services income does not exist, in order for the guidelines to apply.

The ATO have also advised that the guidelines do not apply in relation to other tax compliance issues. Additional compliance issues that you should be aware of include non recognition of net capital gains, transfer pricing, misuse of the superannuation system, promotion of schemes, late lodgement of returns, income injection to entities with carry forward losses, trust reimbursement arrangements, avoidance of Division 7A, inappropriate access to low income tax offsets or other benefits, or non tax advantages which are dependent on taxable income.

The ATO have stated that taxpayers will be rated as higher risk where such compliance issues are encountered.

When do the guidelines come into effect?

Whilst the guidelines issued by the ATO have been issued in draft and may not be supported by legislation or case law, the ATO will be applying the guidelines from the 2014/15 income tax year. Unfortunately, where you do not comply with the ATO guidelines, you may be subject to ATO compliance action and the ATO have indicated that Part IVA (anti avoidance rule) may be applied.

Don't get caught out

If you have any concerns about the structure and documentation of your professional practice and the means by which you receive income from your practice or associated entities, you should contact your Shadforth business advisory services adviser.

Your Shadforth adviser can help ensure you are aware of the tax compliance risks and can assist in planning for ATO compliance action based on the 'risk' of the your professional arrangements.

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