The ATO recently released ‘guidelines’ which discuss how the ATO will assess the risk of the income tax general anti-avoidance provisions (Part IVA) applying to the allocation of profits from a professional services firm such as accounting, architectural, legal, engineering, medical and financial services practices. The guidelines set out three tests for assessing whether the ‘individual professional practitioner’ (IPP)is at a high risk of having his or her taxation affairs audited. If the IPP does not satisfy one of the tests, then the IPP will be at a high risk of ATO audit activity. It should be noted there is no statutory or case law basis for the ATO selection of these benchmarks.
Over recent years, the structuring of professional firms has generally evolved from a partnership of natural persons to a unit trust, or a company, and more recently a partnership of discretionary trusts. The operation of professional practices through these alternate structures has given the IPP the ability to stream income to associates, which has the effect of lowering the overall tax-rate of income that would in the past have been assessed solely in the hands of IPPs. The ATO seemed not to weigh in the real risk professional practices face in negligence, which these structures may help mitigate.
The ATO’s concern is that professional practice income is being treated as derived from the business structure, even though the provision of services by ‘partner’ individuals may be a significant source of that income. In this regard, the ATO considers that the Part IVA may have application where the IPP, through business structures, arranges for firm profits to be directed to his or her associates without regard to the value of services provided by the IPP to the business. The ATO has made no effort to explain why the same issues don’t arise for non-professional partnerships.
However, taxpayers will be rated by the ATO as ‘low risk’, and will not be subject to compliance action on this issue, if the IPP satisfies one of the following three tests:
- The IPP receives assessable income from their firm in their own hands at an ‘appropriate’ return for the services they provide to the firm;
The guidelines note that the IPP would be receiving an appropriate return if the salary the IPP receives is at least equal to the salary paid by the firm to the highest band of professional employees providing equivalent services. - Fifty percent (50%) or more of the collective income that the IPP and the IPP’s associated entities are entitled in the relevant year is assessable in the hands of the IPP; or
- The IPP and the IPP’s associated entitles have an effective tax rate of 30% or higher on income received from the firm.
The latter two benchmarks are arbitrary, but on balance, it is better the ATO set benchmarks for audit activity rather than to leave the market guessing. If the IPP does not meet one of the above three tests, then the ATO will consider the IPP to be a higher compliance risk. If this is the case, the ATO have stated that the lower the IPP’s effective tax rate, the greater the likelihood of ATO compliance action being commenced. This ignores asset protection features the structure may provide, and the fact that the higher the ratio of employees to principals, the less likely the IPP’s effort necessarily generates the firm’s income. The ATO attention on professional service firms only, rather than all service firms that have traditionally traded as partnerships e.g. plumbers in partnership with their spouse, is curious.
What to do?
The fact that an IPP is not able to meet one of the three tests does not mean that the IPP is not complying with their taxation obligations. However, it does leave the IPP open to a high risk of audit activity, which can cause significant inconvenience and stress as the IPP’s affairs are examined in detail by the ATO. If this risk can be easily avoided, then it should be avoided.
To minimise the risk of the IPP being subject to audit activity, it should not be difficult for the IPP to be paid a salary equal to the highest paid ‘non-equity’ employee of the firm.
Even so, given the ATO’s focused attention in this area, it would be prudent for the IPP and the professional services firm to review their current structures and practices so that required changes can be implemented prior to any ATO compliance activity.
Pointon Partners has extensive experience in advising professional services firms and their equity partners on structuring to achieve compliant tax effective outcomes.
In this regard, please do not hesitate to contact either Anthony Pointon or Robert Gordon on (03) 9614 7707.