The ATO has released long-awaited draft guidance on its proposed compliance approach to the taxation of the profits of professional firms – which outlines how partners in law, accounting, engineering and architectural firms should split profits.
The Practical Compliance Guideline PCG 2021/D2 (‘draft Guideline’) which will apply from 1 July 2021 represents a fundamental change from the former guidance that the ATO suspended in December 2017.
The draft guideline has been issued in response to concerns about taxpayers who may redirect their income to an associated entity from a business or activity which includes their professional services, which in turn may alter their tax liability.
The draft guideline adopts a traffic light system for self-assessing the level of tax risk for an equity partner in a professional firm.
The risk assessment is based on:
- The proportion of the partner’s profit distributions that are taxed in their own hands, as opposed to being taxable income for an associate.
- The effective tax rate on the partner’s profit distributions, including those distributed to associates.
- The partner’s personal remuneration as compared to commercial benchmarks.
Importantly, the draft Guideline will apply to partnerships, companies, trusts, etc. that are generating business income and not personal services income (‘PSI’).
However, the ATO’s proposed risk-based compliance approach outlined in the draft Guideline requires two qualifying ‘gateways’ to be passed before applying the risk assessment framework:
- The arrangements must have a genuine commercial rationale and are implemented in a commercial manner and appropriately documented.
- The arrangements do not exhibit specific high-risk features.
Whilst there is no need to panic, we do recommend you review your remuneration and profit distribution arrangements to ensure that the arrangements have a genuine commercial rationale, and do not exhibit any of the listed high-risk features. Subject to satisfaction of these requirements, professional firms will then need to assess their potential tax risk under the draft Guideline.
This will be crucial to ensuring that firms are not inadvertently considered to be in the red zone (high risk) and thereby exposing themselves to the likelihood of an ATO review.
We will be considering these measures and contacting affected clients shortly to provide more detailed guidance on what impacts this may have for their remuneration and profit distribution arrangements.
