The Australian Taxation Office’s (ATO) Practical Compliance Guideline) 2021/4 – Allocation of Professional Firm Profits – ATO Compliance Approach discusses the ATO’s compliance approach to the allocation of profits from professional services firms to the Individual Professional Practitioner (IPP).

The guidelines were released as a result of the ATO’s increasing concern of insufficient profit allocation from professional firms to the IPP.  The ATO is concerned about arrangements where profits are being distributed to related entities who are on lower tax rates, and therefore reducing the overall tax payable for the IPP’s group.

Who does PCG 2021/4 apply to?

PCG 2021/4 applies to the IPP of professional services firms. An IPP is considered to be a person at partner level holding equity within the professional services firm.

A professional service firm is one that sells knowledge and expertise to the public and includes:

• engineers
• architects
• medical practitioners
• accountants
• lawyers
• financial service providers
• other consultants. 

This list is not exhaustive, if you are unsure if the guidelines apply to your business, please contact us for an assessment.

The ATO’s major concern is that IPPs from professional firms are not returning taxable income that correlates to the value of the services that they provide to the firm. For instance, the remuneration of the IPP may be structured in a way that allows them to obtain a tax benefit through the use of an associated entity with a lower tax rate.  

When did the guidelines come into effect?

The guidelines came into effect 1 July 2022, making the 2022/2023 financial year the first year of application.

How do the guidelines apply?

The guidelines apply where:

• an IPP provides professional services to clients of the firm or is actively involved in the management of the firm
• the income of the firm is not subject to the PSI rules
• the firm operates by way of a legally-effective structure e.g. partnership, trust and/or company
• an IPP is an equity holder, directly or through an associated entity
• the arrangement is commercially driven – satisfies gateway one, and
• the firm and IPP do not demonstrate any high-risk features – satisfies gateway two.

Gateway one: commercial rationale

There must be a genuine commercial basis for the arrangement and the way profits are distributed. Indicators to suggest the arrangement lacks a commercial rationale include:

• The arrangement seems more complex than necessary to achieve the commercial objective.
• The arrangement includes a step or series of steps that serve no real purpose other than to gain a tax advantage.
• The tax result of the arrangement appears at odds with its commercial or economic result.
• The parties are operating on non-commercial terms or in a non-arm’s length manner.

Gateway two – high-risk features

Once the IPP is satisfied the arrangement has a commercial rationale (gateway one), they must then assess and be satisfied that the arrangement does not have any ‘high-risk features’.

The ATO considers the following to be a high risk feature:

• financing arrangements relating to non-arm’s length transactions
• exploitation of the difference between accounting standards and tax law
• arrangements where a partner assigns a portion of a partnership interest that is materially different in principle
• multiple classes of shares and units held by non-equity holders.

If the above gateways are not passed by the IPP, the arrangement will be automatically considered to be high risk and likely to be subject to an ATO review or audit.

Once both of the above gateways have been passed, you can then self-assess with against the risk assessment framework to determine the type of compliance attention the ATO may give to the arrangement.

The risk assessment scores these three elements to determine whether an arrangement is in a green, amber or red risk zone:

1. proportion of profit entitlement from the whole of firm group returned in the hands of the IPP
2. total effective tax rate for income received from the firm by the IPP and associated entities
3. remuneration returned in the hands of the IPP as a percentage of the commercial benchmark for the services provided to the firm.

Next Steps

PCG 2021/4 is a guideline that considers the ATO’s viewpoint on profits from professional services firms.  Although this is an assessment tool only, rather than law, it does give guidance to affected parties on how the ATO may treat certain arrangements if subject to a review. 

It is important for businesses who fall into the professional services firm category to consider their current arrangements to profit distribution. 

If you think you may be affected by PCG 2021/4 or would like further information on how the guidelines will apply, AFS is here to help assess your situation. Please contact us on 03 5443 0344 or email afs@afsbendigo.com.au.