Tax Alert:  ATO disappoints professional services sector

There was both good and bad news for the professional services sector when the ATO released TD 2011/D3 in relation to Capital Gains and the entry and exit of partners in “no-goodwill” practices. The good news is that after nearly three years the ATO has finally released the draft Determination for comment.  Unfortunately, that is where the good news ends.  The bad news is the Determination was nothing short of a disappointment.  Many of the issues that the Legal Practitioner’s Working Party (LPWP) articulated to the ATO, which this Determination was understood to clarify, were not addressed. In our view (and after three years of lobbying) the professional services sector is no closer to a resolution.

Overview of Determination
The Determination is said to concern only the dealings of shares in companies during the natural ‘ebb and flow’ of natural person practitioner-shareholders into and out of a company.  It is unclear from our reading of the Determination how the ATO has come to this view.  The ATO’s view is really only supported by the Explanation to the Determination which does not form part of the public ruling.  In our opinion this further demonstrates the ATO’s technical tardiness in drafting this Determination.

In the Determination the ATO has said that they will accept that the shares in a ‘no goodwill’ incorporated professional practice will have nil market value where the following conditions are met:

• The original shareholders in the company are all natural person practitioners who previously held a fractional interest in the "no goodwill" partnership prior to restructure (or would have been eligible to hold a fractional interest had the practice operated as a partnership)
• The provision of a share or shares at the time of incorporation and in the post-incorporated environment must be reflective of that person's status as an active practitioner in the practice
• The company holds no other assets and has a paid up capital which reflects an immaterial value for goodwill and which is generally kept intact such that all of its distributions of income or profits will be dividends within the meaning of subsection 6 (1) of the Income Tax Assessment Act 1936
• The company adopts a constitution or shareholder agreement (or both) that regulates the basis for admission to shareholding and surrender or transfer of shares in the company and the amount that is paid for it, and
• The constitution or shareholder agreement (or both) provide that no payment, or an immaterial payment, is to be made for acquiring a share, disposing of a share, or any change to the profit distribution entitlements attached to a share in the company

In our view, these conditions mean that this Determination (if finalised) will have little if any practical application throughout the whole professional services sector as it is not uncommon to have partners in the partnership that are not natural persons.  Furthermore, the draft Determination fails to address situations where the Commissioner’s conditions as set out in the draft Determination are not met and IT2540 does not apply.  For instance:

• Does the market value substitution rule apply and if so what is the acceptable way to apply it?
• What is the base cost of a partner’s interest in the partnership when incorporating?
• How do you determine the individual cost base for a partner where there could be in excess of 100 partners with 20% movement each year either in equity advancement or entry or exit?  Do we need to undertake a separate valuation for each occasion?

It is also clear from the language of the draft Determination that the tax office wishes to limit the operation of the concessions currently available to natural persons, limiting the opportunities for many practitioners to effectively structure their personal affairs via trust structures as parties (in whole or part) to partnerships.

Why are we so disappointed?
The Determination is extremely narrow.  It only deals with the application of subsection 116-30(1) ITAA 1997 to the admission or exit of a practitioner-shareholder from a ‘no goodwill’ incorporated professional practice for no consideration.  Subsection 116-30(1) sets out the application of the market value substitution rule which applies where there is no consideration paid in relation to a CGT asset (i.e. shares). In such an event, the consideration received is deemed to be the market value of the CGT asset. Quite often the ATO and the profession will have a different opinion as to what a "market value" may be, which is why there continues to be so much uncertainty around this issue.

Furthermore, the provisions of the Act do not discriminate as between the types of entities to which the market value substitution rules apply.  It is our opinion that the draft Determination clouds the way in which the law is to be interpreted.

This is hugely disappointing given that it has been well over three years since the LPWP asked the ATO to provide the following information:

• An explanation as to why the market value substitution rules apply (that is the basis on which the triggers are met)
• Outline the existing administrative practice around no goodwill arrangements for entry/exit of partners and explain why this doesn’t follow into incorporation arrangements
• Consider and advise whether employee share scheme issues are relevant 
• Advise if there are any GST issues that need to be considered

As a general concept, we also find it difficult to understand the reasons why the ATO takes offence to the fact that partners within a partnership can act at “arms length”. 

Today the tax and stamp duty consequences of incorporating a ‘no goodwill’ professional services partnership still remain uncertain.  There has also been no guidance from the ATO around employee share scheme and GST issues.  The ATO has stated that another Determination which will in effect be an addendum to this Determination, will be issued with respect to the application of the employee share scheme provisions.

As a general rule, the ‘no goodwill’ professional services partnerships which have been waiting for this draft Determination before incorporating have not been rewarded for their patience to date.

Grant Thornton response
We will continue to work with the ATO to address the concerns of our clients and to obtain certainty about how they may structure their affairs. 

Click here for more background information on this topic.

To discuss the draft Determination and how it relates to your specific situation, please contact your usual Grant Thornton advisor or:

Scott Treatt
Director, Tax
T  +61 2 8297 2400
E  scott.treatt@au.gt.com

Bill Shew
Director, Privately Held Business
T  +61 2 8297 2400
E  bill.shew@au.gt.com

Andrew Steer
Director, Privately Held Business
T  +61 3 8663 6000
E  andrew.steer@au.gt.com

Dennis Eagles
Director, Wealth Advisory Services
T  +61 7 3222 0200
E  dennis.eagles@au.gt.com

Steve Westaway
Director, Privately Held Business
T  +61 8 8372 6666
E  steve.westaway@au.gt.com

Kim Hayman
Director, Privately Held Business
T  +61 8 9480 2000
E  kim.hayman@au.gt.com