The ATO’s final Practical Compliance Guideline PCG 2021/4 for the allocation of professional firm profits was released on 16 December 2021, nine months after release of draft guidelines, and following four years of uncertainty since suspension of its guidelines Assessing the Risk: Allocation of profits within professional firms (“Suspended Guidelines”). As we note below, some uncertainty remains to be worked through prior to effective commencement.
The PCG will take effect from 1 July 2022, one year after the initial contemplated start date in Draft PCG 2021/D2. In coming months, professional firms and their Individual Professional Practitioners (“IPP”) will need to address how the PCG affects them and what actions might be appropriate to improve their positions.
Taxpayers may still rely on the Suspended Guidelines for the 30 June 2018 to 30 June 2022 income years and to 30 June 2024 for existing “low risk” taxpayers transitioning to comply with the PCG, as long as those transitional arrangements originally complied with the Suspended Guidelines.
Concerns over redirection of income
This PCG continues to echo long standing ATO concerns that, due to the organisational structure of professional firms, firm arrangements might be used to redirect income from an IPP to an associated entity, which could alter the IPPs tax liability. To address this, the ATO has confirmed in the PCG a risk assessment framework to assess compliance by IPPs. Unlike the Suspended Guideline’s approach, some pre-conditions must be satisfied in order for IPPs to access the framework, including meeting the following two “Gateways”:
- Gateway 1: There is sound commercial rationale for entering into and operating the arrangement or structure; and
- Gateway 2: There must not be certain “high-risk features”, as set out in the PCG.
If an IPPs arrangement satisfies the pre-conditions, including both gateways, the ATO’s risk assessment framework (incorporating three Risk Assessment Factors, or “RAFs”) can assist the IPP understand the tax risks that their arrangement exhibits, depending on whether the arrangement is classified as low (green), medium (amber) or high (red) risk. Generally, the lower the risk the IPPs arrangement exhibits, the more favourable the ATO’s compliance approach will be towards the IPP.
Where an IPPs arrangement fails to meet either or both of the two “Gateways”, the risk assessment framework set out in the PCG will not be available to the IPP and the Commissioner may seek to review the arrangement and apply the anti-avoidance provisions under Part IVA of the ITAA 1936.
The PCG cannot be relied upon by non “equity holders”, which could limit the scope of these guidelines quite substantially.
Key changes from Draft PCG 2021/D2
Whilst the PCG retains the key features of Draft PCG 2021/D2, the ATO has introduced a number of key changes beyond the deferred start date and transitional period changes described above. These include:
- Providing additional examples featuring a wider variety of arrangements and structures used by IPPs. Scenarios that illustrate how an IPPs franked distributions & credits, fringe benefits, and superannuation contributions are treated will be helpful.
- Confirming that being high risk (or not meeting a Gateway) doesn’t automatically result in audit or application of anti-avoidance provision Part IVA.
- Some slightly favourable changes in the benchmark percentages in the Risk Assessment Framework to determine whether an arrangement is low, medium or high risk. For example, an IPP “proportion of profit entitlement” of 50% now reflects a RAF 2 score of 4 (moderate risk) compared to 5 (high risk) in the draft, and an effective tax rate of 30% now reflects a RAF 2 score of 3 (low risk) compared to 4 (moderate risk) in the draft. Other than these changes, the tables containing the three RAFs reflect no change.
Key uncertainties remain
To a degree, the PCG provides professional firms something to move forward with given the four year vacuum since the Suspended Guidelines were withdrawn. But disappointingly, despite the many detailed submissions made by professional bodies and firms including ourselves calling for either reinstatement of the Suspended Guidelines or a less rigid approach, the ATO has chosen to retain the substance of the draft PCG.
And despite the extent of submissions, uncertainties remain for a number of ‘real life’ situations including:
- Understanding when an IPP is an “equity holder” including whether the PCG applies when equity is held through associated entities;
- The treatment of firm income when “warehoused” in one interposed IPP entity and then distributed in subsequent years to family members;
- How IPPs that are subject to Division 293 tax on super contributions are treated; and
- What professional firms and IPPs should do when they don’t meet a Gateway, or are in a higher risk category. To say that there won’t be an automatic audit or application of Part IVA will be of little comfort to many, especially if the steps to resolve the issues are fraught from a commercial and transactional cost perspective.
Our overriding concern is that uncertainty about whether a particular firm’s approach could be branded as “tax driven” will put the brakes on effective succession. The ATO’s apprehension around what is an “equity holder” and consequent potential limitation of protection offered by the PCG will have an impact on a growing and diverse number of IPPs currently on leadership pathways. This would be an unwelcome outcome.
We look forward to more ATO guidance to make the PCG workable in practice before its 1 July 2022 start date.
What you must do now
Professional services businesses and their IPPs should take the time to consider the impact of the PCG to their arrangements well before the 1 July 2022 start date including the following issues:
- Whether their arrangements satisfy the Gateway requirements, and if not, what steps could be taken to meet these requirements.
- How your IPPs would be rated applying the 2 or 3 (if required) RAFs to each IPPs current circumstance.
- What adjustments, if any, to income distribution patterns would be required for an IPP to be rated as low risk under the PCG.
Our close study of this matter and our track record in advising professional services businesses make Grant Thornton ideally placed to assist you to navigate these important changes to tax guidelines.