Late last year the Commissioner released a Taxpayer Alert on the use of partnerships of discretionary trust by professional practices to avoid tax.
In the Taxpayer Alert late last year the Commissioner stated that he was concerned that the dominant purpose for setting up a partnership of discretionary trusts for a professional practice was to gain a tax benefit. Therefore, Part IVA could apply.
In this Taxpayer Alert the Commissioner did state that he would not be considering the use of partnerships of discretionary trust for years before 1 July 2013.
The Commissioner has taken this a step further by releasing a document to assist taxpayers to assess the risk that the Commissioner will apply Part IVA to the allocation of profits within professional firms.
In summary he states he will not review a partnership of discretionary trust structure for professional firms where any of the following three tests are met.
The first test is where the individual working in the practice receives assessable income from the firm in their own hands as an appropriate return for the services they provide to the firm. In determining an appropriate level of income, the taxpayer may use the level of remuneration paid to the highest band of professional employees providing equivalent services to the firm. If there are no such employees in the firm, comparable firms or relevant industry.
The second test is where 50% or more of the income to which the individual and their associated entities are collectively entitled in the relevant year is assessable in the hands of the individual.
The third test is that the individual working in the practice, and their associated entities, both have an effective tax rate of 30% or higher on the income received from the firm.
So if a taxpayer passes any of these three tests the structure will not be reviewed.
But lets be honest… almost no structure will fit within any of these three rules. So the Commissioner is saying “I am coming” to almost every professional practice!
You now have a choice… Stay at what the Commissioner calls “high risk” or decide to comply with one of these three test. If you are going to comply with these rules it is probably easiest to ensure the individual working in the practice receives the same as the highest paid staff member, or 50% of the trust distributions, whichever is the lowest.
Or you can just take the risk… The Commissioner says he will be looking at running cases in this area.
UPDATE: .In the media release launching this document the Commissioner refers to these as “draft guidelines”. He also states that these will only be applied to the 2014/15 year and later years. So it looks like we can lodge the 2014 year returns without having to comply with these tests. But once the guidelines are no longer draft, we will need to talk to clients about the risks that may exist if the structure is used to reduce tax substantially.
UPDATE 2: I keep getting asked about incorporated practices that use discretionary trusts as shareholders. Well the guideline states it applies to any structure. You will still need to ensure 50% of the dividends to the trust shareholder (or the amount the company pays to the top employee of the company) are distributed to the individual professional.
And just a couple of examples…
A professional firm subject to these guidelines has three equal trustee partners (with representative IPPs) and 10 employees. It generates a profit of $1.5 million for the year. The three highest paid professional employees of the firm earned between $240,000 and $250,000 during the year. The IPPs at the firm bring in new clients, personally endorse the work of the employees, provide supervisory services, and represent clients in high-risk and high-value matters.
Trust Partner 1 distributes the $500,000 as follows:
$300,000 to IPP 1
$200,000 to a company owned and controlled by IPP 1.
Trust Partner 2 distributes the $500,000 as follows:
$230,000 to IPP 2
$20,000 to the spouse of IPP 2
$250,000 to a company owned and controlled by IPP 2.
Trust Partner 3 distributes the $500,000 as follows:
$60,000 to IPP 3
$80,000 to the spouse of IPP 3
$260,000 to a trust with losses
$100,000 to a company owned and controlled by IPP 3.
Based on the guidelines above, IPP 1 will be considered low risk because they meet all three of the guidelines. IPP 1 is unlikely to be specifically reviewed for their allocation of profits.
IPP 2 does not meet two of the guidelines, because the amount returned by IPP 2 is less than that paid to the band of the highest paid professional employees of the firm, and IPP 2 does not receive 50% or higher of the profits in their own hands. However, IPP 2 satisfies the effective tax rate measure, and on the basis that IPP 2 demonstrates no aggravating factors, they will be considered low risk.
IPP 3 is considered high risk – they do not meet any of the guidelines. IPP 3 is likely to face additional enquiry from the ATO.
A small professional firm has two equal trustee partners (with representative IPPs) and generates profits of $400,000 for the year. The three highest paid professional employees at the firm earned $90,000 each for the year. The IPPs at the firm bring in new clients, personally endorse the work of the employees, provide supervisory services, and represent clients in high-risk and high-value matters.
The Alphabet Trust distributes its $200,000 as follows:
$130,000 to Sam Letters (the IPP)
$70,000 to Letters Pty Ltd, a company owned and controlled by Sam.
The Numeral Trust distributes its $200,000 as follows:
$75,000 to Jo Numbers (the IPP)
$75,000 to Alex Numbers (the IPP’s spouse)
$25,000 to Jamie Numbers (the IPP’s adult child)
$25,000 to Numbers Pty Ltd, a company owned and controlled by Jo.
Sam would be considered low risk – he satisfies both the comparable remuneration and 50% or greater distribution guidelines, even though he does not meet the 30% effective tax rate test.
Jo would be considered high risk – she does not meet any of the guidelines provided, because she does not receive comparable remuneration, or 50% or greater of the distribution, and does not have an effective tax rate of 30% or greater. Jo is likely to face additional enquiry from the ATO.