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Allocation of professional firm profits – Important new guideline

Finally the Commissioner answered the question of how much of the profits of a professional firm that we can allocate to entities other than the owner of the firm.

Background

In 2015 the Commissioner released a document called “Assessing the risk: allocation of profits within professional firms guidelines”. This allowed us to send 50% of the profits of certain professional firms to entities other than the owner of the firm (amongst other options). On 14 December 2017 the Commissioner indicated he was going to quickly rewrite this guideline and would publish new guideline in early 2018…

And in March 2021 he has finally released a draft of his rewrite of these guidelines (only in the public service can a six month job take 40 months…

The new way of assessing what amount of professional firm profits can be alienated from the owners – A “spreadsheeters” dream

So can we still just have the partner of the law firm get 50% of the money from the firm and send the rest to the spouse/children/bucket company… No. Now you need a to assess your clients against a series of tables, and the Commissioner states that he “expect(s) you to annually assess your eligibility to apply this Guideline”. 

Have a look at the three tables we now need to consider to understand what the Commissioner thinks of the amount of the income from a professional firm we don’t send to the equity holder…

Risk FactorScore
 123456
Proportion of profit entitlement from the whole of firm group returned in the hands of the IPP>90%>75% to 90%>60% to 75%>50% to 60%>25% to 50%25% or lower
Total effective tax rate for income received from the firm by the IPP and associated entities>40%>35% to 40%>30% to 35%>25% to 30%>20% to 25%20% or lower
Remuneration returned in the hands of the IPP as a percentage of the commercial benchmark for the services provided to the firm>200%>150% to 200%>100% to 150%>90% to 100%>70% to 90%70% or lower

What we do with this first row of this table is we assess our profit proportion that we are sending to the partner and then we give ourselves a score. For example if we send 55% of the total income from the professional firm our score is 4.

Then, looking at the second row, we work out what the effective tax rate across all this income is and then we give ourselves a score. For example if the effective tax rate is 33% on the total income from the professional firm our score is 3.

Then, looking at the third row, we work out, as a percentage, what remuneration was handed to the professional as a percentage of the commercial benchmark for the services provided to the firm. However, in most situation the Commissioner acknowledges we wont consider this as it will be impractical to accurately determine an appropriate commercial remuneration against which to benchmark. 

We then add up our score from the three (or in most case two) rows above and consider this table…

Risk zoneRisk levelAggregate score against first two factorsAggregate of all three factors
GreenLow risk7 or less10 or less
AmberModerate risk811 & 12
RedHigh risk9+13+

So if we use our examples above, we scored 4 in the first row and 3 in the second row for a total score of 7 – And we are low risk. But what does low risk mean? Now the final of our three tables answers that…

Risk zoneATO treatment
Green We will only apply compliance resources to review your allocation of profit in exceptional circumstances, such as where:we are not satisfied your self-assessment is correct, or is adequately supported with evidencewe become concerned that higher-risk features are present in your arrangementwe become concerned, from our own data and analysis, that there is a change in your arrangement causing a shift towards the border of compliancewe become concerned that your broader arrangements present a compliance risk (for example, with Division 7A of Part III of the ITAA 1936)your arrangement relates to a broader set of circumstances being reviewed by uschanges to your arrangement may not have been appropriately treated or disclosed.Where there has been no material change, then we will generally only apply compliance resources to the arrangement to:confirm your calculations were done according to this Guidelineconfirm the absence of any exclusionary factors provide binding advice where you request it.
AmberWe are likely to conduct further analysis on your arrangement. We may contact you to understand the arrangement and resolve any areas of difference.
RedReviews are likely to be commenced as a matter of priority. Cases may proceed directly to audit. We are likely to use formal powers for information gathering.                

If we can show the Commissioner our score is 7 when he comes to review, in most cases that will be the end of the review.

Here is an example:

Nicolas is an IPP in a partnership. His total income entitlement from the partnership is $600,000. Nicolas has disposed of 45% of his partnership interest to an associated company.

Nicolas returns 55% of the partnership income ($330,000) in his personal tax return. Nicolas’s tax liability on this amount is $119,167.

The company receives a total of $270,000 from the distribution. The corporate beneficiary’s tax liability on this amount is $70,200 (26% of $270,000).

Together Nicolas and the company have a total effective tax rate of 31.56%.

The risk assessment is:

Risk assessment factorApplication of criteriaScore
(1) Proportion of profit entitlement from the whole of firm group returned in the hands of the IPP330,000, or 55%, of Nicolas’s profit entitlement from the partnership is returned by Nicolas personally.4
(2) Total effective tax rate for income received from the firm by the IPP and associated entities (using tax rates applicable to the 2020-21 income year)Nicolas pays tax of $119,167 on the $330,000 returned by him. The associated company pays tax of $70,200 on the $270,000 received by it, at a rate of 26%. The calculation of total effective tax rate is as follows: ($119,167 + $70,200) / ($330,000 + $270,000) × 100 = 31.56% The total effective tax rate is 31.56%.3
(3) Remuneration returned in the hands of the IPP as a percentage of the commercial benchmark for the services provided to the firmNot applicable. Nicolas has determined that in the circumstances it is impractical to accurately determine an appropriate commercial remuneration to benchmark against and therefore his aggregate score is determined against the first two factors only.0

TOTAL SCORE – 7

The aggregate score of 7 places Nicolas’ arrangement in the green zone.               

What clients can I use these tables on? The fine print on when the Guidelines can be relied on…

The draft Guideline states that it only applies if all of the following criteria are met:

  • an Individual Professional Practitioner (IPP) provides professional services to clients of the firm, or is actively involved in the management of the firm and, in either case, the IPP and/or associated entities have a legal or beneficial interest in the firm;
  • the income of the firm is not PSI;
  • the firm operates by way of a legally effective structure, for example, partnership, trust or company;
  • an IPP is an equity holder, that is, an IPP holds full rights to participate in the voting, management and income of the firm;
  • the arrangement is commercially driven (described as Gateway 1); and
  • the firm and IPP do not demonstrate any high-risk features (described as Gateway 2).

The draft Guidelines make it clear that the Commissioner’s main focus, before even getting to the tables above, will be whether the two “Gateways” have been passed.

Arrangements that are commercially driven (described as Gateway 1),

The Commissioner will be looking for the following indicators to assess if an arrangement lacks a sound commercial rationale:

  • The arrangement seems more complex than is necessary to achieve the relevant commercial objective;
  • The arrangement includes a step, or a series of steps, that appear to 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, for example, a tax loss is claimed for what was a profitable commercial venture or transaction;
  • The arrangement results in little or no risk in circumstances where significant risks would normally be expected;
  • The parties to the arrangement are operating on non-commercial terms or in a non-arm’s length manner; or
  • There is a gap between the substance of what is being achieved under the arrangement (or any part of it) and the legal form it takes.

The Commissioner also states that there must be a genuine commercial basis for the way in which profits are distributed within the group, especially in the form of remuneration paid. Relevant considerations are whether:

  • the IPP actually receives an amount of the profits or income which reflects a reward for their personal efforts or skill;
  • the income has been distributed in substance;
  • the IPP ultimately benefits from the distribution of income to associates, which is referrable to the personal efforts or skill of the IPP;
  • the remuneration is less than a true commercial comparable and would not be perceived as an arm’s length payment;
  • there are loan accounts relevant to the arrangement – whose name those accounts are in and whether they are aware of the loans
  • the payment recipients have control in managing the entity’s cash flows and financials and actually receive the money and keep it, or whether it is distributed out to others.

High-risk features (described as Gateway 2)

According to the draft Guidelines, these include:

  • 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 are materially different in principle from Everett and Galland; and
  • multiple classes of shares and units held by non-equity holders.

In relation to indentifying arrangements where a partner assigns a portion of a partnership interest that are materially different in principle from Everett and Galland, the Commissioner is looking for the following:

  • arrangements purporting to admit an individual as a partner, where the individual is not an owner or equity holder in the partnership, with full rights, obligations and entitlements, and
  • arrangements where the IPP’s relationship has characteristics indicating their relationship with the partnership is akin to a contractor or employee.

So be on the lookout for the indemnification of non-owner/equity holders by equity partners against any professional liability in respect of actions against the partnership, a fixed draw or salary, and a lack of rights to full participation in management and the benefits of the partnership, relative to other partners.

These two “Gateways” mean that if you step outside the normal professional firm structures you may need to consider what that means for where you send the profits.

What do I need to do?

Have a look at the professional you advise who fit in this Guideline. Like me you are probably sending 50% or less to associates. Now work out what your score is and whether you sit nicely in “green”. If not, what could you change to get into “green”

For the few clients you have who might have a problem with the two “Gateways”, ask them what their risk profile is, warn then of what might occur and ask them whether they would like to reconsider their structure and income distribution practices.Of course, at the moment it is only a draft, but I doubt it will another 40 months till we see the final Guideline.

By Ken Mansell

As a stay at home Dad most of the week this is my way of pretending I am still the tax counsel of ASX and SEC listed companies, working at big 4 firms, working at the Federal Treasury, on the Henry Review and at Parliament House for the previous government.

One reply on “Allocation of professional firm profits – Important new guideline”

Thanks for the article Ken. I’m wondering what are your thoughts on why this guideline applies to professionals only.
If you run any other kind of business – a plumbing business, or cafe, or selling socks on ebay – you are free to distribute profits however you like, in accordance with the law.
Surely as long as you are paying yourself a market salary – profit is profit. If an architect runs a firm of 100 people that makes a profit of $4 million – is it reasonable that they must pay personal income tax on $2 million of this – even though a typical salary for a practice manager might be $300,000?
I wonder if someone is planning on a test case to see if the “guideline” will stand up in court.

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