ATO’s take on allocating profits within professional firms

ATO’s take on allocating profits within professional firms

Gavin: at page 10 in the October 2014 edition of Voice, we wrote an article entitled “professional Practices under attack”, they still are!

The ATO has now finalised its guidelines and published a document titled “assessing the risk: allocation of profits within professional firms.”

The document basically mirrors the earlier draft guideline and the five examples appear to be identical.

The background

The ATO states that: “These guidelines only apply where the practice income is being generated by a business structure and does not, therefore, constitute income from personal services.”

“Broadly, income from personal service is income earned mainly as a result of personal efforts or skills, rather than being generated by assets or employees of the firm.”

Basically, the ATO believes that, in relation to such a practice*, part IVA may apply where an individual professional practitioner (IPP) is not directly rewarded for the services they provide to the business, or receives a reward which is substantially less  than the value of those services.

(*) Editor: This guideline does not just apply to tax practices, but to all your clients’ professional practices, such as doctors, Lawyers, architects, etc.

Where an IPP attempts to alienate amounts of income flowing from their personal exertion (as opposed to income generated by the business structure), the ATO considers that Part IVA may apply.

That is, it considers that Part IVA may apply where the IPP arranges for the distribution of business profits to associates, without regard to the value of the services they have provided to the business.

The guideline say that this is particularly the case where:

• The level of income received by the IPP, whether by the way of salary, distribution of partnership or trust profit, dividend or any combination of them, does not reflect their contribution to the business, and is not otherwise explicable by the commercial circumstances of the business; and
• Tax paid by the IPP and/or associated entities on profits of the practice entity is less than that which would have been paid if the amounts were assessed in the hands of the IPP directly; and
• The IPP is, in substance, being remunerated through arrangements with their associates; and
• The structure does not provide the IPP with advantages, such as limited liability or asset protection.

The Wash-up

The ATO will now apply the three tests outlines on page 11 of October Voice.

• Equivalent remuneration test – The IPP needs to receive remuneration that is equivalent to, or higher than, the lowest paid member of the upper quartile of professional employees in the firm (or similar firms in the area). This will include the cost of any Fringe Benefits and FBT amount payable in relation to those Fringe Benefits to reflect the true cost to the business of employing these individuals;
• 50% test – At least 50% of the income to which the IPP and their associated entities are collectively entitled is assessable in the hands of the IPP; or
• 30% tax rate test – The IPP and their associated entities must both have an effective tax rate of at least 30% on the income received from the firm.

If a tax payer passes one of the tests, it will be rated low-risk and not subject to audit activity. If the taxpayer fails all three, they’re higher risk and more likely to be audited.

 ATO says Everett assignments are also toast!

Editor: In Everett, the taxpayer practised in partnership with three other solicitors. He executed a Deed of Assignment to assign just under half of his share of income from the firm to his wife.

The high court found that the assignment was effective for tax purposes. Income payable to the taxpayers spouse was trust income which was assessable in her hands only.

The ATO now considers that Part IVA may apply to such assignments (on a prospective basis).

It said that part IVA may be applied where taxpayers enter into an Everett assignment in the 2015/16 income tax year and later years.

This means that from July 2015, if an IPP enters into an Everett assignment, one of the benchmarks needs to be met in order for the assignment to be rated as low-risk.

Pre-1 July 2015 Everett assignments

The ATO says that it may consider the application of the Part IVA to a pre-1 July 2015 assignment where, after 30 June 2015 either:

• A further assignment occurs; or
• A power of appointment, or other discretion, is exercised; and as a result,
• The IPP does not satisfy any of these benchmarks in the guidelines.

Where this occurs, the ATO will only consider applying Part IVA in the 2015/16 and later income years, and will provide an opportunity for the IPP to self-correct their arrangement in the following income tax year.

Example: Everett assignment

A professional Practice has 3 partners who share equally in the profits of the firm. It generated $2m in annual profit.

The firm does not operate a service entity and has no plans to commence a service entity arrangement.

On 15 July 2015, the partners decide that it would be acceptable for each of them to undertake Everett assignments. On that date, the following transactions take place:

• Partner 1 assigns 50% of their interest to their family trust.
• Partner 2 makes two assignments, being 20% to their spouse and then 30% of the remainder of their interest to their family trust.
• Partner 3 assigns 70% of their interest to their family trust.

The trustee of the family trust then exercises its discretion to distribute all of the income to a corporate beneficiary with a discretionary trust shareholder.

A dividend is declared and the trustee distributes it equally to the partners spouse and another corporate entity with $300, 000 carried forward losses.

In this example, Partners 1 and 2 would be considered low-risk. Partner 1 will comply with the 50% distribution benchmark, as would Partner 2.

Partner 3 does not comply with the 50% entitlement benchmark and, assuming that he does not comply with either of the other two benchmarks, he will be considered higher risk.

The ATO will review the arrangement and consider the application of Part IVA to the Everett assignment transaction itself, as well as the appointment of the income flowing from the Everett assignments to beneficiaries other than Partner 3.

Ref: ATO website – assessing the risk: allocation of profits within professional firms