For some time the Australian Taxation Office (ATO) has been focusing on the issue of income splitting and alienation of profits through business structures. Whether it has been partnership assignments to spouses, Phillips trust arrangements or its recent compliance activities in relation to service entity mark ups, the ATO seem to have an insatiable appetite for challenging the tax position of professional practices operating via a business structure. The campaign that culminated in the 2006 Guidance Booklet and TR 2006/2 in regard to service entities was quite successful and saw the demise of service entities as a preferred model in professional firms.
Recently, the ATO released Taxpayer Alert TA 2013/3 which put taxpayers on notice that it would be reviewing certain arrangements used by professional services partnership firms operating through discretionary trusts.
The big question is whether this long expected follow up position focussing on personal remuneration of principals will be as effective. The suggested application of the general anti-avoidance provisions in Part IVA is certainly a more onerous and difficult task than simply disallowing deductions to service entities. The ATO is likely to pick their targets carefully and will be seeking to secure a solid win in any test case.
It is equally difficult and onerous for taxpayers to engage in a Part IVA dispute and all the more difficult as the ATO's focus is clearly on the individual practitioners and not the practice. For that reason alone practitioners should think carefully before staying outside the ATO guidelines. It is worth highlighting that an overwhelming number of professional practices firmly hold the belief that there is no case to answer if:
- the personal services income provisions are not breached; and
- the mark-ups charge by their service trust are within the ATO's safe harbour's
What many may have overlooked in the context of professional practice structures is the potential application of the Part IVA, being the general anti-avoidance provisions, to arrangements where the dominate purpose is to create a tax benefit, e.g. reducing the tax payable by the principal.
The ATO is however spoiling for a fight and in this regard they have again sharpened their focus on the use of business structures in the context of income splitting and they clearly have Part IVA in mind. In essence the ATO has a general concern that practice income is in some circumstances being treated as being derived from a business structure, notwithstanding the source of that income is mainly from the provision of professional services by one or more practitioners. The ATO are now putting forward the position that if it is evident that a practitioner is receiving substantially less than the value of their services being provided (i.e.as a result of income splitting or alienating their profits), the ATO may consider removing any tax benefits from such arrangements by applying the Part IVA.
In addressing this form of alienation of profits by professional services firms, the ATO has released new guidelines highlighting how it will classify firms according to a risk-based approach and review entities classified as high risk. The guidelines apply quite broadly. As stated in the ATO publication, these guidelines apply if:
- "An individual professional practitioner ("IPP") which provides professional services to clients of the firm, or is actively involved in the management of the firm and, in the either case, the IPP and/or associated entities have a legal or beneficial interest in the firm; and
- The firm operates by way of a legally effective partnership, trust or company; and
- The income of the firm is not personal services income."
Once an entity falls within the scope of the guidelines, the ATO will classify it according to a risk-based approach. The ATO states that taxpayers will be rated as low risk and will not be subject to compliance action where their circumstances satisfy one of the three tests, which are as follows:
- "The IPP 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, or if there are no such employees in the firm, comparable firms or relevant industry benchmarks – for example, industry benchmarks for a region provided by a professional association, agency or consultant; or
- 50% or more of the income to which the IPP and their associated entities are collectively entitled (whether directly or indirectly through interposed entities) in the relevant year is assessable in the hands of the IPP; or
- The IPP, and their associated entities, both have an effective tax rate of 30% or higher on the income received from the firm."
If the entity is unable to satisfy any one of the three tests, the entity will be classified as high risk and may be potentially subject to an ATO review.
Practitioners should be aware that the ATO will continue to review these guidelines during the 2016-17 year with the possibility that it may change 'subject to judicial guidance', suggesting that it may be looking for a test case or it already has one in the pipeline. Of particular interest is the fact that the ATO has indicated that it will dedicate resources to review high risk entities in the 2014-15 income tax year as well as later years.
It is clear, that the ATO has a renewed focus on ensuring that firms are compliant and firms should be weary of this strong focus in relation to allocation of profits within professional services firms. Given the specific 'safe harbours' that allow an entity to be classified as 'low risk', it is worthwhile for business who fall within the guidelines to evaluate that they come under one of these safe harbours. Moore Stephens will be happy to assist in this regard.
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