The Australian Taxation Office (ATO) has introduced stricter guidelines for taxing professional profits to ensure they are taxed at an appropriate average tax rate. This change is reflected in the final practice compliance guideline PCG 2021/4, titled “Allocation of Professional Firm Profits – ATO Compliance Approach.” These new guidelines differ significantly from the previous treatment of professional profits and aim to allocate profit in professional firms more strictly. The ATO’s intention is to ensure that the individual primarily responsible for generating a professional firm’s income receives a significant portion of the taxable income. The guideline establishes gateways or criteria that must be met to appropriately allocate professional firm profits. Non-compliance may result in the ATO conducting audits and amending taxable income for individuals and entities.
Business or Personal Services Income
The allocation of professional profits is subject to certain conditions outlined by the Australian Taxation Office (ATO). To allocate profits elsewhere, the entity must not fall into the personal services category. This determination is primarily based on whether more than 50% of the income is derived from the personal exertion and skill of one individual.
The ATO has provided a general guideline suggesting that an entity should have an equal or greater number of non-principal practitioners compared to principal practitioners. A practitioner is someone who earns substantial fees for the firm, while a principal practitioner has partial or complete ownership of the practice.
Several additional factors are considered when classifying a business rather than personal services. These factors include the number of arm’s length employees, the presence of goodwill, the extent to which income-producing assets are utilized, the nature of activities performed, the size of the operation, and the level of dependence on an individual’s personal skills, efforts, or expertise. These factors contribute to determining whether an entity falls within the business category for profit allocation purposes.
Gateway 1 – Commercial Rationale
Once the arrangement is determined to be a business structure, the rules outlined in PCG 2021/4 come into effect, allowing for some flexibility in profit allocation. The first gateway requires that there is a genuine commercial basis for the arrangement, rather than being driven solely by tax considerations. Similarly, there must be a commercial rationale behind the distribution of profits, once again not driven by tax motives.
Common examples of commercial reasoning for profit allocation include asset protection and the use of a separate company for investment purposes. These factors demonstrate a legitimate commercial basis for the distribution of profits within the business structure.
Gateway 2 – High-Risk Features
To pass the gateway, a business must avoid generating any high-risk features specified by the ATO (Australian Taxation Office). These features include:
- Financing arrangements with associated entities to create tax benefits.
- Exploiting artificial differences in accounting and taxable income.
- Issuing multiple different classes of shares and/or units.
- Involvement in arrangements that are flagged by a taxpayer alert.
By steering clear of these high-risk practices, the business can successfully navigate the gateway.
Risk Assessment Framework
PCG 2021/4 contains a risk assessment framework in relation to allocation of profit arrangements and allows professionals to assess their compliance risk of receiving an audit.
The following table outlines the scores for each of the risk assessment factors:
These scores are then used to generate a risk zone for your professional firm regarding its profit allocation, these zones are generated as follows:
Scores for each factor can be calculated using figures from your tax return or accessible through your accounting software.
Profit Entitlement
The first risk factor assigns a score based on the percentage of total business profits returned to the individual professional practitioner (IPP). This is calculated by dividing the profit of the business returned to the IPP by the total profit of the business. This gives the following formula:
In this example, a surgeon operating a practice with a net profit of $2 million receives $750,000 of this profit, which is included in their assessable income. The profit entitlement percentage is calculated as 37.5% (750,000 / 2,000,000), resulting in a score of 5 for this risk factor.
Effective Tax Rate
The second risk factor gives a score based on the effective tax rate paid by the IPP and their associated entities. This can be calculated using the following formula:
In this updated example, the surgeon utilizes a trust to distribute income as follows: $180,000 to their partner, $20,000 for their child’s university fees, and the remaining $1,050,000 to invest in shares through a bucket company taxed at 30%. Assuming this is the child and partner’s only income, the calculation for the effective tax rate would be as follows:
(Tax paid by the IPP: $323,167 + Tax paid by partner: $55,267 + Tax paid by the child: $0 + Tax paid by the company: $315,000) / $2,000,000 = 34.7%
Based on this calculation, the effective tax rate is 34.7%, resulting in a score of 3 for this risk factor. Therefore using our table above, for the first two factors this surgeon is in the Amber Zone with an aggregate score of 8.
Remuneration Returned
The third risk factor can be challenging to quantify, hence an audit risk zone is determined based solely on scores for factors 1 and 2. This factor involves comparing the income allocated to the individual professional practitioner (IPP) with their benchmark average.
In this final example, the surgeon does not participate in any business management and solely performs surgeries. Their salary can be compared to an industry average of $600,000 for professionals with a similar level of expertise. The remuneration returned percentage is calculated as 125%, resulting in a score of 3 for this risk factor.
When combining all three factors, the surgeon’s total score is 11, once again placing their arrangement in the Amber Zone.
This compliance guideline is self-assessed and should you require any assistance with assessing your arrangement please contact TBM Accountants.
TBM Accountants offers a wide array of accounting and tax services in Adelaide, tailored to meet the unique needs of small businesses. Our skilled tax accountants in Adelaide are ready to assist you in optimizing your financial strategies and providing essential small business tax advice. Don’t hesitate, contact TBM Accountants today to enhance your financial stability.
