Practical Compliance Guideline: Does ATO’s Guideline 2021/D2 Impact You?
PCG 2021/D2 is interested in the allocation of profits within professional firms, and so applies to professional firms that redirect portions of income to a service trust. If you operate a professional firm, such as an accounting firm, architectural firm, law firm, medical practice, or engineering firm, the Australian Taxation Office (ATO) has issued a Practical Compliance Guidance (PCG) that may require review of your service trust or other equitable arrangements. When the arrangement in question operates so as to reduce the tax liability of an individual professional practitioner, the ATO may conduct a review of any such service trust arrangement. This will apply when a practitioner such as a doctor, lawyer, or engineer provides services to clients of the firm, or the firm itself, in circumstances where they or their associated entities have a legal or beneficial interest in the firm.
My Profession Isn’t on the List – Am I Exempt?
Not necessarily. The types of professional firms are not limited to the above list. While ‘profession’ isn’t defined in taxation legislation in Australia, a profession is often recognised as such if it is subject to a regulatory body, is generally accepted by the public as possessing of special knowledge and skills, and adheres to ethical guidelines. If any of these qualities apply to your circumstances, the PCG may apply to you. This is subject to meeting a number of conditions outlined here in the following section.
Will I be Subject to a Review?
You can assess whether the PCG applies to your professional firm by reference to the following conditions:
- An individual professional practitioner provides professional services to clients of the firm, or is actively involved in the management of the firm and, in either case, the individual professional practitioner and/or associated entities have a legal or beneficial interest in the firm;
- The income of the firm is not professional services income, which is defined as income earned mainly as a result of personal efforts of skills of the independent professional practitioners;
- The firm operates by way of a legally effective structure, for example a partnership, trust or company;
- An individual professional practitioner is an equity holder and holds full rights to participant in the voting, management, and income of the firm.
If all of the above criteria are met, you must then closely assess whether your firm satisfies the two gateways:
- Gateway 1: the arrangement is commercial driven; and
- Gateway 2: the firm and the individual professional practitioner does not demonstrate any high-risk features.
Commercially-Driven Arrangement
Your firm will likely satisfy Gateway 1 if any service trust or other equitable arrangement, including distribution of profits, is operated for a genuine commercial basis. If the arrangement your firm employs reflects the commercial needs of the business, such as increasing incomes or profits, the arrangement is likely to be justified. Documentation showing that the commercial purpose was achieved is important.
It is less likely that your firm will satisfy Gateway 1 if the commercial rationale for the arrangement is unclear or complex. This also contemplates the inclusion of additional steps that serve only to gain tax advantages, or unusual features such as insufficient securities or interest rates that depart significantly from the market rate. Distribution of profits will also be considered in Gateway 1. For example, any independent professional practitioners should be receiving compensation reflective of their personal efforts or skill.
If you come to the conclusion that the arrangement employed by your professional firm is commercially-driven, the next step is to consider whether there are any high-risk features that might elicit an ATO review.
High-Risk Features
There are a number of features that the ATO has identified as potentially high-risk:
- Financing arrangements relating to non-arm’s length transactions;
- Exploitation of the difference between accounting standards and tax law;
- Certain arrangements where a partner assigns a portion of a partnership interest;
- Multiple classes of shares and units held by non-equity holders.
This list is not exhaustive. However, if you come to the conclusion that your professional firm does not employ any features that can be viewed as high-risk, you will satisfy Gateway 2 and the PCG will likely apply to you.
How does Application of the PCG Work?
If the PCG applies to your firm, you still have an obligation to assess your compliance with taxation legislation. The PCG operates simply to provide you with some confidence that, if the arrangement your professional firm engages in is ‘low-risk’, the ATO will generally not seek to review that arrangement. In other words, it is a guideline for you to cross-reference your arrangement against. The ATO may confirm your calculations were done in accordance with the PCG, confirm absence of exclusionary factors, or provide you with advice when requested.
The following tables have been developed by the ATO and will assist you in assessing whether your professional firm will likely be viewed as low-risk.
If your firm is found to be of moderate risk, the ATO is likely to conduct further analysis. If your firm is found to be of high risk, the ATO is likely to commence review as a matter of priority and consider engaging both immediate audit and formal powers to obtain information.
| Risk assessment factor | Score | |||||
|---|---|---|---|---|---|---|
| 1 | 2 | 3 | 4 | 5 | 6 | |
| (1) 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% |
| (2) Total effective tax rate for income received from the firm by the IPP and associated entities [6] | >40% | >35% to ≤40% | >30% to ≤35% | >25% to ≤30% | >20% to ≤25% | ≤20% |
| (3) 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% |
| Risk zone | Risk level | Aggregate score against first two factors | Aggregate of all three factors* |
|---|---|---|---|
| Green | Low risk | ≤7 | ≤10 |
| Amber | Moderate risk | 8 | 11 & 12 |
| Red | High risk | ≥9 | ≥13 |
Next Steps
The PCG will apply prospectively from 1 July 2021. Whether you are an individual professional practitioner or operate a professional firm, you may wish to assess where you sit on the ATO’S risk assessment formula. While PCG 2021/D2 is in place, best practice will be to assess its application to your firm as well as your firm’s compliance with the PCG on an annual basis.