Historically, most professional firms were partnerships of natural persons. Currently, professional firms are structured in a variety of ways, reflecting the economic and legal choices made by owners of those firms. In some cases, these structures may be used in ways that give rise to different tax consequences and resulting tax compliance risks.

These guidelines explain how the Australian Taxation Office (ATO) will assess the risk of Part IVA applying to the allocation of profits from a professional firm carried on through a partnership, trust or company, where the income of the firm is not personal services income.

The ATO has formulated these guidelines after extensive consultation with legal and accounting professional bodies, in order to understand the commercial, structural and operational issues affecting professional firms in these industries and, more generally, for their clients in other professions. As a result, the guidelines apply to relevant arrangements within professional firms including, but not limited to, those providing services in the accounting, architectural, engineering, financial services, legal and medical professions.

The ATO recognises there are a wide variety of businesses of all sizes where equity holders contribute to the business through the provision of their skilled labour, including tradespeople. However, these guidelines only apply to tax compliance risks arising from the particular commercial and regulatory contexts for professional firm arrangements.

While we are continuing to consult on the practical issues flowing from the application of these guidelines, they apply from their date of issue. Where we receive feedback on their practical application as part of our broader public consultation, we will update the guidelines as appropriate.

Intention

These guidelines explain how the ATO will assess tax compliance risks associated with the allocation of profits from the business structure of a professional firm carried on through a partnership, trust or company.

More specifically, these guidelines apply if:

  • 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 firm operates by way of a legally effective partnership, trust or company, and
  • the income of the firm is not personal services income.

The ATO guidance booklet Your service entity arrangements, which deals with the interaction between the service entity and the professional practice, continues to apply. For the purposes of these guidelines, income received from the service entity will be considered when determining whether the IPP and/or associated entities meet the guidelines set out below.

This document is intended to highlight the situations which we will consider to be low or higher risk, rather than a technical analysis of the various judicial decisions in this area (which are examined in some detail in the rulings referred to on the following pages). The ATO is continuing work to identify appropriate cases to obtain further judicial guidance on these issues in light of current business practices for professional firm structures.

IPP who provides professional services

These guidelines cover how we assess tax risks relating to the inclusion of profit or income of the firm in the assessable income of the IPP, being a person who provides services to clients of the firm, or to the firm itself, in circumstances where the IPP and/or associated entities have a legal or beneficial interest in the firm.

The themes emerging from the case law indicate that the profit or income of a professional firm may comprise different components, reflecting a mixture of income from the personal exertion of the firm’s IPPs and income generated by the business structure – for example, from the activities of employees of the firm.

Legally effective partnership, trust or company

These guidelines only apply where the business is being carried on by a legally effective partnership, trust or company. In this context, a partnership includes a partnership of trustees or companies.

Whether a partnership exists is a question of fact – see Taxation Ruling TR 94/8External Link Income tax: whether business is carried on in partnership (including ‘husband and wife’ partnerships).

This will only be the case where:

  • the practice entity is a legally valid and enforceable partnership, trust or company, and
  • subject to Part IVA of the Income Tax Assessment Act 1936, the arrangement has the effect of causing the partner, trustee, or company to derive income or share in practice profits for income tax purposes.

Whether a trustee, company or partner derives practice income, or shares in practice profits, is inherently a question of fact and circumstance. This depends on a close examination of the contractual relationships, if any, existing between the IPP, the clients of the firm and the practice entity and whether, in substance, the practice is conducted in accordance with the terms of those contractual relationships.

Generally, where one or more IPPs appear to be contracting with clients – for example, the IPP holds themselves out to be a partner of the firm – the IPP will be taken to share in practice profits or derive practice income in their own right, unless the IPP can produce evidence that establishes they are contracting in a different capacity, such as a trustee, agent or employee.

Income of the firm is not personal services income

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 services is income earned mainly as a result of personal efforts or skills, rather than being generated by assets or employees of the firm.

For the purposes of determining whether income earned by an IPP from a professional practice is personal services income, the ATO will continue to follow the guidelines set out in its existing rulings.

Find out more

These views are set out in Taxation Rulings

IT 2639 provides, as a general rule of thumb, that if the trust, company or partnership carrying on the professional practice has at least as many non-principal practitioners as principal practitioners, then the income will be considered to be derived from the business structure. This rule of thumb will be applied for the purposes of these guidelines. For the purposes of applying the test in IT 2639 to these guidelines:

  • ‘Practitioner’ includes IPPs and both full-time professional and non-professional staff whose function is to derive fees for the practice (see further, paragraph 11(a) in IT 2639).
  • ‘Principal practitioner’ means the IPP.
  • ‘Non-principal practitioners’ are those practitioners who are not ‘principal practitioners’.

What are the ATO’s concerns?

The ATO’s concerns about tax compliance risks associated with the allocation of practice profits have been discussed with the legal and accounting professions over recent years.

In some cases, practice income may be treated as being derived from a business structure, even though the source of that income remains, to a significant extent, the provision of professional services by one or more individuals. In this context, we are concerned that Part IVA may have application, despite the existence of a business structure. In particular, we are concerned that Part IVA may apply to schemes which are designed to ensure that the 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. Where an IPP attempts to seperate amounts of income flowing from their personal exertion (as opposed to income generated by the business structure), the ATO may consider cancelling relevant tax benefits under Part IVA.

The ATO acknowledges that the general anti-avoidance provisions have historically been applied to assess individuals on income generated by their personal exertion or application of their professional skills, rather than profits or income generated by a business structure. However, we consider that Part IVA also has potential application where the IPP arranges for the distribution of business profits or income to associates without regard to the value of the services the IPP has provided to the business.

This is particularly the case where:

  • the level of income received by the IPP, whether by way of salary, distribution of partnership or trust profit, dividend or any amalgamation of them, does not reflect their contribution to the business and is not otherwise explicable by the commercial circumstances of the business
  • 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.

ATO risk assessment factors for remuneration of IPPs

The ATO has prepared risk assessment guidelines for the application of compliance resources in 2014–15 and beyond for this issue. We will review the guidelines during the 2016–17 year, subject to the possibility of judicial guidance pending an appropriate test case being identified as outlined above.

In the meantime, the ATO is reviewing our potential application of Part IVA to arrangements of this type. We propose allocating compliance resources to applying these views to higher risk arrangements for the 2014–15 income tax year and later years.

Taxpayers will be rated as LOW RISK, and will not be subject to compliance action on this issue, where their circumstances indicate they meet one of the following guidelines regarding income from the firm (salary, distribution of partnership or trust profit, distributions from associated service entities, dividends from associated entities or any combination of these):

  • 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, similar firms or relevant industry benchmarks – for example, industry benchmarks for a region provided by a professional association, agency or consultant, and/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.

Where none of the guidelines outlined above can be contented, the IPP’s arrangement will be considered higher risk. In these cases, the lower the effective tax rate, the higher the ATO will rate the compliance risk posed by the arrangements and the greater the likelihood of ATO compliance action being commenced. For example, an arrangement with an effective tax rate of 15% will be rated as higher risk than one with an effective tax rate of 25%.

Note: The above guidelines do not apply in relation to other compliance issues. In cases where other compliance issues are evident, taxpayers will be rated as higher risk. This would include cases of non-recognition of net capital gains, transfer pricing, misuse of the superannuation system, promotion of schemes, late lodgment of returns, income injection to entities with carry forward losses, trust reimbursement arrangements, avoidance of Division 7A, improper access to low income tax offsets or other benefits, or non-tax advantages which are dependent on taxable income.

Where you have queries in relation to the guidelines, or wish to provide comments or feedback, please email us at Professionalpdts@ato.gov.au

Case 1

A professional firm subject to these guidelines has three equal trustee partners (with representative IPPs) and 10 employees. It generates a profit of $1.5 million for the year. The three highest paid professional employees of the firm earned between $240,000 and $250,000 during the year. The IPPs at the firm bring in new clients, personally advocate the work of the employees, provide supervisory services, and represent clients in high-risk and high-value matters.

Trust Partner 1 distributes the $500,000 as follows:

  • $300,000 to IPP 1
  • $200,000 to a company owned and controlled by IPP 1.

Trust Partner 2 distributes the $500,000 as follows:

  • $230,000 to IPP 2
  • $20,000 to the spouse of IPP 2
  • $250,000 to a company owned and controlled by IPP 2.

Trust Partner 3 distributes the $500,000 as follows:

  • $60,000 to IPP 3
  • $80,000 to the spouse of IPP 3
  • $260,000 to a trust with losses
  • $100,000 to a company owned and controlled by IPP 3.

Based on the guidelines above, IPP 1 will be considered low risk because they meet all three of the guidelines. IPP 1 is unlikely to be specifically reviewed for their appointment of profits.

IPP 2 does not meet two of the guidelines, because the amount returned by IPP 2 is less than that paid to the band of the highest paid professional employees of the firm, and IPP 2 does not receive 50% or higher of the profits in their own hands. However, IPP 2 satisfies the effective tax rate measure, and on the basis that IPP 2 demonstrates no aggravating factors, they will be considered low risk.

IPP 3 is considered high risk – they do not meet any of the guidelines. IPP 3 is likely to face additional enquiry from the ATO.

Case 2

A small professional firm has two equal trustee partners (with representative IPPs) and generates profits of $400,000 for the year. The three highest paid professional employees at the firm earned $90,000 each for the year. The IPPs at the firm bring in new clients, personally approve the work of the employees, supply supervisory services, and represent clients in high-risk and high-value matters.

The Alphabet Trust distributes its $200,000 as follows:

  • $130,000 to Sam Letters (the IPP)
  • $70,000 to Letters Pty Ltd, a company owned and controlled by Sam.

The Numeral Trust distributes its $200,000 as follows:

  • $75,000 to Jo Numbers (the IPP)
  • $75,000 to Alex Numbers (the IPP’s spouse)
  • $25,000 to Jamie Numbers (the IPP’s adult child)
  • $25,000 to Numbers Pty Ltd, a company owned and controlled by Jo.

Sam would be considered low risk – he satisfies both the similar remuneration and 50% or greater distribution guidelines, even though he does not meet the 30% effective tax rate test.

Jo would be considered high risk – she does not meet any of the guidelines provided, since she does not receive similar remuneration, or 50% or greater of the distribution, and does not have an effective tax rate of 30% or greater. Jo is likely to face additional enquiry from the ATO.