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The New Profit Allocation Rules Impacting Professional Firms

It is common for professionals such as lawyers to jointly practice with other individual practitioners.  These practices will often use various profit allocating arrangements that result in some share of practice income being flown to related parties such as a family trusts/spouse.

Recently the Australian Taxation Office (“ATO”) has released new guidelines which outline a self-assessment framework to determine the risk associated with profit allocation arrangements.

What are the New Profit Allocation Guidelines?

Practical Compliance Guideline (‘PCG’) 2021/4 contains a traffic-light risk assessment that may be used by taxpayers to understand the level of scrutiny they may expect from the ATO.

Its release should not be viewed as a change of the tax laws in this area nor the creation of a safe harbour. Instead, it should offer some insight as to what the ATO considers in determining who to review.

Will they Apply to my Firm?

The guidelines apply to Individual Professional Practitioners (“IPP”) – being owners of professional firms such as law firms.

The IPP must either provide professional services to clients or be actively involved in management of the firm. They must also have a legal or beneficial interest in the firm, and be a full equity holder and have rights to participate in voting, profits and operations.

Application Dates

Previously many law firms may have been cognisant of ATO guidelines published as “Assessing the risk: allocation of profits within professional firms”. Those guidelines contained three alternative benchmarks which required one to be satisfied for an IPP to be considered low risk.

Those guidelines were withdrawn in December 2017 and are now referred to ‘Suspended Guidelines’. The ATO has indicated that IPPs which meet some eligibility criteria can continue to rely on the Suspended Guidelines until 30 June 2024, however new arrangements will be subject to the new guidelines from 1 July 2022.

Self-Assessment under PCG 2021/4

The risk assessment framework is available where the IPP’s arrangement passes two gateways.

Gateway 1 – Commercial Rationale

This Gateway requires there to be a genuine commercial basis for the arrangement and resulting distribution of profits that reflects the needs of the business and its profitability. The Guidelines recommend that the IPP evidence this by recording the commercial rationale for arrangements and distribution of profits.

Gateway 2 – High-risk features

This Gateway requires that the IPP’s arrangements to not contain features the ATO considers high-risk. This requires consideration of:

  • financing arrangements in relation to related-party acquisitions in the professional firm,
  • financing arrangements relating to non-arm’s length transactions
  • exploitation of differences between accounting standards and tax law,
  • the assignment of partnership interests involving non-equity partners, and
  • whether there are multiple classes of shares and units held by non-equity holders

These gateways may leave some IPPs in a position of uncertainty given Gateway 1 can be subjective, and the Gateway 2 list of high-risk features is not exhaustive. If either of these gateway criteria is not satisfied, the Commissioner may apply greater scrutiny.

Satisfying both gateways results in the IPP being able to self-assess their risk rating which requires further examination of the:

  • Proportion of profit entitlement from the whole of firm group returned in the hands of the IPP
  • Total effective tax rate for income received from the firm by the IPP and associated entities
  • Remuneration returned in the hands of the IPP as a percentage of the commercial benchmark for the services provided to the firm (this is an optional assessment noting it may be difficult to determine).

There is a matrix within PCG 2021/4 which prescribes a risk-rating score attributable to each factor above. Your overall score will then give you a colour rating that determines your level of risk.

A red zone rating would result in a priority review from the ATO, while a green zone rating would likely result in the ATO confirming the guidelines have been correctly applied.

Wider Considerations

Working through the self-assessment criteria, it becomes apparent that the distribution patterns of your business partners may indirectly draw the attention of the ATO to your family group’s tax affairs. For this reason, it is important for all partners to understand the PCG and to manage their distributions carefully. It may warrant discussions at a business level to ensure the tax risk profiles are openly managed as a group.

Risk Assessment Toolkit

Should you wish to understand the risk profile of your current arrangements, you can access a risk assessment toolkit through the Pitcher Partners Website. and if you have any further questions, please don’t hesitate to reach out.

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