ATO’s risk approach to the taxation of profits of professional firms

The ATO recently released Draft Practical Compliance Guideline PCG 2021/D2 dealing with the allocation of profits of professional firms to individual professional practitioners (IPPs). The guideline contains information about the ATO’s new ‘gateway’ approach to risk that will be used to determine whether:

• Part IVA may apply to the distribution of profits from professional firms to individual professional practitioners (IPPs); or
• The IPP can self-assess the risk of a potential ATO audit. If the IPP determines in good faith there is a very low risk, the ATO will not take action in relation to prior years and will not impose general interest charges in the case of an ATO enquiry.

Under the gateway approach, IPPs can self-assess their risk of a potential ATO audit if:

• The professional firm’s operating structure is designed on a genuine commercial basis and the way of distributing profits are done on genuine commercial terms; and
• Any profit distribution arrangement does not contain ‘high risk features’ such as arrangements covered by a Taxpayer Alert, non-arm’s length financing arrangements, discrepancies between accounting and tax values, assignments of partnership interests, or when non-equity holders hold shares or units in the business.

If these two gateways are passed, the IPP and the ATO can conduct a ‘traffic light’ risk assessment to determine whether the professional firm’s risk zone is red, amber or green. Professional firms are placed into different risk zones depending on the amount of points they score based on:

• The proportion of profit returned to the hands of the IPP. 25% or less of profits of the firm returned to the hands of the IPP attracts more points and more risk.
• The total effective tax rate for income received by the IPP. A total effective tax rate for income received from the firm by the IPP of 20% or lower attracts more points and more risk.
• The remuneration returned to the IPP as a percentage of the commercial benchmark for the services provided to the firm. Total remuneration received from the firm by the IPP of 70% or lower than the benchmark attracts more points and more risk.

A professional firm that scores in the amber and red zone may be subject to ATO review. Professional firms in the green zone should be relatively safe from further ATO scrutiny.

Although these guidelines will not be legally binding when finalised, if a taxpayer has relied on these guidelines in good faith to determine they fall in the green zone, the ATO will generally not take action in relation to prior years and will not impose general interest charges.

If the two gateways are not passed, the traffic light risk assessment methodology is not available for IPPs and such high-risk arrangements may be subject to Part IVA.

Once this draft PCG is finalised, it will apply from 1 July 2021. The old guidance materials that were suspended on 14 December 2017 will apply up to 30 June 2021 (or up to 30 June 2023 for arrangements that are low risk under the old guidance but have a higher risk under the new guidance) that were entered into before 14 December 2017.

If your professional firm requires assistance with the taxation of its profits, please speak to your adviser or get in touch with the Crowe Tax Advisory team.