On 2 September 2014, the Australian Taxation Office (ATO) issued guidelines on, when in their view, a tax avoidance scheme (Part IVA) might be in place with regard to the structuring of professional services firms, which includes legal firms. The guidelines are called: “Assessing the risk: allocation of profits within professional service firms.”
On 22 November 2013, the ATO issued Taxpayer Alert TA 2013/3 “Purported alienation of income through discretionary trust partners”. The overview of this Taxpayer Alert stated:
“This Taxpayer Alert describes arrangements where an individual purports to make the trustee of a discretionary trust a partner in a firm of accountants, lawyers or other professionals (firm); but fails to give legal effect to that structure or fails to account for its tax consequences.”
The net of the ATO guidelines released on 2 September 2014 is cast far beyond Taxpayer Alert TA 2013/3. It catches every partnership, company and trust structure that exists within Australia. Importantly, it does not apply to personal services income, which in my view was one of the primary focusses of TA 2013/3, in that it was looking to catch out salaried partners of firms that received their income distributions via a discretionary trust, without having any equity ownership in the legal firm, and those salaried partners distributing the income to associates. These arrangements continue to have the potential to be caught by the PSI rules.
The guidelines only 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 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
In other words, every legal firm that is not a sole principal practicing in their own name without a service entity.
The guidelines describe when an individual professional practitioner’s distribution strategy from the firm, will result in the risk being LOW in terms of the application of Part IVA. It is critical to note that the ATO’s view, and the application of these guidelines, commence from the date of issue. This means that the 2014/15 year, the current financial year, the ATO will be reviewing your legal firm distribution strategy and assessing it as HIGH or LOW RISK. The ATO has stated that taxpayers who are rated as LOW RISK will not be subject to compliance action on this issue.
To be regarded as LOW RISK, the taxpayer (the IPP) must meet one of the following three guidelines in relation to their income from the firm:
- The IPP receives assessable income from the firm in their own hands as an appropriate return for the services they provide to the firm, and/or
- 50% or more of the income to which the IPP and their associated entities are collectively entitled 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
Interestingly, these are guidelines only. Many commentators disagree with the guidelines and their current alignment to ATO Rulings and case law; however they are what they are. The ATO’s view. This approach is similar to the ATO’s approach to service trusts, whereby they effectively regulated the use of service trusts via the rulings program as opposed to legislation, and what we saw was the death of service entities. Where service entities continue to be used, they are effectively redundant, regardless of their validity, the ATO achieved their outcome.
It looks like the ATO is taking the same approach with professional service firms. To ignore these guidelines would be like standing still in the middle of a Pamplona street in Spain, completely covered in red, as the bulls approach during the San Fermin Festival. You are asking to be trampled.
The ATO has announced that they will not be reviewing the guidelines until 2016/17, “subject to the possibility of judicial guidance pending an appropriate test case being identified”. Further, the ATO have stated that they “propose allocating compliance resources to applying these views to higher risk arrangements for the 2014/15 income tax year and later years”.
Proceed with caution, and be aware, but make sure your legal firm structure and your distribution strategy puts you in the LOW RISK audit category.
If you’d like further information on these changes, feel free to watch our webinar here
Take action now to ensure your legal firm structure and distribution strategy is categorised as LOW RISK. Contact Matt Schlyder, The Lawyer’s Accountant, on firstname.lastname@example.org or call 07 3833 3999 to protect your firm.