ATO Targets Structures Professional Firms: You Need to Know

The Australian Taxation Office (ATO) has long expressed concerns over the tax structures used by professional services firms. These include a wide range of industries such as legal, medical, engineering, and architecture practices, many of which operate through trusts, companies, and partnerships of discretionary trusts. The ATO’s primary concern is how these structures impact the taxation of profits within these firms, and whether the profits are being diverted in ways that reduce taxable income.

The recent release of the ATO’s draft guidance (PCG 2021/D2) signals a much stronger stance on these practices. The document highlights the risks associated with professional services firms using complex structures to divert income in an attempt to minimize their tax liabilities. If these structures are seen to divert income to reduce the professional’s taxable income or to artificially shift profits away from the individual providing the services, the ATO may apply Part IVA of the Income Tax Assessment Act.

Part IVA is an integrity rule that allows the Commissioner of Taxation to remove any tax benefit that results from arrangements designed to achieve a tax benefit through contrived means. Essentially, if a firm is set up in a way that ensures the professional doesn’t receive an appropriate level of remuneration for their services, or receives an amount significantly less than the value of those services, Part IVA could apply. This is a key development for professionals considering the tax structure of their firm and should be closely monitored as it could have major tax implications.

Draft Guidance and the New Risk Assessment Framework

The draft guidance, which is set to apply from July 1, 2021, outlines a new risk assessment framework for professional services firms. Under this framework, firms will be given a risk score based on their structural choices and the distribution of profits. This score will classify the firm into one of three categories: Green, Amber, or Red. The classification will then determine the likelihood that the ATO will review or audit the firm.

• Green Zone: Firms that are classified in the green zone are considered low-risk. They will not likely be subject to a review or audit by the ATO unless other red flags are raised.
• Amber Zone: Firms in the amber zone may face increased scrutiny. While they are not automatically subject to an audit, they are at a higher risk of being reviewed.
• Red Zone: Firms in the red zone will be prioritized for investigation. These cases are likely to proceed directly to an audit by the ATO.

The Gateway Tests: The First Step to Risk Classification

The risk assessment framework is divided into two main gateway tests that must be passed before a firm can be classified in one of the risk zones. These tests evaluate the commercial rationale behind the firm’s structure and profit distribution methods.

Gateway 1: Commercial Rationale

This test assesses whether the structure and profit distribution of the firm make sense from a commercial perspective. Red flags include overly complex structures that seem unnecessary to achieve the firm’s commercial objectives or situations where there is a mismatch between the business’s commercial operations and its tax outcomes. For example, a profitable firm that claims a tax loss would likely raise suspicions.

Gateway 2: High-Risk Features

This test looks at whether there are any high-risk features present in the firm’s structure. High-risk features may include non-arm’s length financing arrangements, irregular assignments of partnership income, or the presence of multiple classes of shares or units held by non-equity holders. These features can indicate potential tax avoidance schemes that would attract the ATO’s attention.

The ATO’s Risk Assessment Factors

Once a firm has passed the gateway tests, it can proceed to self-assess its risk level using the ATO’s risk assessment factors. These factors are used to calculate a score that will determine whether the firm falls into the Green, Amber, or Red zone. The three key factors the ATO uses to assess risk include:

1. The professional’s share of profit: This compares the share of firm profits received by the professional and their related parties against the total profits of the firm. An unusually low share of profits for the professional could indicate a diversion of income.
2. Effective tax rate: This factor looks at the total effective tax rate for income received by the professional and their related parties. A lower tax rate compared to the firm’s average could signal that profits are being shifted to reduce the professional’s taxable income.
3. Remuneration vs. benchmark: This factor compares the professional’s remuneration to a commercial benchmark for the services they provide to the firm. If a professional is being paid significantly less than the commercial rate for their services, it could indicate that profits are being allocated elsewhere to reduce tax liabilities.

The resulting score from these assessments places the firm into one of the risk zones. Firms that previously may have been classified as low-risk may now find themselves in a higher-risk category based on the new criteria.

What Should Professional Services Firms Do Next?

For professional services firms, it’s now more important than ever to assess their tax structures and profit distribution models. Each principal practitioner within the firm needs to evaluate their position under these new risk assessment criteria. Those in the Amber or Red zones will need to consider changes to their business structure or remuneration practices to reduce their risk and avoid a potential audit.

Firms that fail to meet the requirements of the gateway tests or show evidence of non-compliant practices—such as failing to recognise capital gains, misuse of superannuation, or late lodgment of returns—will not be classified in the Green zone, regardless of their risk score. Therefore, it’s critical to review the entire tax and compliance framework of the business.

How to Stay Compliant and Avoid an Audit

Professional services firms need to be proactive in assessing and adjusting their structures to avoid triggering scrutiny from the ATO. This includes ensuring that profit distribution aligns with the commercial realities of the business, remuneration is consistent with industry standards, and no high-risk features are present. By addressing these factors early, firms can improve their chances of remaining in the Green zone and avoid the costly and disruptive effects of an audit.

In conclusion, the new ATO guidance is a wake-up call for professional services firms. While it is important to minimize tax liabilities, it is equally essential to ensure that the business structure remains compliant with ATO regulations. Failing to do so could result in a costly audit or, in some cases, the application of Part IVA, which would strip away any perceived tax benefits.

If you’re unsure if these changes affect you, speak to an expert.