PCG 2021/4 – Finalised ATO guidance on allocation of professional firm profits
On 17 December 2021, the ATO released its long-awaited Practical Compliance Guideline (PCG) on its intended compliance approach to the allocation of firm profits by professional services firms. Professional services firms offer customised, knowledge-based services to clients in a variety of professions which include, but are not limited to, accounting, architecture, engineering, financial services, law, medicine and management consulting.
The PCG is a significant change from the former guidelines suspended by the ATO in December 2017. It also has some notable differences from draft PCG 2021/D2 issued in March 2021.
Firstly, the new guidelines will apply from 1 July 2022 rather than 1 July 2021 as proposed in the draft PCG.
Secondly, taxpayers with pre-existing arrangements are able to continue to rely on the suspended guidelines up until the year ended 30 June 2022 as long as their arrangements comply with the suspended guidelines, are commercially driven and do not exhibit certain high-risk features. This is a significant departure from the draft PCG which stated that taxpayers must have entered into arrangements prior to 14 December 2017 in order to rely on the suspended guidelines. The absence of the reference to this date in the finalised PCG appears to allow arrangements entered into post this date to now also be able to rely on the suspended guidelines.
The ability to rely on the suspended guidelines is significant – unlike the PCG, the suspended guidelines provided a simplified and easier to satisfy ‘safe harbour’ compliance approach if the individual professional practitioner (IPP) was assessed on at least 50% of the income to which the IPP and associates were collectively entitled from the professional services firm, or the IPP and their associates had an effective tax rate of 30% or higher on the income derived from the firm.
Importantly, the finalised PCG states that IPPs with pre-existing arrangements that are considered low-risk under the suspended guidelines but have a higher risk rating under the PCG will be allowed to apply the suspended guidelines to their arrangements until 30 June 2024.
Apart from the above, the finalised PCG is substantially the same as the draft PCG. The PCG provide a risk assessment framework for IPPs to self-assess whether the ATO would be likely to expend any of its compliance resources on particular arrangements. Before the risk assessment framework can be used, there are two ‘gateway tests’ that need to be satisfied:
- Gateway 1 – this test considers whether the implemented arrangement and the way in which it operates are commercially driven. There must be a genuine commercial basis for the arrangement and also for the way in which profits are distributed. The arrangement should reflect the commercial needs of the business.
- Gateway 2 – this test requires the consideration of whether any high-risk features are present, such as financing arrangements relating to non-arm’s length transactions, exploitation of difference between accounting standards and tax law and the issue of, for example, dividend access shares to non-equity holders whereby distributions are linked to the personal performance of the non-equity holder.
Once the gateway tests are passed, the IPP may self-assess their risk against the following factors whereby a risk rating is worked out:
The ATO has stated that IPPs in the amber risk zone will likely trigger further analysis and for red zones, reviews are likely to be commenced as a matter of priority. We do note, however, that the PCG is provided for self-assessment purposes. That is, it is recommended that IPPs self-assess their risk rating per the PCG and then engage with the ATO should they be in the amber or red zones to discuss their arrangements. It is expected that IPPs annually assess their arrangements using the PCG. If the ATO undertakes a review of such arrangements, their starting point will be consideration of contemporaneous documentation substantiating the risk rating.
As the ATO has now released the finalised version of the PCG, it is important that professional services clients undertake a risk assessment using the PCG. While clients relying on the suspended guidelines could continue to do so until 30 June 2024, consideration should be given to how these clients would be able to obtain a low risk rating from 1 July 2024 onwards.
We recommend that a risk assessment is undertaken for the 2022 income year using the PCG. If clients are in the amber or red zones, they should be advised of the ATO’s risk ratings and what would be required if the client wishes to ultimately move towards the green zone.
If you have any queries in relation to the above, please contact Gaurav Chitnis.