The ATO has put professional business owners on notice. Here’s what you need to know

Just before Christmas, the Australian Taxation Office (ATO) issued its new approach to professional firm profits — the Practical Compliance Guideline (PCG) 2021/4 — four years after the previous guideline on professional firm profits was suspended.

The guideline provides a broad outline of the ATO’s approach in applying additional scrutiny to business owners who share in the profits of a professional business.

The changes could impact a wide range of professional equity owners in businesses — while leaving non-professional equity owners untouched.

So what does the new guideline mean for professional business owners?

How the change will play out

Here’s a tale of two mates called Joe.

Each advises property developers on construction projects. Each is senior enough to have an equity position in his business.

Each Joe receives a share of the profits that — in each case — is divided between personal income and an amount paid to a family trust.

But the situation between Joe the Builder and Joe the Engineer is about to diverge.

From July 2022, Joe the Builder can continue to share in the profits from his business in this way without necessarily coming to the attention of the ATO.

For Joe the Engineer, however, exactly the same business model and approach to profit allocation will put him in the path of ATO due to the updated guidelines.

In this publication, the commissioner expresses a view that part of the income derived by an owner of equity in a professional firm is “personal exertion” income.

Unfortunately, this view — which runs counter to case law and the commissioner’s own ruling — has saddled many thousands across a range of professions with extra compliance requirements.

Who is covered by the new guideline?

In the guideline, the ATO points to the definition of professionals provided by the Australian Council of Professions, which includes elements such as accreditation, ethical guidelines that must be met to maintain practice, specialist knowledge and skills and a requirement of upholding a high standard of behaviour.

That definition — at least based on the membership of the ACP — includes not only lawyers, consultants and accountants, but doctors and dentists, surveyors and engineers, veterinarians, geologists, psychologists and others.

But it equally excludes a vast number of people whose work, while professional in context, lacks formal accreditation: designers are unlikely to be caught up in the rules, for example, but architects probably would be.

The broad use of terms like accreditation, ethical guidelines and specialist knowledge are not defined by law so could include groups like real estate agents, but it is far from clear.

In other words, it is a shot across the bow for business owners who share in profits, based on some fairly arbitrary distinctions as to whether the ATO considers them to be professionals or not.

Ironically, the PCG creates market distortions, by putting business owners who are required to follow ethical guidelines and uphold a high standard of behaviour at a competitive disadvantage to those who don’t face the same formal requirements in their line of work.

What will it mean for people in this situation?

The lack of consistency is one of the reasons professional services groups are so unhappy about the PCG — but not the only one.

The new guideline, which the ATO concedes “does not set out the commissioner’s interpretation on the application of relevant laws,” tries to create a risk assessment framework for professionals whose firm derives income from a business structure rather than personal services income of a professional, or income related directly related to their personal exertion.

It uses three risk zones, labelled green, amber and red.

Falling in the red or amber zone means “the commissioner is likely to give closer attention to the individual facts and circumstances of the arrangement, including a deeper consideration of whether anti-avoidance provisions apply”.

There are also two gateways that must be passed before the risk assessment framework can be applied: whether the existing structure arrangement has a genuine commercial basis, and whether there are high-risk features within the arrangement.

Suggestions on what ‘high-risk’ means here includes financing arrangements relating to non-arm’s length transactions, or multiple classes of shares or units held by professionals who don’t also hold equity (not an uncommon circumstance in some firms where profits are shared with partners in name but not holders of an equity position).

If a professional’s circumstances fail to pass either of these gateways, the ATO suggests it might view the arrangement as an attempt to redirect income away from the individual.

In other words, rather than a structure set up for talent retention, for example — which is sometimes the case in firms with more aspiring partners than available equity stakes — the ATO is likely to see the arrangement as tax avoidance.

After widespread opposition to the PCG draft, the ATO has clarified some elements of the gateway provisions and risk assessment in the final version of the guideline, but questions remain. For example:

• It remains unclear as to what exactly the ATO would consider a commercially driven arrangement to pass Gateway 1;
• The ATO only lists a few ‘high-risk’ features that might be red flags for Gateway 2, but this cannot be an exhaustive list. Nor are those features listed as uncommon as the ATO might assume;
• Implications around the timing of profit sharing are also unclear. In the real world, profit distribution can sometimes take place well after the profit was made, and it is not clear, for example, how the ATO would view franked dividends paid to partners after the end of the income year in which they were made; and
• The legal standing of the guideline also remains uncertain — as the ATO itself notes.

I’m a professional: What are the implications?

The short answer to this is that if you, as owner of a professional business or associated with one, are a white-collar worker, a member of an accrediting body, with specialist knowledge who derives income from a business that is not counted as personal services income, you may find you fall under the general scope of the guideline.

As such, it would be wise to consider three questions.

1. Is your arrangement considered “low-risk” under the Suspended Guidelines?;
2. Would it be viewed by the ATO as commercially driven?; and
3. Does it exhibit any ATO considered high-risk features?

If yes to any of the above, the new PCG doesn’t apply to existing arrangements until July 1, 2024.

After that date, you will need to pass the gateways and assess how risky — if at all — your personal arrangements might be.

If you find that current arrangements considered low risk under the Suspended Guidelines would now fall in the amber or red zone for risk, you have until June 30, 2024 to modify your arrangements or risk facing ATO scrutiny.

For those planning to acquire equity in a professional practice, the new guidelines will apply to you from July 1, 2022.

Either way, seeking advice to understand the scope of the PCG and how it might impact your tax position is critical.

And if you are not technically a professional but have a similar arrangement in place?

Well for now, Joe the Builder can progress without fear he will be in the ATO spotlight in relation to how his profits are earned and shared.

Whether he will continue to avoid that scrutiny remains to be seen.