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PKF Australia

Accountants and Business Advisers

Taxation of Professional Firms: Where are we at?

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Evan Brownsmith

Director

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Taxation of Professional Firms: Where are we at?

Key Points

  • The ATO commonly take a view that complex practice structures are primarily designed to deliver a tax benefit. This places many practitioners at risk of audit.
  • On 14 December 2017, the ATO suspended its “Assessing the Risk: Allocation of profits within professional firms”.
  • The ATO recently advised that taxpayers within arrangements existing at this date can continue to rely on the suspended guidelines for the 2018-19 year.

Many professional practices have traditionally operated as partnerships, often due to professional restrictions. As the professions have modernised, the restrictions softened and many professionals now practice through companies or trusts.

These operating structures provide superior asset protection to professional service providers – such as lawyers, accountants, engineers and medical practitioners. They may also provide significant tax benefits.

For this reason, the taxation of professional services income has brought practice structures under scrutiny within the Part IVA anti-avoidance provisions.

The stance adopted by the Australian Taxation Office (ATO) consistently undervalues the relevance and effectiveness of asset protection. The Commissioner has routinely argued that complex practice structures are principally designed to deliver a tax benefit.

ATO Guidelines: Allocation of Profits

The ATO accepts that income will be derived from the 'business' of a professional practice, and not from personal exertion, where there are at least as many non-principal practitioners as ‘principal’ practitioners (IT 2639).

In 2014, the ATO introduced guidelines to assist professionals in determining whether the allocation of profits from professional practices will attract attention under Part IVA. Arrangements will be rated ‘low risk’ if they satisfy one of the following guidelines:

  • The principal practitioner receives a commercial return for their services, measured by reference to the highest band of professional employees within the firm, or a comparable firm or an industry benchmark;
  • 50% or more of the income to which the principal practitioner and their associates are collectively entitled, is assessable in the hands of the principal practitioner; and
  • The principal practitioner, and their associates, all have an effective tax rate of 30% or higher on the income received from the firm.

A principal practitioner may legitimately choose to operate outside the guidelines but will be subject to enhanced risk of an ATO review or challenge. The further a principal practitioner departs from the three tests, the higher the risk of ATO review.

Example – XYZ Legal Services Pty Ltd

Xenophon, Yass and Zdrilic operated a professional practice under a partnership model for many years. To aid succession and to deliver better asset protection they incorporated the practice as XYZ Legal Services Pty Ltd.

In the 2019 financial year each principal earns a salary of $150,000 and a $120,000 franked dividend.

 

Notes

Xenophon Family Trust

Yass Family Trust

Zdrilic Family Trust

Dividend XYZ LS Pty Ltd

 

120,000

120,000

120,000

Franking Credits

 

45,517

45,517

45,517

 

1

165,517

165,517

165,517

Distribution of Trust Income

       

Principal

 

50,517

20,517

517

Spouse

 

75,000

120,000

150,000

Adult Child

2

40,000

25,000

15,000

   

165,517

165,517

165,517

Notes:

  • Total trust income includes dividend from XYZ Legal Services Pty Ltd, plus franking credits.
  • When utilising children as beneficiaries, care must be taken to ensure their marginal tax rate is at least 30% or the taxpayer risks breaching the guidelines.

 

 

Calculation

Xenophon Family Trust

Yass Family Trust

Zdrilic Family Trust

Income Assessed to Principal:

       

Salary

 

150,000

150,000

150,000

Trust Distribution

 

50,517

20,517

517

 

A

200,517

170,517

150,517

Total Assessed to Family Group:

       

Salary

 

150,000

150,000

150,000

Trust Distribution

 

165,517

165,517

165,517

 

B

315,517

315,517

315,517

% of income assessed to Principal

A÷B

64%

54%

48%

 

Xenophon receives 64% of the practice income assessed to his family group and is low risk. Zdrilic receives less than 50%, and may attract the attention of the ATO.

Conclusion

It is clear from this example that practitioners can operate within ATO guidelines and still achieve significant tax advantages. Although, care must be taken not depart from accepted commercial norms.

PKF recommends you regularly review your practice structure to assess your risk relative to the ATO guidelines. Contact your PKF adviseor today for a practice health check.


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