In our first article we discussed how the ATO are again taking aim at how Professional Services Firms allocate their profits to the owners (Principals) with the announcement late last year that they will start contacting Professional Service Firms to “assist” them in managing those risks.
The ATO issued PCG 2021/4 outlining the ATO’s compliance approach in regards to how profits are allocated within Professional Service Firms. The PCG was to apply from 1 July 2022, so the 2023 tax year will be the first year the ATO expects to formally apply its guidelines. However, where an existing Firm can satisfy the ATO’s former “suspended” guidelines, they will continue to apply through to 30 June 2024.
The PCG only applies to Professional Service Firms, which they define to mean “knowledge based services” including accounting, architecture, engineering, financial services, law, medicine and management consulting.
The object of the PCG is to determine the Firm’s risk level and as such, the level of engagement the Firm can expect from the ATO.
The ATO expects that the Principals/owners of Professional Service Firms will annually assess their eligibility to apply the PCG to determine their risk level.
The eligibility question is dealt with by two Gateways that the ATO expects Firms to satisfy in order to be able to use the PCG’s risk matrix. We dealt with those Gateways in our first article.
Where a Professional Services Firm has determined that it has satisfied the two Gateways, it can then undertake its 2023 Risk Assessment, using either the first two, or all three of the Risk Assessment Factors.
The first factor deals with the Principal’s share of their profit entitlement from the Firm.
This factors effectively requires a determination of all income derived from the Firm to which the Principal is entitled (based on their profit or equity share). This is by way of:
- Salary;
- Superannuation;
- Allowances;
- Fringe Benefits;
- Non-cash benefits;
- Dividends, including franking credits from ordinary and class shares; and
- Any trust distributions from the Firm or a related business, such as a Service Trust.
Once this figure is determined, you then need to identify what amount of all of the above profit entitlements (including superannuation) are returned in the “hands” of the Principal.
In order to stay within the ATO’s Low or Moderate Risk zones, between 50% and 75% of the Principal’s profit entitlement must be returned in their hands or in their own name.
The second factor deals with the total effective tax rate for all income the Principal is entitled to receive for that year.
This factor looks at aggregating the tax rate applied to essentially all of the income in the first factor to determine the average tax rate applied across the Principal and all other entities that receive part of this income.
This includes the tax rate of family members that receive either dividends or trust distributions, the tax rate of the Principal, the tax rate of a superannuation fund, and the FBT rate applied to the Firm where taxable fringe benefits are part of the Principal’s remuneration.
The ATO’s guidelines demonstrate how you can use the higher tax rate where the Principal or other taxpayers derive other non-Firm income to treat the Firm income as being taxed at the highest effective tax rate.
Using the ATO’s Risk Zones, for a Principal to qualify as either Low or Moderate Risk, the aggregate tax rate needs to be between 25% and 35% across all taxpayers receiving Firm income.
Professional Firm Principals need to aggregate their scores from the first two factors and then determine which risk zone they are in, Low, Moderate or High.
Those that fall within the High Risk zones may be subject to ATO compliance action and we are aware of the ATO beginning to undertake reviews across the professional services industry to understand how Firms and Principals are distributing their income.
The third factor, which is optional and, in our view, would only be used to lower a High risk rating after the first two factors, looks at the remuneration returned by the Principal as a percentage of the commercial benchmark for the Principal’s services.
In our experience this factor is particularly difficult to apply and should only be used in circumstances where a comparable commercial benchmark exists for remuneration of the specific Principal.
For Firms and Principals that can show that they still satisfy the ATO’s original, but now suspended, guidelines these new ATO guidelines will only apply from 1 July 2024, however for new Firms and those that do not satisfy the old guidelines, these guidelines apply from 1 July 2022. Accordingly, they will need to be considered in finalising a Principal’s 2023 remuneration and Firm profit distributions.