While the scrutiny of the tax affairs of professional services firms is nothing new, it is now being pursued with renewed vigour by the ATO. The ATOs main concern is with the allocation of profits and the extent to which they should be taxable to the individual partners and principals.
As such, professional services firms, and their partners and principals need to be acutely aware of their tax risks.
It’s not just lawyers and accountants that are garnering the ATOs attention. Medical practitioners, engineers and architects, consultants and any other businesses that provide professional services will also come under the microscope.
Why professional services firms?
Partners and principals in professional services firms are often on the highest marginal tax rate. As such, arrangements which decrease the taxable income allocated to them as individuals, and increase the taxable income allocated to their associated family members and entities can be very attractive.
There are commercially reasonable and tax effective ways to achieve this. However, there are also strategies which don’t have the same commercial underpinnings. It is these latter situations that the ATO is actively targeting.
Service trust arrangements
Since the landmark Phillip’s case in 1977, when a partner in an accounting firm successfully defended the validity of his firm’s service trust arrangement, the use of similar arrangements has become common place in the professional services space.
Service trusts can be a highly effective mechanism for improving the asset protection position of professional firms, and can also deliver a number of tax planning benefits. However, it is not as simple as setting up a trust and applying the same mark ups as were used in Phillips case.
Firstly, you will need to demonstrate that the arrangements are legally and commercially effective. Questions the ATO may ask include: Are the right contractual arrangements in place? Are the services actually being provided by the trust? Are commercial benefits being derived from the arrangement?
A properly established and administered arrangement should pass these threshold issues.
Secondly, the ATO will review the financial position of the service trust. The margins applied will be to determine the service fee charged to the practice will be analysed (the ATO has published guidelines on acceptable margins). The ATO will also consider the proportion of the overall practice profit that is derived by the service trust.
If the service trust derives more than 50% of the overall profit of the practice, the arrangements will be considered a “very high” tax risk, percentages between 30% and 50% will be considered a “medium” to “high” tax risk.
Service trusts remain an area being actively reviewed by the ATO.
Remuneration of Partners and Principals
Recently the ATO has published guidelines on what constitutes a reasonable split of income between the partner/principal in a professional practice and his or her associated entities.
These guidelines are not based on particular judicial decisions or established legal precedents – they are practical, commercial guidelines that seek to distinguish arrangements that the ATO will accept (even though they may not necessarily agree with the treatment) and those which they won’t.
The message from the ATO is clear – the guidelines are like flags at the beach – swim between the flags and you will be okay, swim outside the flags at your own peril.
There are three guidelines. You only need to meet one to be considered “between the flags”:
- The partner/principal receives assessable income from the practice that is at least equal to the remuneration of the highest paid equivalent group of professionals employed in the practice.
- At least 50% of the overall assessable income to which the partner/principal and his or her associated entities are entitled too, is assessable income for the partner/principal.
- The partner/principal and each of his or her associated entities have an effective tax rate of 30% on the income received from the practice.
The form of the assessable income is not relevant – it is the end outcome that ATO is interested in.
The ATO intends to identify and audit professional firms with the view to taking them to Court to get judicial guidance on these issues. For the vast majority of taxpayers – it is better to “swim between the flags” than try and take on the ATO.
The ATO has also signalled a renewed focus on Everett’s assignments. These are arrangements were a partner in a partnership assigns the right to income from the partnership to an associated entity, usually their family trust.
Historically the ATO has accepted these arrangements and taken the view that the general anti-avoidance provisions (Part IVA) don’t apply. Everett’s assignments have become a regular feature of tax planning for partners in professional firms as a consequence. The ATO is now reassessing this position, but will only apply this change in views prospectively (for new arrangements entered into after 1 July 2015).
Where to now?
All professional services firms, and their partners and principals should take action to not only assess and manage their tax risks, but also to see if there valid tax planning opportunities that they are not currently taking advantage of.
Key considerations to assess tax risk:
- Review service trust arrangements. Look at the documentation in place, review the margins being charged, and consider the overall financial results achieved.
- Review partner remuneration to ensure that they fall within the ATO guidelines.
Key considerations for tax planning:
- Review the legal structure – amongst other attributes, does it allow for the maximum permissible amount of income to be distributed to associated entities?
- Review remuneration structures for partners – could a more tax effective or cost effective (think on-costs) way to remunerate principals be implemented?
- Look at the principal’s personal situation on a holistic basis. Strategies around debt and interest deductions can be effective, even if the majority of the income is still assessable to the individual partner or principal.
William Buck acts for many professional services firms and their partners and principals, and has extensive experience in dealing with these tax issues.