The recent release of a guidance statement by the ATO has put income splitting in professional practices such as accountants, doctors, lawyers, and architects squarely in the spotlight. Our tax history is littered with a myriad of rulings and tax cases on the question of income splitting by professionals. While much of this was dealt with by the early 1990’s, in recent years the ATO has again started looking at such tax arrangements.
Broadly, the guidance statement makes the point that where remuneration received by a practising professional (be it by way of salary or profit share) is below what is reasonable for that individual, there is a strong suggestion that this constitutes a breach of the anti-avoidance provisions of the tax laws. The ATO has signalled that arrangements which in the past were acceptable under previous ATO public rulings may now be deemed unacceptable.
The guidance statement sets out three indicators which a professional can use to determine the degree of risk that an arrangement will fall foul of what the ATO considers acceptable. Meeting any one of the following will indicate low risk:
• The professional receives an amount of income which is more than the business’ highest-paid band of employees providing equivalent services (or if there are none then in line with comparable industry benchmarks);
• 50% or more of that owner’s profit share goes to the professional;
• The professional or their related entities each have an effective tax rate of 30% or more
If none of the above is satisfied, the arrangement will be considered high risk. In such a case, the lower the effective tax rate on the profit share, the higher the risk of ATO activity.
The guidance statement provides the following helpful example:
A professional firm subject to these guidelines has three equal trustee partners, with representative Individual Professional Practitioners (IPP’s) and 10 employees. It generates a profit of $1.5 million for the year. The three highest paid professional employees of the firm earned between $240,000 and $250,000 during the year. The IPPs at the firm bring in new clients, personally endorse the work of the employees, provide supervisory services, and represent clients in high-risk and high-value matters.
Trust Partner 1 distributes the $500,000 as follows:
o $300,000 to IPP 1
o $200,000 to a company owned and controlled by IPP 1.
Trust Partner 2 distributes the $500,000 as follows:
o $230,000 to IPP 2
o $20,000 to the spouse of IPP 2
o $250,000 to a company owned and controlled by IPP 2.
Trust Partner 3 distributes the $500,000 as follows:
o $60,000 to IPP 3
o $80,000 to the spouse of IPP 3
o $260,000 to a trust with losses
o $100,000 to a company owned and controlled by IPP 3.
Based on the guidelines above, IPP 1 will be considered low risk because they meet all three of the guidelines. IPP 1 is unlikely to be specifically reviewed for their allocation of profits.
IPP 2 does not meet two of the guidelines, because the amount returned by IPP 2 is less than that paid to the band of the highest paid professional employees of the firm, and IPP 2 does not receive 50% or higher of the profits in their own hands. However, IPP 2 satisfies the effective tax rate measure, and on the basis that IPP 2 demonstrates no aggravating factors, they will be considered low risk.
IPP 3 is considered high risk – they do not meet any of the guidelines. IPP 3 is likely to face additional enquiry from the ATO.
According to the ATO press release on this topic, the guidance statement is a draft, but notably it makes the point that it applies to the current (2014-15) tax year, with possible modifications impacting the 2016-17 year subject to the outcome of test cases which the ATO is seeking to run. As stated above, the guidance statement is aimed at professionals; tradespeople, who often operate in partnership with a spouse who generally has little if any involvement in the business, are outside the scope of the statement.
It would seem that the ATO may well be banking on the reluctance of taxpayers to get caught in the crosshairs of the ATO audit scope, and who will therefore voluntarily apply the low risk option. Unfortunately the costs of an ATO audit are real and significant, and not recoverable in the event that a taxpayer comes out with a clean bill of health.
RDL accountants is continuing to monitor this situation so we can keep you informed.