On 1 March 2021, the ATO released its Draft Practical Compliance Guideline PCG 2021/D2, which sets out its intended compliance approach to the allocation of professional firm profits. If you operate a professional firm including, but not limited to, accounting, architectural, financial services, medical and engineering the PCG may require a review of your arrangements.

What are Practical Compliance Guidelines?

The ATO issues practical compliance guidelines to inform the Taxpayers of their approach in relation to an issue. It does not replace the actual law. It merely sets out how the ATO intends to apply its resources when considering the affairs of a Taxpayer. If the Taxpayer has followed the PCG in good faith, the ATO says it will administer the law in accordance with the approach. However, the PCG does not bind the ATO to actually doing this.

Does PCG 2021/D2 Apply to Your Professional Firm?

Pursuant to paragraph 25 of the PCG 2021/D2, the ATO will only apply the guideline if all the following criteria are satisfied:

  • an individual professional practitioner ('IPP') provides professional services to clients of the firm, or is actively involved in the management of the firm and, in either case, the IPP and/or associated entities have a legal or beneficial interest in the firm;
  • the income of the firm is not personal services income;
  • the firm operates by way of a legally effective structure, for example, partnership, trust or company;
  • an IPP is an equity holder and holds full rights to participate in the voting, management, and income of the firm.

If all the above criteria are met, the ATO believes you must closely assess if your firm satisfies the following two gateways:

  • Gateway 1 - the arrangement is commercially driven; and
  • Gateway 2 - the firm and IPP do not demonstrate any high-risk features.

Gateway 1 - Commercial Rationale

The first gateway concerns whether there is a genuine commercial basis for the way the arrangements are structured, and profits are distributed. If the arrangement reflects the commercial needs of the firm, such as increasing profits, the arrangement is likely to be justified.

The ATO believes it is important that the arrangement is documented with evidence that the commercial purpose was or will be achieved.

Gateway 2 - High-Risk Features

The second gateway considers whether the arrangement contains any 'high-risk' features. Some examples of high-risk features the ATO have identified include:

  • financing arrangements relating to non-arm's length transactions;
  • exploiting the difference between accounting standards and Tax law;
  • multiple classes of shares and units held by non-equity holders;
  • arrangements where a partner assigns a portion of a partnership interest that are materially different in principle from Everett and Galland.

Risk Assessment Scoring Table

Where the preconditions and gateways are satisfied, the ATO uses the following risk assessment framework to ascertain what compliance attention they will generally give to the arrangement.

Risk Assessment Factor Score
1 2 3 4 5 6
(1) Proportion of profit entitlement from the whole of firm group returned in the hands of the IPP >90% >75% to 90% >60% to 75% >50% to 60% >25% to 50% 25% or less
(2) Total effective Tax rate for income received from the firm by the IPP and associated entities >40% >35% to 40% >30% to 35% >25% to 30% >20% to 25% 20% or less
(3) Remuneration returned in the hands of the IPP as a percentage of the commercial benchmark for the services provided to the firm >200% >150% to 200% >100% to 150% >90% to 100% >70% to 90% 70% or less

Based upon the score above, the ATO will ascertain a risk zone which the IPP falls into as follows:

Risk zone Risk level Aggregate score against first two factors Aggregate of all three factors*
Green Low risk ≤7 ≤10
Amber Moderate risk 8 11 & 12
Red High risk ‚â•9 ‚â•13

*Note: the use of the third risk assessment factor is optional - the ATO recognised that a commercial benchmark may be difficult to determine.

Broadly, an IPP who falls within the amber or red zone may be contacted by the ATO to undertake a review of the overall arrangement.

Status of PCG 2021/D2 & Transitional Arrangements

The Guideline is still in draft stage and once finalised will apply prospectively from 1 July 2021.

The ATO will allow Taxpayers who entered into arrangements prior to 14 December 2017 to continue to rely on the Suspended Guidelines for the 2018 to 2021 income years, as long as their arrangement complies with the Suspended Guidelines, is commercially driven and does not demonstrate any of the high-risk features outlined in PCG 2021/D2.

Further, the ATO is allowing a grace period till 1 July 2023 for practices that were considered low risk under the suspended guidelines but may have a higher risk rating under the new Guideline to modify their arrangements.

The PCG has been heavily criticised by the accounting professional bodies on the basis that the ATO position is not supported by the current Tax law. They believe that the ATO is trying to impose how they would like the Tax law to operate without it actually being law.

Nevertheless, clients who wish to minimise their risk should assess their affairs in line with the PCG.