A Tax Audit? Who? Me?
Taxpayer Alert TA 2013/3
Allocation of Profits within Professional Firms
It may come as a surprise to many lawyers and other professionals to learn that the Tax Commissioner thinks you might “misuse (discretionary trusts) … to avoid … tax …” (my emphasis), and if you don’t start paying more tax you will have the invigorating (and perhaps novel) experience of your own personal tax audit.
This sort of strong language (by itself) may be enough to convince some people that they really have been avoiding tax, and they should mend their ways. At the other end of the spectrum, maybe the Commissioner’s statements are only threats, light on legal justification and just a low cost way for the ATO to scare some more tax dollars out of easy targets.
This paper considers (in a general way) the ATO view of how much of a law firm’s profits should be taxed in the hands of individual practitioners, the history of ATO campaigns against professional firms, the justifications for the current ATO position and the choices that need to be made in response to the ATO campaign.
Context
Questions about how professionals structure their business activities and how these structures are taxed have been on the table for a very long time, including Tupicoff’s case in 1984 (Tupicoff v Federal Commissioner of Taxation 84 ATC 4851). In this case the anti-avoidance rules operated to negate any tax benefits Mr Tupicoff otherwise achieved by receiving income from selling insurance through a trust, rather than directly as an individual, as had previously been the case.
There has been a lot of litigation and extensive ATO activity around the dividing lines between employees, contractors, personal services income and professional firms in the 30 years since the Full Federal Court handed down its judgement in Tupicoff. There has also been a lot of change in the ways in which professionals are allowed to operate their practices, as well as changes to preferred business structures generally, for a whole range of reasons including amendments to tax laws in the Small Business Capital Gains Tax (“CGT”) Concession area.
One constant has been that dealing with the dividing line(s) between the taxation of “work income” and “business income” can be a nightmare, mixing vagueness and complexity with the threat of punitive tax outcomes if you are unlucky enough to guess wrong and attract the Commissioner’s attention.
The pain can start with trying to identify the difference between employees and contractors for tax purposes, continue through the Personal Services Income rules (PSI) and end up in the Tax Bermuda Triangle, where even if the relevant income is generated by a business “structure”, the ATO may still be unhappy with the tax outcomes that may arise, and threaten Part IVA.
Changes to Professional Firm Structures
In recent years the rules restricting the ways that professional firms can be set up have changed, so that subject to professional association requirements and relevant legislation, professional firms can now take a variety of shapes, including a company, trust or a partnership of discretionary trusts.
From a tax perspective, the benefits of operating a business or income generating activity through a discretionary trust are obvious and there are many hundreds of thousands of discretionary trusts in use in Australia. Trusts also provide a measure of asset protection in many circumstances, although professionals may still retain some personal liability in some cases.
Partnerships of trusts are not the only way professional firms are structured. Often these choices are a balancing act – a company with shares held by discretionary trusts can provide limited liability, allow for complex group structures and different share classes can be used to give different income entitlements. Of course, companies can’t access the CGT discount, amongst other things.
ATO issues with Practice Structures
The proliferation of practice structures which are no longer limited to partnerships of individuals has changed the playing field as far as income splitting is concerned. If you can operate your practice directly through a discretionary trust (for example), then maybe all the complex service entity rules, paperwork and risk are no longer all that relevant, and that may provide some explanation of the reasons behind the new ATO crackdown.
Given the historical campaign the ATO has conducted to keep smaller professional practices on one side of the fence with larger firms on the other side, it probably shouldn't come as a great surprise that the ATO has now taken aim at practices that involve discretionary trusts.
The ATO has adopted a similar approach this time around to the way it dealt with Service Entities in 2006. As we will see, the ATO has again set out some quasi safe harbours and threatened audit activity if you stray too far from the party line. The Service Entity audit threat approach is probably being repeated because it works, at least from the Commissioner’s perspective.
It is worth noting that the Inspector General of Taxation looked at the ATO actions in relation to service entity arrangements as part of his review of the ATO management of complex issues, and we can expect that the ATO will have learned from that experience.
Taxpayer Alert TA 2013/3
The ATO fired a shot across the bows of professionals using discretionary trusts with Taxpayer Alert TA 2013/3 – “Purported Alienation of Income through Discretionary Trust Partners”.
This Taxpayer Alert addressed ATO concerns that discretionary trusts partnerships could involve alienation of income, unreported CGT consequences and may amount to schemes to which Part IVA applies.
When the ATO says “purported” it probably has in mind cases like “Kelly” (Kelly v Commissioner of Taxation [2012] FCA 423), where attempts to assign individual partners interests in a law firm partnership were ineffective at law (at least in some cases) so that the claimed tax effects did not accrue. Kelly also tells us that where an assignment is properly implemented, discretionary trusts can have interests in professional firm partnerships.
Assessing the risk: Allocation of Profits within Professional Firms
The next major step in the Commissioner’s campaign against these structures was the issue of a publication titled “Assessing the Risk: Allocation of Profits within Professional Firm” in September 2014. These guidelines set out how the ATO will assess risk relating to the inclusion of firm income or profit in the assessable income of the Individual Professional Practitioner (“IPP”), or in plain English, who the Commissioner will target for audit.
The guidelines point out that they only apply where a business is being carried on by a legally effective partnership, trust or company. The point the ATO is making here is that if the steps required to assign interests, for example, have not been properly implemented or were simply misconstrued then you won’t get the intended tax benefits in any case.
The guidelines only apply where a business structure generates the firm income, so that if the PSI rules apply (because, amongst other things, there is no personal services business being carried on) the guidelines do not need to be considered, and the safe harbours in the guidelines don’t offer any safety.
When are the “guidelines” triggered?
The ATO say its guidelines apply to professional firms, including but not limited to firms providing accounting, architectural, engineering, financial services, legal and medical services.
The guidelines operate where:
· an IPP provides professional services to firm clients; or
· is actively involved in the management of the firm;
· the IPP or associated entities have a legal or beneficial interest in the firm;
· the firm operates through a legally effective partnership trust or company; and
· the firm income is not personal services income.
Removing (or reducing) the Bullseye
As with the service entity program, the ATO gives some guidance on what may be high risk or low risk, bearing in mind that low risk does not actually guarantee anything. Apart from a loss of face, there is probably nothing in the law that would prevent the ATO conducting an audit and raising an amended assessment in any circumstances if they feel that way inclined.
Assuming a level playing field, we know that the ATO wants you to move to the low risk end of the scale and that should at least make you a smaller target, if not a protected species.
Low Risk
The ATO says you (the taxpayer i.e. the IPP) will be low risk and not subject to compliance action (on this point) if following is satisfied:
It is worth remembering that these numbers are simply the Commissioner’s view of where he wants people to be. While there has most likely been a lot of work done at the Treasury and ATO to settle on these low risk positions, they are not the law nor is it a scientific undertaking.
Higher Risk
The ATO says that if none of these guidelines can be satisfied you will fall into the “higher risk” category. Within that higher risk category, the lower the effective tax rate the bigger the bullseye.
Conclusion
The Tax Commissioner has had professional firms and income splitting high on his agenda for decades. The issues he was prepared to litigate 30 years ago are pretty much the same type of issues he is willing to litigate now in cases like Kelly.
Using the threat of audit to modify taxpayer behaviour generally is not new, and the safe harbour approach being offered to discretionary trust partners is pretty much service entities revisited.
Whether you think the Commissioners current campaign against professional service firms is a natural next step reflecting changes in the way firms can be structured, or see it as a bully campaign light on law, the reality we face is that these issues are clearly high on the Commissioner’s agenda.
The Commissioner has made it abundantly clear that he will look to apply Part IVA if he doesn't like the tax outcomes that discretionary trust arrangements produce. We know that Part IVA is a high cost weapon for the ATO because it needs to look at individual circumstances. The need to look at the facts of each case can be a two edged sword because it requires taxpayers to reach their own view on whether or not the ATO is likely to be successful with Part IVA, and that is a costly and imprecise process at the best of times.
Of course, even before we get to Part IVA, transactions “purporting” to assign interest in partnerships to discretionary trust (for example) will be stress tested by the ATO and the courts to see how they hold up. If Kelly’s case is any indication, the intersection of complex partnership and trust law, the law of equitable assignments and tax is so hard for many advisors to navigate that the Commissioner may win plenty of cases on the grounds the arrangements are legally ineffective without having to trouble himself with Part IVA.
The challenges for all professional firms that come within the scope of the Commissioner’s new guidelines include the time, money, wear and tear and the reputational costs of dealing with ATO audit activity in your own practice. Unless you are particularly robust you might not want to spend your own money trying to prove that the ATO campaign is misguided.
If you are not attracted by the ATO safe harbour guidelines, it will be prudent to carefully consider the arrangements you have in place to ensure, as far as possible, that they actually have the legal effect being aimed for, that any claimed asset protection or other non-tax benefits are real, and that the important Part IVA issue of dominant purpose has been carefully considered.
Damian O'Connor
February 2015
Tax + Law
M: +61 0407195317
E [email protected]
W: www.taxpluslaw.com.au
Disclaimer
The material and opinions in the paper are of a general nature and should not be used or treated as professional advice. Readers should rely on their own enquiries in making any decisions concerning their own interests.
Copyright © D O’Connor 2015
Taxpayer Alert TA 2013/3
Allocation of Profits within Professional Firms
It may come as a surprise to many lawyers and other professionals to learn that the Tax Commissioner thinks you might “misuse (discretionary trusts) … to avoid … tax …” (my emphasis), and if you don’t start paying more tax you will have the invigorating (and perhaps novel) experience of your own personal tax audit.
This sort of strong language (by itself) may be enough to convince some people that they really have been avoiding tax, and they should mend their ways. At the other end of the spectrum, maybe the Commissioner’s statements are only threats, light on legal justification and just a low cost way for the ATO to scare some more tax dollars out of easy targets.
This paper considers (in a general way) the ATO view of how much of a law firm’s profits should be taxed in the hands of individual practitioners, the history of ATO campaigns against professional firms, the justifications for the current ATO position and the choices that need to be made in response to the ATO campaign.
Context
Questions about how professionals structure their business activities and how these structures are taxed have been on the table for a very long time, including Tupicoff’s case in 1984 (Tupicoff v Federal Commissioner of Taxation 84 ATC 4851). In this case the anti-avoidance rules operated to negate any tax benefits Mr Tupicoff otherwise achieved by receiving income from selling insurance through a trust, rather than directly as an individual, as had previously been the case.
There has been a lot of litigation and extensive ATO activity around the dividing lines between employees, contractors, personal services income and professional firms in the 30 years since the Full Federal Court handed down its judgement in Tupicoff. There has also been a lot of change in the ways in which professionals are allowed to operate their practices, as well as changes to preferred business structures generally, for a whole range of reasons including amendments to tax laws in the Small Business Capital Gains Tax (“CGT”) Concession area.
One constant has been that dealing with the dividing line(s) between the taxation of “work income” and “business income” can be a nightmare, mixing vagueness and complexity with the threat of punitive tax outcomes if you are unlucky enough to guess wrong and attract the Commissioner’s attention.
The pain can start with trying to identify the difference between employees and contractors for tax purposes, continue through the Personal Services Income rules (PSI) and end up in the Tax Bermuda Triangle, where even if the relevant income is generated by a business “structure”, the ATO may still be unhappy with the tax outcomes that may arise, and threaten Part IVA.
Changes to Professional Firm Structures
In recent years the rules restricting the ways that professional firms can be set up have changed, so that subject to professional association requirements and relevant legislation, professional firms can now take a variety of shapes, including a company, trust or a partnership of discretionary trusts.
From a tax perspective, the benefits of operating a business or income generating activity through a discretionary trust are obvious and there are many hundreds of thousands of discretionary trusts in use in Australia. Trusts also provide a measure of asset protection in many circumstances, although professionals may still retain some personal liability in some cases.
Partnerships of trusts are not the only way professional firms are structured. Often these choices are a balancing act – a company with shares held by discretionary trusts can provide limited liability, allow for complex group structures and different share classes can be used to give different income entitlements. Of course, companies can’t access the CGT discount, amongst other things.
ATO issues with Practice Structures
The proliferation of practice structures which are no longer limited to partnerships of individuals has changed the playing field as far as income splitting is concerned. If you can operate your practice directly through a discretionary trust (for example), then maybe all the complex service entity rules, paperwork and risk are no longer all that relevant, and that may provide some explanation of the reasons behind the new ATO crackdown.
Given the historical campaign the ATO has conducted to keep smaller professional practices on one side of the fence with larger firms on the other side, it probably shouldn't come as a great surprise that the ATO has now taken aim at practices that involve discretionary trusts.
The ATO has adopted a similar approach this time around to the way it dealt with Service Entities in 2006. As we will see, the ATO has again set out some quasi safe harbours and threatened audit activity if you stray too far from the party line. The Service Entity audit threat approach is probably being repeated because it works, at least from the Commissioner’s perspective.
It is worth noting that the Inspector General of Taxation looked at the ATO actions in relation to service entity arrangements as part of his review of the ATO management of complex issues, and we can expect that the ATO will have learned from that experience.
Taxpayer Alert TA 2013/3
The ATO fired a shot across the bows of professionals using discretionary trusts with Taxpayer Alert TA 2013/3 – “Purported Alienation of Income through Discretionary Trust Partners”.
This Taxpayer Alert addressed ATO concerns that discretionary trusts partnerships could involve alienation of income, unreported CGT consequences and may amount to schemes to which Part IVA applies.
When the ATO says “purported” it probably has in mind cases like “Kelly” (Kelly v Commissioner of Taxation [2012] FCA 423), where attempts to assign individual partners interests in a law firm partnership were ineffective at law (at least in some cases) so that the claimed tax effects did not accrue. Kelly also tells us that where an assignment is properly implemented, discretionary trusts can have interests in professional firm partnerships.
Assessing the risk: Allocation of Profits within Professional Firms
The next major step in the Commissioner’s campaign against these structures was the issue of a publication titled “Assessing the Risk: Allocation of Profits within Professional Firm” in September 2014. These guidelines set out how the ATO will assess risk relating to the inclusion of firm income or profit in the assessable income of the Individual Professional Practitioner (“IPP”), or in plain English, who the Commissioner will target for audit.
The guidelines point out that they only apply where a business is being carried on by a legally effective partnership, trust or company. The point the ATO is making here is that if the steps required to assign interests, for example, have not been properly implemented or were simply misconstrued then you won’t get the intended tax benefits in any case.
The guidelines only apply where a business structure generates the firm income, so that if the PSI rules apply (because, amongst other things, there is no personal services business being carried on) the guidelines do not need to be considered, and the safe harbours in the guidelines don’t offer any safety.
When are the “guidelines” triggered?
The ATO say its guidelines apply to professional firms, including but not limited to firms providing accounting, architectural, engineering, financial services, legal and medical services.
The guidelines operate where:
· an IPP provides professional services to firm clients; or
· is actively involved in the management of the firm;
· the IPP or associated entities have a legal or beneficial interest in the firm;
· the firm operates through a legally effective partnership trust or company; and
· the firm income is not personal services income.
Removing (or reducing) the Bullseye
As with the service entity program, the ATO gives some guidance on what may be high risk or low risk, bearing in mind that low risk does not actually guarantee anything. Apart from a loss of face, there is probably nothing in the law that would prevent the ATO conducting an audit and raising an amended assessment in any circumstances if they feel that way inclined.
Assuming a level playing field, we know that the ATO wants you to move to the low risk end of the scale and that should at least make you a smaller target, if not a protected species.
Low Risk
The ATO says you (the taxpayer i.e. the IPP) will be low risk and not subject to compliance action (on this point) if following is satisfied:
- The IPP gets an appropriate return for the services they provide to the firm as assessable income in their own hands:
- Income to which IPP and associated entities are collectively entitled (directly or indirectly) ends up as assessable income of IPP; or
- IPP and associated entities “both” have an effective tax rate of 30% or higher on income from the firm.
It is worth remembering that these numbers are simply the Commissioner’s view of where he wants people to be. While there has most likely been a lot of work done at the Treasury and ATO to settle on these low risk positions, they are not the law nor is it a scientific undertaking.
Higher Risk
The ATO says that if none of these guidelines can be satisfied you will fall into the “higher risk” category. Within that higher risk category, the lower the effective tax rate the bigger the bullseye.
Conclusion
The Tax Commissioner has had professional firms and income splitting high on his agenda for decades. The issues he was prepared to litigate 30 years ago are pretty much the same type of issues he is willing to litigate now in cases like Kelly.
Using the threat of audit to modify taxpayer behaviour generally is not new, and the safe harbour approach being offered to discretionary trust partners is pretty much service entities revisited.
Whether you think the Commissioners current campaign against professional service firms is a natural next step reflecting changes in the way firms can be structured, or see it as a bully campaign light on law, the reality we face is that these issues are clearly high on the Commissioner’s agenda.
The Commissioner has made it abundantly clear that he will look to apply Part IVA if he doesn't like the tax outcomes that discretionary trust arrangements produce. We know that Part IVA is a high cost weapon for the ATO because it needs to look at individual circumstances. The need to look at the facts of each case can be a two edged sword because it requires taxpayers to reach their own view on whether or not the ATO is likely to be successful with Part IVA, and that is a costly and imprecise process at the best of times.
Of course, even before we get to Part IVA, transactions “purporting” to assign interest in partnerships to discretionary trust (for example) will be stress tested by the ATO and the courts to see how they hold up. If Kelly’s case is any indication, the intersection of complex partnership and trust law, the law of equitable assignments and tax is so hard for many advisors to navigate that the Commissioner may win plenty of cases on the grounds the arrangements are legally ineffective without having to trouble himself with Part IVA.
The challenges for all professional firms that come within the scope of the Commissioner’s new guidelines include the time, money, wear and tear and the reputational costs of dealing with ATO audit activity in your own practice. Unless you are particularly robust you might not want to spend your own money trying to prove that the ATO campaign is misguided.
If you are not attracted by the ATO safe harbour guidelines, it will be prudent to carefully consider the arrangements you have in place to ensure, as far as possible, that they actually have the legal effect being aimed for, that any claimed asset protection or other non-tax benefits are real, and that the important Part IVA issue of dominant purpose has been carefully considered.
Damian O'Connor
February 2015
Tax + Law
M: +61 0407195317
E [email protected]
W: www.taxpluslaw.com.au
Disclaimer
The material and opinions in the paper are of a general nature and should not be used or treated as professional advice. Readers should rely on their own enquiries in making any decisions concerning their own interests.
Copyright © D O’Connor 2015
