According to the Taxpayers’ Charter, the ATO has an obligation to treat all taxpayers equally; the Charter states (amongst other things):
“…We [ATO] do not discriminate against or favour anyone. We act with due care and diligence…We apply the law with balance, judgment, common sense and without bias…”
Yet it seems not all taxpayers are treated the same considering the recently released draft publications, PCG 2021/D2 Allocation of professional firm profits-ATO compliance approach (on 1 March 20201) and TR 2021/D2 Income Tax : personal services income and personal services businesses (on 11 March 20201).
PCG 2021/D2 – An Overview
Draft practical compliance guideline PCG 2021/D2 explains the ATO’s risk-based approach to individual professional practitioners (IPPs) and how their professional firms allocate profits. The Guideline provides a risk assessment framework designed to ensure personal exertion income of an IPP and profits generated by the business structure are not being inappropriately diverted to the IPP’s associates who are subject to lower marginal tax rates. Where an IPP attempts to alienate income generated from their personal exertion, the Commissioner will consider applying the general anti-avoidance provisions in Pt IVA of the ITAA 1936. The Guideline primarily applies to professional firms in the accounting, architectural, engineering, financial services, legal and medical professions.
It should be noted that there is no new tax law being introduced here. PCG 2021/D2 merely sets out the ATO proposed compliance approach to the taxation of income or profits from the provision of services by certain professional firms. If the ATO is meant to apply the tax law equally to all taxpayers why are professional firms in the accounting, architectural, engineering, financial services, legal and medical professions being singled out. There is no legal justifications as to why income generated by these professional firms is any different from income generated by businesses with skilled workers in other fields such as electricians, plumbers, financial planners, pharmacists etc. Having regard to the indicators of who should be treated as a ‘professional’ from the perspective of the ATO, and given that the basis of PCG 2021/D1 is to assist the ATO with identifying arrangements that alienate income from personal exertion, shouldn’t the risk assessment framework be extended to all skilled workers who are required to be accredited/licensed by the relevant regulatory bodies to enter into and maintain practice in their relevant field.
PSI ruling TR 2021/D2 – An Overview
Draft taxation ruling TR 2021/D2 is about the personal service income (PSI) rules contained in the Income Tax Assessment Act 1997 and purports to combine Taxation Ruling TR 2001/7 Income Tax : the meaning of personal services income and Taxation Ruling TR 2001/8 Income TAX : what is personal services business. The draft ruling clarifies the ATO view having regard to several judicial decisions which have further clarified the law since the issue of those earlier rulings. TR 2021/D2 contains 40 examples and practitioners may wish to consider examples 6 and 8 as follows:
Example 6 – not personal services income – income from a business structure
159. Jim is an electrician who operates a partnership with his wife, Jane. Jane does not perform any of the electrical work but performs some of the administrative work. Jim undertakes the work required by clients but engages three full-time employees who undertake electrical work for him. The partnership owns two vans equipped with the necessary tools and equipment that are used by Jim and his employees. The partnership has generated goodwill, having a trade name and approximately 150 regular clients. The income is derived from the business structure of the partnership and is not PSI.
Example 8 – personal services income – not business structure
161. Chris, Adrian and Simon are lawyers who provide their services as principals through CAS Law Firm, not as individuals but rather in their capacity as trustees for their respective family trusts. A service entity, CAS Services, provides office accommodation, all staff requirements, IT equipment, and other services as required for CAS Law Firm to operate. In the past three years, CAS Law Firm has established a wide customer base. Chris, Adrian and Simon each receive income from CAS Law Firm only in their capacity as trustees of their family trusts.
162. Applying the general guidelines for determining whether income from a practice company or trust is from a business structure, Chris, Adrian and Simon, as trustees, are principal practitioners. As CAS Law Firm has three principal practitioners (Chris, Adrian and Simon) and no other practitioners (principal or non-principal), the following various business structure factors are applied to determine if the income is generated by a business structure:
- Chris, Adrian and Simon operate a small firm.
- The firm has established a wide customer base.
- The services provided are legal services that can only be provided by qualified lawyers.
- The legal services provided by Chris, Adrian and Simon require a high level of knowledge and skill as well as substantial training and qualifications.
- The income-producing activities of the firm are dependent on the exercise of the personal skills, efforts and expertise of Chris, Adrian and Simon.
163.In this example, CAS Law Firm has established a wide customer base which suggests that it enjoys a measure of goodwill and its operations are quite extensive. On the other hand, it does not have substantial income-producing assets or employees so its income is dependent upon the rendering of the personal skills of each of Chris, Adrian and Simon. The income of CAS Law Firm is therefore mainly derived from the personal efforts or skills of Chris, Adrian and Simon rather than from a business structure. Chris, Adrian and Simon each have their own PSI to which they will have to separately apply the PSB tests to see if the PSI rules will apply.
The author notes that the fact pattern in both examples appear to be similar, to some extent. Both businesses are being operated under a partnership structure (albeit in Example 8 it is a partnership of trusts). Both businesses generate significant goodwill, have a trading name and a wide customer base. Both businesses operate in a skilled industry and its income producing activities are dependent on the exercise of the personal skills, knowledge, effort and expertise of the relevant individuals. Both businesses engage others to perform the principal work (albeit in Example 8 they were engaged via CAS Services as opposed to directly being engaged by Jim and Jane, the principal service providers in Example 6 as full-time employees).
Whilst there are no substantial income producing tangible assets being used to generate the income in Example 8, consultancy service industries do not generally require substantial investment in income generating assets. As the fact patterns in both examples are to some extent similar, it is difficult to understand why a different conclusion is drawn. One can only infer that either a disproportionate weight is being placed on some factual evidence (or lack thereof) more than others, or another possibility could be that a more stringent set of rules are being applied by the ATO to the legal profession and by extension (in light of PGC 2021/D2) to professional firms in the accounting, architectural, engineering, financial services, and medical professions. If it is the latter, then this breaches the ATO’s obligations under the Taxpayers’ Charter, as quoted above.
Business structure guidelines
It is worth noting that in determining whether income is from a business structure TR 2021/D2 at paragraphs 36 to 38 states:
36. Sole traders and PSEs that are not practice companies may have regard to the following factors to determine whether their income is mainly a reward for the personal efforts or skills of individuals or is derived from a business structure:
- the number of arm’s length employees or others engaged by the sole trader or PSE to perform work;
- the existence of goodwill;
- the extent to which income-producing assets of the business are used to derive the income;
- the nature of the activities carried out;
- the size of the operation, and
- the extent to which the income is dependent upon a particular individual’s own personal skills, efforts or expertise.
Guidelines for determining whether the income from a practice company or trust is from a business structure
37. As a practical matter, in determining whether the income of a practice company or trust is generated from the business structure and not from PSI, the Commissioner’s starting point is to apply the following guidelines as a general rule of thumb:
- Where a practice company or trust has at least as many non-principal practitioners as principal practitioners, the income of the entity is considered to be derived from a business structure.
- Where a practice company or trust has fewer non-principal practitioners than principal practitioners, then whether the income is considered to be from a business structure will need to be determined by considering the various factors discussed at paragraph 36 of this Ruling.
38. For the purposes of applying these guidelines:
- ‘Practitioners’ include both full-time professional and non-professional staff who derive material fees for the practice. Part-time staff are counted proportionately.
- ‘Practitioners’ does not include administrative, clerical, or support staff. For example, a nurse under the direction of a doctor, or a legal secretary under the direction of a solicitor, are not practitioners unless they earn material fees in their own right.
- ‘Principal practitioners’ are those who own or share in the ownership of the practice, whether directly or indirectly.
- ‘Non-principal practitioners’ are those who are not principal practitioners; that is, who do not own or share in the ownership of the practice, whether directly or indirectly.
If the above guidelines (relevantly the factors discussed at paragraph 36) were to be applied to the fact pattern in Example 8, and had CAS Law Firm employed three or more fee earning junior solicitors, will the ATO then treat the income generated by the firm as being derived from a business structure? Will the ATO then concede that PCG 2021/D2 would not apply since the IPPs are appropriately commercially remunerated for the services they provide to the firm, most importantly if the ATO does not concede, why not? It seems that it is becoming increasingly more difficult to convince the ATO that income generated by professional firms is not income from the personal exertion of the principals.
Part IVA of the ITAA 1936
It should be noted that TR 2021/D2 dispels the misconception that a personal service entity (PSE) or a sole trader conducting a personal service business (PSB) provides safe harbour against the application of the anti-avoidance provisions contained in Part IVA. Example 40 illustrates that Part IVA would apply if it can be concluded that the dominant purpose of the arrangement is the splitting of PSI even though the PSI rules do not apply.
Once finalised PCG 2021/D2 will apply prospectively from 1 July 2021. For TR 2021/D2, it is proposed to apply to arrangements begun to be carried out from the date after TR 2001/7 and TR 2001/8 are withdrawn. Going forward, it seems that some skilled service providers such as accountants, lawyers, medical professions will be faced with a higher compliance burden than others.
This article provides a general summary of the subject covered and cannot be relied upon in relation to any specific instance. Webb Martin Consulting Pty Ltd and any person connected with its production disclaim any liability in connection with any use. It is not intended to be, nor should it be relied upon as, a substitute for professional advice.