From 1 July this year, the Australian Taxation Office (ATO) is proposing to implement new compliance guidelines for allocating professional firm profits. These guidelines will potentially affect the taxable income of legal practitioners for the 2021/22 financial years and beyond.
The draft compliance guidelines were released by the ATO on 1 March. They supersede previous ATO profit allocation guidelines that were withdrawn in December 2017. The ATO has advised that there will be a transitional ‘grace’ period for compliance with the new requirements until 1 July 2023.
Which legal practitioners will be affected by the new compliance guidelines?
The new compliance guidelines will affect legal practitioners who redirect income from their professional services to an associated business structure such as a company or trust. These taxpayers are referred to by the ATO as individual professional practitioners (IPPs).
The allocation of a professional firm’s profit to an IPP must pass two gateways under the guidelines. Firstly, there must be a commercial rationale for the firm’s business structure and profits must be distributed accordingly. Secondly, the profit distribution arrangement must not contain any elements that the ATO considers to be ‘high risk’ in terms of non-compliance with tax obligations, such as non-arm’s length transactions.
The new compliance guidelines will not affect legal practitioners whose earnings are subject to the personal services income tax regime.
Compliance risk assessment
The ATO’s draft guidelines contain a risk assessment framework for allocating professional firm profits. This framework allocates compliance risk as being in one of three zones:
- Green (low risk)
- Amber (medium risk)
- Red (high risk).
Firms whose risk is assessed as being in the amber or red zones are more likely to attract ATO compliance attention (for example, an audit) to ensure they are paying the appropriate amount of tax for the income earned and distributed to IPPs.
Three risk assessment factors are taken into consideration when determining the compliance risk zone:
- The proportion of total profits from the firm that are allocated to the IPP. The higher the percentage, the better.
- The total effective tax rate of firm income received by the IPP. Again, the higher the percentage, the better.
- The total remuneration received by the IPP expressed as a percentage of the commercial benchmark of services provided to the firm. Once again, the higher the percentage, the better.
The ATO allocates points to each risk assessment factor. A score of 10 or less across all three factors is required for a professional firm and IPP to be in the green (low-risk) zone. A score of 11 or 12 will place a firm/IPP in the amber (medium-risk) zone and a score of 13 or more will place it in the red (high-risk) zone.
How we can help
Ensuring your law firm’s compliance with the new profit allocation guidelines for IPPs is crucial. Our experienced team of business tax planning specialists at Wilson Pateras can provide professional advice to ensure your compliance. Contact us to discuss your specific situation.