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Arrangements that fail to satisfy a gateway or fall into the higher risk zone under PCG 2021/4 may increase audit risk but will not necessarily be Part IVA, says a specialist lawyer.
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Professional profits guidance a ‘blunt tool’ for assessing risk
18 September 2023
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A specialist law firm is alerting accountants that arrangements involving the allocation of professional firm profits that fail a gateway or fall into a higher risk category under the “blunt tool” of PCG 2021/4 do not mean that Part IVA applies.
Cooper Grace Ward Lawyers partner Fletch Heinemann said that where arrangements were being tested for Part IVA under the PCG 2021/4 guidelines, it was important to realise there was a difference between audit risk and legal risk.
“We’re going to get a different result if we’re looking at the audit risk [for the client] versus their legal risk,” said Mr Heinemann during a recent webinar. “It’s really important to get that distinction right because the client is going to have to make a call on what they want to do based on an understanding of both their audit risk and their legal risk.”
Mr Heinemann said the PCG provided some level of comfort that just because a gateway was not satisfied or the arrangement was in the higher-risk red zone, it did not necessarily mean that Part IVA would apply.
“So even though being in that red zone will mean that your audit risk is high, it doesn’t mean that Part IVA is going apply,” he said.
“We’ve had tonnes of cases where people have put arrangements to us since [these guidelines] were first mooted a few years ago, where people have said, ‘I can’t believe my arrangements are falling in the red zone, I don’t understand why they’re in the higher risk zone’ and those arrangements are not Part IVA.”
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One example of a genuine arrangement that could end up in the red zone involved maternity leave, said Mr Heinemann.
“We had people who were going on maternity leave for a particular period of time and because the income had dropped off below effective marginal rates, they were suddenly in the red zone for a particular period despite very low levels of income splitting going on,” he said.
“Similarly we’re also seeing genuine arrangements where we’ve got different classes of units where again we’re getting particular circumstances that are falling within that red zone.”
“However, when you really drill down into it to determine whether the solo or dominant purpose for the structure and distribution is designed for someone to pay less tax, we’re coming to the conclusion that objectively, it’s probably not.”
Mr Heinemann said the Commissioner’s concerns were relatively straightforward regarding the allocation of professional firm profits.
“The crux of it is that where there is income from a business structure and there is a partner or director working in the business, the Commissioner wants to see some income returned in the partner’s individual name and they want that to be an amount that’s commensurate with the amount of their contribution, so the personal exertion part of that income. However, that becomes really difficult to figure out in practice.”
Mr Heinemann said this was why the risk matrix set out in PCG 2021/4 was a “fairly blunt tool” for figuring out Part IVA risk.
“It’s a risk assessment [tool] rather than [something] that’s going to give an answer as to whether an arrangement is avoidance,” he said.
PCG 2021/4 sets out two gateways, one which looks at the commercial rationale of the arrangement and the second which looks at the high-risk features. If taxpayers satisfy Gateway 1 and 2, they can then self-assess their level of risk.
With Gateway 1, Mr Heinemann said the Commissioner was looking at whether the arrangements were overcomplicated, whether they served a purpose other than to gain a tax advantage, whether or not the tax result was consistent with the commercial result, and where there were significant risks expected but no risks in practice.
The ATO was also looking at whether parties were operating on non-commercial or non-arm’s length terms and whether there was a gap between substance and legal form.
“In a lot of the cases that we’re reviewing, I’m not seeing any difficulties with the actual structure itself. So typically, the structure that we’re looking at is that we’ve got a company and we’ve got a discretionary trust that owns shares in the company or we might have a partnership with discretionary trusts,” he said.
“So the structure itself is not particularly complicated. And there are commercial reasons as to why you would want to use that structure.”
The second part to be dealt with in Gateway 1 was the actual distribution of income.
Mr Heinemann said the Commissioner was looking at whether the principal received profits that were reflective of their personal efforts or skill, that income had been distributed, whether there were loan accounts relevant to the arrangement and whether the principal had control over the firm’s cash flow and financials.
“The bulk of it is how much of the income is being distributed to other entities and for other reasons in the sense that it’s a return based on the net profits of the business structure or potentially the assets,” he said.
“If we’re thinking about an accounting or legal practice, we might be thinking about the business structure part of the income being that income generated by the employees. However, if you think about it in a medical practice context, for example, where you’ve got some pretty expensive equipment at times, then part of the income from the business structure side of it will be a return on that equipment, as well as potentially the employees using that equipment.”
“So again, the PCG risk assessment matrix is a pretty blunt instrument to deal with a set of circumstances where businesses are going to be operated very differently in practice. What is a proper return or an appropriate return for the individual is going to change [across different businesses].”
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