New ATO draft guidelines pose challenges for personal service businesses

The Australian Taxation Office (ATO) has released Draft Practical Compliance Gideline PCG 2024/D2 (the Draft PCG), which sets out its intended compliance approach with respect to the application of Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) to income splitting or retention of profit arrangements involving personal service businesses (PSB).

The Draft PCG expands on comments previously made by the ATO in Taxation Ruling TR 2022/3 and seeks to dispel the ‘incorrect assumption’ made by some taxpayers that where a PSB is being conducted and the alienation of personal services income (PSI) provisions constituted by Division 86 of the Income Tax Assessment Act 1997 (ITAA 1997) do not apply, then Part IVA will also not apply.

Overview

Broadly, an individual or personal services entity (PSE) will be excluded from the PSI rules where they are conducting a PSB. Absent this exclusion, the PSI rules may operate to attribute income to an individual and/or deny deductions for certain expenditure incurred in connection therewith.

A PSB will exist where a PSB determination is in effect , or the relevant individual or PSE satisfy at least one of four tests, being:

• The ‘results’ test;
• The ‘unrelated clients’ test;
• The ‘employment’ test; or
• The ‘business premises test.

Notably, the note to section 86-10 of the ITAA 1997 has always provided that Part IVA of the ITAA 1936 may still apply to cases of alienation of PSI that fall outside Division 86 (e.g., due to the operation of the PSB rules).

Draft PCG

The Draft PCG seeks to provide practical guidance on the types of income alienation or profit retention arrangements the ATO will consider of ‘low’ or ‘higher risk’ of Part IVA applying, and the likelihood of the ATO applying compliance resources to review those arrangements.

A view that is apparent throughout the Draft PCG is that a particular arrangement can often have two different schemes – a narrower scheme and a wider scheme, with the former in question instead of the wider scheme where a PSE is interposed for clearly commercial reasons (e.g., a tender requirement), but there remains concern that the PSE has failed to adequately remunerate the individual and instead distributed that income to associated entities with lower tax rates or retained the income in a lower-taxed entity. This view, which is informed by obiter commentary by Sackville J in Commissioner of Taxation v Mochkin [2003] FCAFC 15, is reflected in Example 7.  

At paragraph 35, the ATO non-exhaustively enumerate various ‘low risk’ and ‘higher-risk’ indicia that ‘may’ contribute to an arrangement being assessed as low or higher risk. Salient principles from those indicia include:

• The greater the extent of income alienation, the more likely an arrangement will be assessed as ‘higher risk’;
• The extent to which alienation reduces the aggregate tax liability on PSI will be a relevant consideration; and
• Whilst retention of net PSI (or part thereof) by the PSB will generally result in ‘higher’ risk, except in very limited circumstances. This includes where the retained funds are made available for an individual’s personal use (e.g., through a Division 7A-compliant loan).

At paragraphs 36 and 37 the ATO clarify that the Draft PCG is not intended to establish and acceptable level of income splitting, and that their decisions will be made on a case-by-case basis, in the context of which materiality will be a relevant factor.

Examples

The Draft PCG contains a total of 13 illustrative examples – six describing ‘low-risk’ arrangements, and seven describing ‘higher risk’ arrangements. A selection thereof are summarised below.

‘Low-risk’ arrangements

Example One: an individual providing accounting services to unrelated third party clients through a family trust by which he is employed, with supporting administrative services being provided by an associate of the first individual, who is also an employee of the trust. The trust self-assessed as a PSB and pays both individuals arm’s length remuneration and withholds requisite tax and superannuation amounts therefrom. After claiming allowable business deductions, the balance of the trust’s net income is distributed to the first individual whose PSI constitutes the trust’s income.

The ATO regard Example One as a ‘low-risk’ arrangement because the entire net PSI received by the trust has been included in the first individual’s tax return through the salary and trust distribution.

Example Four: owing to personal circumstances involving an unforeseeable serious medical procedure requiring a lengthy recovery period, an individual who provides his personal services as a solicitor through a controlled company, which has self-assessed as a PBS, is unable to complete a necessary profit analysis to determine the amount of the company’s income that should be distributed to him by 30 June and instead completes the analysis and directs the distribution in the following income year upon his recovery, whereafter the individual and his controlled company resume their usual, compliant behaviour.

The ATO accept Example Four as a ‘low risk’ arrangement because the temporary deferral of income tax was temporary and clearly driven by factors beyond the taxpayer’s control, whereas the normal pattern of behaviour resumed in the following income years, demonstrating that the timing difference was an isolated occurrence.

Example  Six: Example Six concerns the retention of profits by an interposed company for a commercial purpose. Specifically, an interposed company that engages the services of a specialist medical practitioner retains an amount of profits derived from the individual’s personal services to acquire a customer relationship management platform in the next income year. The ATO accept this arrangement as ‘low-risk’ on the basis that the acquisition of the asset has a clear commercial purpose (viz. the potential for the specialist medical practitioner to charge more for her personal services, take on more clients, and therefore increase future profits).  

‘High-risk’ arrangements

Example Seven: An individual broker who was previously found personally liable for defaults of her clients established a discretionary trust to prevent recurrence. Thereafter the trustee company of the trust enters into new arrangements with each of the individual’s previous clients for her personal services and all principles is done by her. Following a self-determination that the trust is a PSB, the trust resolves to distribute to distribute its net income to the individual and her children, who each pay income tax on their respective distributions at their marginal tax rates, although the distribution received by the individual broker is not commensurate with the value of her personal services, and the aggregate amount of tax paid by the three beneficiaries is less than it would have been if the individual broker returned the entire net PSI in her individual tax return.

The ATO posit the view that although the trust was interposed between the individual broker and her clients for a clearly commercial purpose (i.e., to limit personal liability), the narrower scheme involves the utilisation of an interposed entity to distribute net PSI without regard to the value of her personal services which generated the income, resulting ultimately in a tax benefit (i.e., less tax being paid). Therefore, the ATO view Example Seven as a ‘higher risk’ arrangement that would render it more likely to have cause to apply compliance resources to review the arrangement, including a consideration of whether Part IVA should apply.

Example Eight: An individual corporate consultant incorporates a private company through which to provide his personal services following advice from his accountant. After self-assessing as a PSB, the company pays the individual corporate consultant an amount for his services that is less than the income it receives therefor and is not commensurate with the value of the services he provided. The net profit retained by the company is loaned to the individual corporate consultant on Division 7A-compliant terms for his private purposes.

In respect of Example Eight, the ATO express concern that the use of the interposed entity does not provide the individual corporate consultant with any additional material commercial or practical benefit as compared to the previous arrangements whereby he was paid directly by clients for services provided, whereas the interposed of the company resulted in the non-inclusion of amounts that would otherwise have been included in his assessable income and the relevant retention of profits results in a tax benefit (i.e., less tax being paid). The ATO therefore regard Example Eight as a ‘higher-risk’ arrangement.

Interestingly, the ATO note that had the individual corporate consultant received an amount that represented a more significant part of the PSI derived, then although Part IVA could still apply, they would be less likely to have cause to apply resources to pursuing Part IVA on a materiality basis.

Key Takeaway

The Draft PCG, which once finalised will apply to arrangements entered into both before and after its due date of issue, has a due date of 11 October 2024 for any comments thereon, and is potentially of great impact to a significant population of taxpayers.

Of particular note is the broad application of the Draft PCG versus PCG 2021/4, which concerns the allocation of professional firm profits. Relevantly, the  scope of the latter was expressly limited to the allocation of profits or income from professional firms, the Draft PCG can apply to taxpayers in any industry, the scope of PCG 2021/4. Also relevant is the ‘narrower’ and ‘wider’ scheme dichotomy, which clarifies that commercially-justifiable structures may nonetheless attract the operation of Part IVA.

Given the various individual and entity tax returns require taxpayers to disclose information regarding the existence of a PSB, the Commissioner of Taxation will have a host of intelligence available to him by reference to which to conduct the compliance activity foreshadowed in the Draft PCG. Whilst the Draft PCG is not law and will remain something other than law even post-finalisation, it places taxpayers on notice regarding the ATO’s intentions regarding compliance activity and some of the bases for such compliance activity. The Draft PCG also includes useful information regarding the types of records the ATO will expect or require in the event of a review.

Please contact your local RSM advisor if you wish to discuss the potential application of the Draft PCG to your circumstances. 

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Please contact your local RSM advisor if you wish to discuss the potential application of the Draft PCG to your circumstances.