Risk matrix in PCG 2021/4 a ‘blunt tool’ for assessing risk

A specialist law firm has reminded accountants that just because an arrangement involving the allocation of professional firm profits fails a gateway or falls into a higher risk category under PCG 2021/4, this does not mean that Part IVA applies.

Speaking in a recent webinar, Cooper Grace Lawyers partner Fletch Heinemann said that where arrangements are being tested for Part IVA under the ATO’s guidelines in PCG 2021/4, it’s important that clients are aware that there is a distinct difference between audit risk and their 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. 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,” said Mr Heinemann.

Mr Heinemann said the PCG provides some level of comfort that just because a gateway is not satisfied or the arrangement is in the higher risk red zone, it doesn’t necessarily mean that Part IVA will 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 plainly not Part IVA.”

One example of where genuine arrangements can end up in the red zone is where professionals go on maternity leave for a period of time, 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 are 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,” he said.

Mr Heinemann said this is why the risk matrix set out in PCG 2021/4 is a “fairly blunt tool” for figuring out Part IVA risk.

“It’s a risk assessment [tool] rather than [something] that’s going to give to give an answer as to whether an arrangement is avoidance,” he said.

The 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 is looking at whether the arrangements are overcomplicated, whether they serve a purpose other than to gain a tax advantage, whether or not the tax result is consistent with the commercial result, and where there are significant risks expected but no risks in practice.

The Tax Office is also looking at whether parties are operating on non-commercial or non-arm’s length terms and whether there is 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 that must be dealt with in Gateway 1 is the actual distribution of income.

Mr Heinemann said the Commissioner is looking at whether the principal received an amount of profits that is reflective of their personal efforts or skill, that income has been distributed, whether there are loan accounts relevant to the arrangement and whether the principal has 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].”