We have reported that there has been a lot of activity around the allocation of profits within professional firms, in the last 6 months (December 2017 to May 2018). [See Related TT Article]
In the light of this, we thought it worth surveying the types of structures, and some of the history, that gets us to the present position where the ATO is, again, interested in the ‘allocation of profits within professional firms’.
- An early example, in Peate’s case  HCA 84, was the insertion of a practice company, which employed the former medical practitioner partners, to provide medical services to patients (making the patient fees travel a loop through the company, where only part of this money made it to the employee/practitioners and the balance went as employer contribution the employee/practitioner’s superannuation). In those days employee superannuation was more generous than member contributions (a problem that now, no longer, exists). This was not an income splitting structure, because any profits left in the company, would have been taxed twice, if then distributed to shareholders (a problem fixed in 1986, by the franking system of imputing company tax to shareholders). This structure was struck down by the, then, general anti-avoidance’ provision: s260 of the ITAA36. This was a product of the times (1958 – 1960 years of income & 1964 ultimate appeal), in as much as, having a practice company, instead of a partnership, stood out, and begged explanation, which was easy enough to identify, as tax driven (in this case accessing favourable employer super contributions). Ultimately all of these factors fell away, as the Commissioner, later, accepted that ‘practice companies’, to only access employer superannuation, and not income split, were not struck down, as tax avoidance. Employer superannuation contributions are no longer more generous than member contributions. And, professional restrictions, on the mode of practice, have been progressively relaxed, over the intervening 60 years, to the point where they are structure neutral, and practices are commonly mediated by a separately incorporated entity.
- Next, in Phillips case  FCA 28, the Full Federal Court accepted that so called ‘service trusts’ were an effective way for a professional to split income with family members. The accounting firm: Fell & Starkey established a trust to employ non-professional staff and provide equipment and other services, for a fee, which was held to be deductible to the partnership and margin over cost, distributed to the professional/partner’s related entities, was not struck down, as tax avoidance, under the former anti-avoidance provision: s260 (in the 1972 & 1973 financial years). Some relevant features of this case, were that the pricing ‘mark ups’ (and thus profit in the trust) were reasonable by reference to market rates and the trust also offered a measure of asset protection to the partners. Another feature, worth noting, is that the trust’s income was not profits from carrying on the relevant accounting practice, and so could be shared by non-qualified people/entities. This was the first income splitting structure, that the courts held to be effective, and it formed a paradigm structure, that is still used today (though confined, rather tightly, by the Commissioner’s Guidelines on service trusts).
- In Everett’s case  HCA 6, the High Court held that a second type of structure was effective, for professionals to ‘split income’ with related entities (in his 1973 financial year). In this case, a partner in a legal practice: Dibbs, Crowther & Osborne, assigned 6/13ths of his interest, in this partnership, to his wife. His wife was legally qualified, also, and this assignment did not, therefore, offend the professional rules prohibiting an unqualified person sharing the profits of lawyers (a prohibition promptly relaxed by many professional bodies, after the success of this case). Interestingly, the Commissioner did not argue sham or general anti-avoidance (under the then still operational s260). Rather, the Commissioner pressed the point that the profits, of the partnership, were primarily derived by the partners’ personal exertion (although these profits were also generated by its goodwill, exertion of employees, and use of various assets). His essential point was that the income tax law can’t be construed as allowing a person to assign income from personal exertion – that it must be ‘derived’ before the assignment or tax avoidance. In the High Court, there was a dissenting judgement, but the best His Honour could do, was assert this principle and cite non-binding New Zealand authority. The majority, however, held that, despite the partner working in the partnership, his right to income was ‘proprietary’ – coming from his inter-se rights, with his partners, to apply their capital, and their efforts, to carrying on the legal practice, until the partnership is terminated; to then receive a share, of the net assets, of the partnership (after paying liabilities); and, in the interim, to receive profits, as struck, at the end of each financial year. The majority went on to hold, that by assigning an undivided share of the partner’s interest in the partnership, by deed, and for consideration, fully paid, the partner had successfully assigned a share of his existing legal rights, that carried with them, the right to annual income. In other words, he had transferred the ‘tree’ and, with it, the fruit from the tree. It held that such a transfer was not void, as ‘tax avoidance’ any more than transferring a share, and with it, the dividends that are later paid. The majority also held that, though, the assignor legally remained a partner, he held a share in his partnership interest, for his wife, as trustee. The result was that Division 6 of Part III of the ITAA36, taxed his wife on this share of the income (and not him as trustee). At the same time, it was Division 5 (of the same Part) that defined the quantum of partner’s taxable income (from the partnership) and thus the quantum, for tax purposes, of the income he held on trust for his wife.
- From about 1980, professional rules started to relax – initially to accomodate the advantage Everett’s case created. This has continued, to the current day, when it is now, generally, possible to practice in virtually any structure, and the profits can be shared by almost any one, provided all the professional work is controlled by suitably qualified professionals.
- In Galland’s case  FCA 402, the taxpayer pressed the Everett ‘envelope’, in two important ways, and succeeded. The first respect was, that the 49% assignment occurred just before year end, and the Full Federal Court held that this was effective to assign the whole the year’s income, from the partnership (reinforcing the High Court’s analysis, in the Everett case, that the right to income is proprietary, arising from his right, under the Partnership agreement, to profits only when calculated, at the end of each financial year). The second was that the ‘assignee’ was the trustee of a family discretionary trust, giving the partner great freedom, as to where the trust’s assigned partnership income might go (including, theoretically, back to himself). If this latter aspect had mattered, it might be that it pushed the envelope too far, and became tax avoidance, under s260, but the Commissioner did not argue this point, and the Court found against the Commissioner on the arguments he did press.
- In the three Gulland, Watson & Pincus cases  HCA 83, three doctors unsuccessfully attempted to split income (not just access employer superannuation contributions, as in Peate’s case). Each of the doctors had practiced as either on their own account or as a partner in a partnership. In or about 1977, they then sold the practice to the trustee of a family trust and became an employee, taking a salary that left the Trust making a profit, which accrued to the related party unit holders. In each case, the disputed assessment was for the 1979 year. Despite the rash of previous, successful income splitting cases (partnership interest assignments in Everett and Galland, and the service trust in Phillips’ case), the High Court held that these arrangements were void, as against the Commissioner because they offended s260 by their ‘purpose’ or ‘effect’ being to ‘avoid’ income tax. Ultimately, in 1979, it was still too rare for a doctor’s practice, to be carried on by a unit trust, for it to be explained as an ‘ordinary dealing’, and s260 defeated it has having the purpose of avoiding tax. (The ‘ordinary dealing’ test, precluded a person, being able to relevantly ‘predicate’, that the arrangement was entered into, for the purpose of avoiding tax – as was required in the important Privy Council decision, in Newton’s case (1958) 98 CLR 1.) Another way of looking at this was that the Peate precedent (of transferring a medical practice, to a company or trust) was just too strong to overcome – at least at that time.
- In 1981, a new general anti-avoidance provision replaced s260 (for arrangements entered into after 27 May 1981). This was in Part IVA of the ITAA36. It still operated on the same broad basis as s260, requiring there be a ‘scheme’ (s177A) that had the ‘purpose or effect’ (s177D & s177A(4)) of giving a party a ‘tax benefit’ (s177C), but it was defined in much more (agonising) detail. It also ‘rectified’, what many regarded as defects, in s260. Principally it could assess, when it was necessary, to reverse a ‘tax benefit’ and was not limited to just ‘annihilating’ arrangements (which had been the case, with s260, which could only deem offending arrangements ‘void’ as against the Commissioner).
- In 1985, Parliament introduced a ‘capital gains tax’ (CGT) into our tax law (originally in the ITAA36 and now in the ITAA97, s100-1 and following). This had the unexpected effect of almost killing off ‘Everett’ assignments, of partnership interests, which had been a popular means for professionals to split income. The partner could sell his/her interest for what he/she paid for it, but this would result in a deemed capital gain, because the assignee was a related party and the partner is deemed to receive arm’s length consideration (based on a multiple of revenue, which he/she had to keep working, to support, whilst the assignee didn’t).
- In 1986, the double taxation of company profits, ceased being a problem, when Parliament introduced a system for company tax paid, to be ‘imputed’ to shareholders, by a system of ‘franking’ dividends. This made it possible for a company carrying on a professional practice, to generate a profit, and not have it taxed again, when distributed to shareholders (and typically, in professional practices, all profit is distributed).
- Soon after this, it became increasingly common for practices to be conducted as companies (aided by the progressive relaxation of various professional rules about practice vehicles and sharing profits). Indeed, most did not bother about trading through a trust. Often, also, there was no attempt to split income, often taking all the profits out as deductible salary. The benefits were some limitation, for the professionals, on practice related liabilities and the relative ease with which they could introduce and exit ‘partners’ as shareholders.
- In 1999, however, Parliament introduced ‘small business CGT concessions’ in Div 152 of the ITAA97. They gave partners in professional firms, the opportunity to do ‘Everett assignments’ again, as the capital gain that will (usually) result, can be absorbed by these concessions. Initially, ‘small’ constituted having ‘net assets’ greater than $5m (and later $6m). Later, there was access by being a ‘small business entity’ ($2m turnover limit under Div 328 of the ITAA97). This was not limited to partnerships that could pass those tests, but, rather, on the partner had to pass those tests (as related party aggregation of assets or turnover, did not extend to the partner’s other partners – s328-130(2)). The May 2018 Budget measure, will change this, so that the concessions only apply to ‘small’ partnerships.
- In 2000, Parliament introduced Personal Services Income (PSI) provisions as Part 2-42 of the ITAA97. Though they sound relevant, in most cases, they won’t be. This is not because of the definition of ‘personal services income’ (‘income that is mainly a reward for your personal efforts or skills”), which is wide enough to include most professional services. And a key effect of these provisions, is assess PSI earned by a ‘personal services entity’ back to the person providing the services (which would be very relevant, if it applied). In practice, these PSI provisions will not be a problem, for most professionals. This is because they don’t apply if the ‘personal services entity’ is carrying on a ‘personal services business’ (s86-15(3) & s86-60(2)). Most professional practices will satisfy this ‘business’ test (in s87-15(2)) by passing some or all of: the ‘results test’ (s87-18); the ‘unrelated clients test’ (s87-20); the unrelated employees test (s87-25) or the ‘business premises’ test (s87-30).
- In 2007, Australia got its first publicly listed legal practice: Slater + Gordon. This was a company, carrying on a legal practice, using its capacity to issue tradable shares to acquire new practices and offer incentives to employees. It has endured, now, for 11 years and (save for a ‘near death’ experience, recently) has done very well. The Commissioner makes no suggestion that the General Anti-Avoidance Provisions apply, to this company and its shareholder.
- Trusts carry on practice, too – unit trusts, for arm’s-length parties, discretionary trusts (for single family practices).
- There are even partnerships of family trusts (usually with a corporate trustee). At this point, there is no need for an Everett assignment. The discretionary trust is, already, the partner and already has all of that income. Neither is there any obvious technical reason why the professional has to be paid any remuneration by either the partnership, or the partner trustee (assuming the professional is committed, somehow, to working in the practice). It would only be a question of whether such a feature might be enough to attract the operation of the General Anti-Avoidance Provisions i Part IVA of the ITAA36.
- And, in 2013, Parliament made further changes to Part IVA of the ITAA36 (the ‘general anti-avoidance provision’). A key change was to require assessment of whether the taxpayer could be expected to, for instance, have additional assessable income, by ignoring income tax effects (and thus only looking at non-tax / commercial considerations – s177CB(4)(a)(ii)).
Indeed, my central thesis, is that the only ‘weapon’ the Commissioner has, to influence the allocation of remuneration, to the individual professional (out of his/her overall equity entitlement) is the potential application of the General Anti-Avoidance Provisions in Part IVA. It seems to me that this has little scope to apply.
- Service Trusts were held to be immune from challenge under the former General Anti-Avoidance Provision: s260, in Phillips’ case (and still stands up if you follow the Commissioner’s guidance).
- Assignment of partnership interests allowed the assignee to derive the share of the partnership income and withstood challenge from s260 also, in Everett’s case. Indeed, the High Court even reached the same conclusion in Galland’s case (for the whole of the partnerships income that year, even though the assignment occurred on the right near the end of that year). I’m inclined to think that the result would be no different now, with the current Part IVA. It was CGT that killed Everett assignments, until the small business CGT concessions came in, and the 2018 Federal Budget announced changes to those concessions that would crimp but not eliminate that relief (for small partnerships). See related Tax Technical Article.
- Incorporated trading vehicles – was the area where the General Anti-Avoidance Provisions were effective, but this was back in 1964, when Peate’s case was decided and even in 1980, when the Gulland, Watson & Pincus cases were decided. Professional rules now widely allow incorporated trading vehicles of many types and they are routinely and widely used. In my opinion, it is very difficult to think that an arrangement would be struck down, as tax avoidance, now, just because there was an incorporated trading vehicle.
This remains a live issue, but it ought not be overstated, either.
Study questions (Answers available)
- Were the two cases, involving practicing through an incorporated entity: Peate’s case and the trio: Gulland, Watson & Pincus?
- Did these arrangements succeed in their tax objectives?
- Did ‘service trusts’ allow professionals to ‘income split’?
- Did assignments of partnership interests allow professionals to ‘income split’?
- Are ‘Galland and Gulland, the same case?
- Did the introduction of CGT kill Everett Assignments?
- Did small business CGT concessions revive Everett Assignments?
- Does the 2018 Budget, include a measure that will limit the range of firms, where partners can make fresh Everett Assignments?
- Is the scope of the General Anti-Avoidance Provisions, the main consideration for professionals wanting to ‘split income’?
- Is it just as hard, as in Peate’s case, to have the tax law accept that a professional practice can be carried on through an interposed incorporated entity?