Taxpayer Alert TA 2013/3

Purported alienation of income through discretionary trust partners.

Overview

The Tax Office recently issued Taxpayer Alert TA 2013/3 warning about the use of arrangements where an individual purports to make the trustee of a discretionary trust a partner in a firm of accountants, lawyers or other professionals (firm), but fails to give legal effect to that structure or fails to account for its tax consequences.

While admitting that professional practices may legitimately operate as a partnership of discretionary trusts, the ATO clearly takes the view that many are misusing the arrangement and are obtaining tax benefits they are not entitled to.

The ATO concerns seem to centre around individual professionals deriving less taxable income than they would as individual partners but without being able to demonstrate the integrity of the structure through which they are operating.

Description

Taxpayer Alert TA 2013/3 applies to arrangements where a trustee of a discretionary trust (trustee) is appointed as a new partner in a professional firm or the individual assigns their existing interest in the partnership to the trustee. In considering whether the arrangement is “legitimate” the ATO will look for the following features:

• the trustee does not actively engage in the conduct of the firm’s practice and may not hold professional qualifications,
• the practice is carried on in much the same way as it had been before the trustee purported to become a partner, specifically:

a) the individual renders substantial personal services to clients of the firm,
b) the individual has the same or similar roles, responsibilities and obligations as they had before the trustee purported to become a partner,
c) the trustee arrangement does not result in any limitation of liability for the individual, as if they had been a partner,
d) the trustee arrangement does not assist in the provision of professional services by the individual.

• the amount of salary or other remuneration payable to the individual is considerably lower than the income which they formerly derived from the practice, or would have derived if they had been a partner,
• the individual has the ability to remove the trustee, revoke or alter the trust arrangement, or otherwise control the trustee’s interest in the partnership.

In addition, or in the alternative, the arrangement may have some or all of the following features:

a) inconsistencies in the documentation that make it unclear whether the individual or the trustee is a partner in the firm,
b) the individual contracts with clients or other third parties on the basis that the individual is a partner,
c) the firm or the individual represents to the public that the individual is a partner,
d) the trustee does not contribute any capital to the partnership,
e) the individual purports to make drawings from partnership equity for their personal use.
f) In each financial year:

i. the firm directs distributions of net profits of the firm to the trustee as partner of the firm. This distribution may correspond to the amount the individual could reasonably be
expected to have received if they had not entered into the arrangement.
ii.the trustee resolves to distribute most or all of the income to lower taxed beneficiaries of the trust.

g) The individual does not report any income from the professional firm in their tax return, except to the extent (if any) that such income is part of their entitlement as a beneficiary of the trust.

What are the ATO’s concerns?

Broadly, the ATO’s concerns with these types of arrangements revolve around whether:

a) the transactions referred to above are legally effective
b) any transactions intended to make the trustee a partner in the firm may give rise to, or increase, a net capital gain for the individual in the year of income,
c) the general anti-avoidance rules in Part IVA of the ITAA 1936 applies to cancel tax benefits obtained by the individual.

The Second Commissioner of Taxation, Mr Bruce Quigley, acknowledges that professional practices may legitimately operate as a partnership of discretionary trusts. The ATO’s concern is the aggressive “misuse” of these arrangements to avoid tax. It is also acknowledged that anti-avoidance provisions will not apply to assignments of partnership interests of the same nature as that considered in FC of T v. Everett 80 ATC 4076; 10 ATR 608 (Everett)

What action is the ATO taking?

The ATO is looking to review arrangements which it considers are a sham or ineffective in alienating the individual’s income, or where CGT has not been correctly recognised. The ATO is also reviewing relevant Tax Rulings and Determinations and consulting with relevant professional bodies. We note the ATO’s review of these arrangements will be in relation to the 2013/14 income year and later income years. The review is not retrospective.

What should you do?

If you have entered into a similar arrangement to that described above, or have a practice structure outside of a partnership of individuals, we recommend that you seek independent professional advice.

If you would like to discuss how this Alert may affect you and your practice please contact Whitehawk Advisors.